There are two types of entrepreneurs that prepare
financial projections: 1) the "visionary entrepreneur" who considers financial projections silly, so he makes up numbers that look good in order to get financing; 2) the "intense entrepreneur" who develops a 1200 by 2000 cell spreadsheet that includes the number of software licenses she needs to buy over the five period.
If you are like first type of entrepreneur, you are in
danger that the funder won't trust your projections because they are “too good” to be true. This type of entrepreneur often distances investors and lenders because of his casual attitude. However, if you are the second type of entrepreneur, you run the risk that the funder will think that you actually believe your projections.
Entrepreneurs must remember that there is only one type of funder: a person who doesn't believe your financial projections, whatever they are. So, what is an entrepreneur to do?
The reason for financial projections is to inform the lender or investor about an opportunity using numbers to create the story. Financial projections outline the resource requirements, market forces, growth potential, milestone achievements, and profits. Financial projections create a numerical structure that complements and supports the dream you've painted with words in the business plan.
The funder doesn’t really care about the precision of the numbers. He or she just wants to know what the numbers say about the economics of your business, and what they say about your understanding of your business. The goal is to tell a realistic and credible, as well as exciting, story about what your business could become.
To be realistic and credible, your projections have to make sense on the first glance. If you are implying that your company will sky-rocket and be more profitable than any company in your industry, you lose all credibility. Your figures must support answers to 5 simple questions:
- Do the capital requirements shown in your projections match the funding you are asking for?
- Do you know how long it takes to breakeven and have you budgeted the working capital requirements to weather this period?
- Do your projections link the number of customers you need in order to generate the revenues you are projecting?
- Do you know what resources will be required to support customers?
- Do you know how much you will have to spend to stay ahead of the competition with your product or service offering?
Despite the fact that many lenders and investors only require two or three year projections, it’s a good idea to develop a financial model of your business for five years going forward. Often a five-year window allows you to make explicit the driving factors behind your revenues and expenses as you go through several stages of product development, market penetration, and organization expansion. As they say, if you don't know where you're going, any road will get you there, but you might not like your final destination.
Most importantly, you need to show funders how you will grow your company from the bottom up rather than from the top down. This means sale-by-sale, employee-by-employee. No one believes that a profitable business can be built and sustained on getting "only one percent of the target market." It may start that way but there has to be thought shown on how it will grow over time and capture market share. Even if you never end up sharing your plan with investors and lenders, the exercise of thinking through all that goes into financial projections and the business plan are crucial for you to better understand how you are going to run the business once you raise capital. A well thought-out operating plan will reflect your ability to allocate resources-people and money-to the highest priority objectives.
The problem with financial projections, however, is that it compels you to present your figures using functional categories, such as sales, marketing, engineering, general, and administrative. But if you are a startup company, you will really operate as projects, with most projects running across functions.
Even a startup needs to present the financials using
the standard framework of accounting. That means that the details of your business plan will exist in projections built around the activities required to achieve your critical milestones. That way, when a funder drills down into why you are planning to spend money the way you are, you can frame your answer in terms of business priorities and deliverable milestones, rather than saying something like, "Most companies spend X% on sales." It makes the projections more realistic and you have more credibility.
Nonetheless, structuring your plan from the bottom up based on projects you need to accomplish is difficult. Almost everyone over-estimates how much can accomplished in a day, a month, a year. Make sure your projections reflect real world experiences. If you have any hope of keeping your funders happy, you want to over-deliver during the early years, not under-deliver. You don't want to have to ask for more money because the business isn’t meeting its target milestones.
Two Final Lessons
First, don't refer to your projections as "conservative." This is a major red flag. Funders want to see a realistic plan that is well thought-out, if things goes reasonably well, but not everything going perfectly, because that never happens. They don't want to see a fantasy plan either. Show that you have assembled a team with the right experience and insight to substantiate your bold optimism.
Second, pattern your company on other real world successes. No one is asking you to reinvent the wheel, yet don’t be a total copy cat. You can model your financial projections on companies that have already been successful. Review IPO filings of companies with business natures similar to yours to get an idea of what is realistic. If your projections are wildly different than other highly successful companies, then your assumptions may be out of line.
Don’t consider your business plan and projections to
be cast in concrete; it will evolve over time. You will want to periodically test your assumptions and adjust your plan and actions as you learn what works best. You want to use methods that most effectively utilize your resources –time, people and money- for the highest return, instead of letting apathy perpetuate activities and expenditures that are not productive.
Remember: The number one reason for business failure is running out of money and the primary cause of running out of money is the inability to grow revenues faster than expenses are growing. Have a plan that systemically grows revenues while limiting the expenses it takes to get there and you will have a successful business from the start.