As an angel investor and business advisor on new ventures, I expect to see five-year financial projections from every entrepreneur. Yet I get more pushback on this request than almost any other issue. Founders point to the great number of financial unknowns in any new business, and are reluctant to “commit” to any numbers which may come back to haunt them later.
From my perspective, projecting financial returns is part of the homework every business person needs to do in sizing customer opportunity, product costs, pricing, competition and customer value, before expending their own resources in a highly risky venture. You need these projections to assess viability, set internal goals and milestones, and measure your team’s progress.
For investors, it’s more of a credibility and intelligence test. Does this entrepreneur understand the basics of business costs in the selected business domain, growth dynamics, and the competitive environment? Reasonableness and business sense are the issues, rather than accuracy, since everyone knows that key parameters will change often before success.
There is no black magic involved in predicting numbers, and I always recommend sticking with the some basic guidelines, outlined here. With these, if you can paint a positive picture for your new venture, I assure you that investors will sit up and take notice, and you will also know how to drive yourself and your team:
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Determine your gross margin on sales. Per-unit cost less your cost per unit sold is your gross profit margin. If you lose money on every unit, you won’t make it up in volume. As a rule of thumb, most new businesses need a margin above 50 percent, even on wholesale prices, to cover operational expenses and survive long-term as a business.
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Project unit-volume and price levels. Based on your market size and penetration expectations, size how many units you will sell, at what price, in every channel. This should ideally be a “bottoms-up” commitment from your sales team, not your own optimistic guess. Be sure to include expected volume cost and price reductions over time.
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Quantify overhead and growth costs. It’s amazing how fast costs escalate as you grow. You need 5 percent or more of revenue for marketing, more for new development, and people costs will double as you add benefits, insurance, training, IT and processes. Check competitor numbers and industry average statistics to get you in the right range.
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Set a target growth and market penetration rate. If you want to be assessed as a “premium” acquisition candidate down the road, an aggressive but reasonable target might be doubling revenue each year. For credibility, market penetration within five years should be at least 5 percent. Numbers far afield from these need special explanations.
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Calculate cash-burn rate and investment timing. Initial sales success means more cash will be needed for inventory, receivables, facilities and people. Project your cash burn rate to keep at least 18 months between venture capital or angel investments. You need to know how many units to sell, and how much time you need to break-even.
From a planning and strategy standpoint, I offer these additional recommendations to maintain your credibility with outside investors, and to balance your risk due to market uncertainty:
- Add a buffer to your investment calculations. Investment requirements should always be based on financial projections and cash-flow calculations, not on what you think you can negotiate. If your cash flow shows a shortfall of $750,000, add a 33 percent buffer, and ask for a million. Be willing to give up 20 to 33 percent of your equity to support this.
- Update financial projections at least every quarter. Financial forecasts for startups are assumed to be estimates that will be updated as more information is known. Adjust revenues quarterly or even monthly, and replace forecasts with actuals as soon as a period ends. A business plan with old projections, ignoring actuals, will kill your credibility.
- Avoid high-medium-low projections, as well as irrational ones. Investors want entrepreneurs to be aggressive, but don’t make projections that make you look like the next Google. Entrepreneurs tend to be driven by their own targets, so pick an aggressive one, and you will likely do better than starting with a conservative one.
I always recommend that entrepreneurs do their own financial projections, rather than rely on an outside expert, because it’s the process that adds the value, more than the numbers. For additional value, I suggest the use of a spreadsheet financial model, with a few variables, like price and volume. This allows a quick analysis of alternate assumptions, with revenue impacts.
You don’t need complicated ratios for a startup business plan, since you don’t have a history. On the other hand, without financial projections, you don’t have a viable venture proposal. You don’t need an MBA to be credible with investors, just some common sense business expectations, and passion based on some data. Most of us need full investor support to turn our dream into reality.
