8 Do’s and 8 Don’ts for Startups Preparing Financial Projections
Guestblog by: EY
Recently we organized a workshop together with Rotterdam-based risk-capital platform Symbid about how startups can create a killer pitch deck for investors. An important (but perhaps not the most fun) part of an investor deck are the financials of your firm. During the workshop we emphasized 8 do’s and 8 don’ts when preparing financial projections as part of your investor deck. Currently working on a financial forecast? Then definitely check out our workshop’s do’s and don’ts explained below to avoid some common pitfalls!
Do #1: Make sure your financial plan is in line with your business plan
Financial projections are often part of a greater business plan including for instance a pitch deck, investment memorandum or overall business plan. Together these documents provide information on the team, value proposition, technology, market, milestones and competition of your specific business. Your financial projections should translate this information to financial and hence measurable values. One could therefore argue that the business plan and financial model are two sides of the same coin.
Claims you make in your business plan should resonate with your financial plan and vice versa. For example, when you plan to launch your product in 2019, you would also expect significant sales and marketing costs in that period. When introducing a second generation of your product or service the year after, your financial projections should likely reflect new cash flows and price changes. When you still have some years of R&D to go before your product is ready to sell one would expect significant research and development costs for the years ahead. It is not uncommon that we find financial models by startups which do not reflect the organization’s strategy.
Do #2: Make sure the underlying assumptions behind the numbers are crystal clear
Maybe even more important than the numbers in your financial model are the underlying assumptions. As mentioned earlier your financial plan should reflect your business plan, meaning you should be able to explain the story behind the numbers. Generally speaking, investors are not interested in the detailed precision of individual numbers. They focus on the predominant cash flows within your organization and want you to display sufficient knowledge of your numbers and the financial management of your company. You should therefore aim to create an attractive, yet credible story in which you showcase your knowledge and experience.
You could even consider an investor’s review of your numbers as a mini due-diligence of your business and your entrepreneurial competences. Your assumptions help you survive this mini due-diligence. It is therefore useful to keep track of your assumptions. This can be as simple as creating a Google Drive folder in which you store your supporting and underlying documentation. Think of all the materials that validate your numbers, such as: historical financial information, annual financial statements (if you have those), competitor analyses, market analyses, (supplier) contracts, letters of intent with potential customers, website visitor analyses, invoices, and so on and so forth. In case an investor might require a ‘real’ due-diligence (which sometimes occurs), you are automatically well-prepared.
Do #3: Apply both top-down and bottom-up forecasting
Generally speaking, there are two methods you can use for forecasting: top-down and bottom-up forecasting. These two approaches are:
1. The top-down approach in which you work from a macro/outside-in perspective towards a micro view. Typically, market size estimates are taken as starting point and narrowed down into targets that are fit for your company. The TAM/SAM/SOM method is an example of top down forecasting.
2. The bottom-up approach begins with a micro/inside-out view and builds towards a macro view, contrary to the top down approach. This means a projection is made based on the capacity of your company instead of an anticipated market share.
Let’s illustrate the bottom-up approach with a sales forecast as an example. Using the bottom-up approach you would for instance estimate the budget available for sales personnel for next year, define how many sales calls these employees can make per day, estimate the conversion rate from calls to meetings and then estimate the conversion from a meeting to an actual client. That’s how you would set sales targets/projections using the bottom-up method. This is in sharp contrast with top-down forecasting in which you would create a sales target based on the anticipated market share you want to capture.
As the top-down method sometimes results in too ambitious targets and the bottom-up approach in too pessimistic targets, it is advisable to use a mixture of both to arrive at a well substantiated forecast that shows ambition as well as proper assumptions backing up the projections. Use the bottom-up approach for the 1-2 years ahead and the top-down approach for the 3-5 years ahead.
Do #4: Know your margins
Margins are crucial indicators for the performance of your firm. Think of for instance the gross margin, EBITDA margin, and the net margin. It is hence crucial to have a clear view of your current and your expected future margins as they provide you and potential investors with key information about your organization’s performance.
Moreover, margins lend themselves for comparisons against competitors and industry averages. No worries: your margins do not have to outperform margins of established companies now already (as a startup you are only just getting started), but you should aim to achieve competitive margins in the long run. Here you can find an overview of margins for different industries within the U.S.
Keep in mind that your gross margin should typically improve when your business expands. This is due to a better bargaining position with suppliers and the potential of spreading out fixed costs over more products or services (called ‘economies of scale’). This is why the gross margin generally shows a positive trend over time for thriving businesses (especially for business selling goods). This should be reflected in your financial model.
Do #5: Calculate ratios to use as sanity checks for your forecast
When you are in doubt whether your numbers make sense, there are some easy checks you can do yourself without having to be a finance expert. For instance, you could check whether your operational expenses are corresponding with your forecasted revenues.
This can be done by categorizing your operational expenses in several categories in a given time period (e.g. the year of 2020), and then representing them as a percentage of your expected revenues. Categories you could use are for instance: sales and marketing, research and development, and general and administrative.
Doing this exercise might help you find out that you are spending 10% of your revenues on sales and marketing in 2020. When this percentage decreases in the years thereafter while your revenues increase significantly this could mean that you are not investing enough in marketing and sales during these years (because how else are you going to realize the revenue growth you are projecting?).
Additionally, you can search the web for industry averages and the expenses of industry leaders for comparison purposes. Here you can find the sales and marketing expenses as a percentage of revenues for a number of large technology firms.
Do #6: Forecast and track KPIs
KPIs (key performance indicators) are measurable (and hence objective) values that function as a measure of performance for your firm. They help you determine whether crucial goals are being achieved. KPIs are vital metrics that help you separate successful activities from the less successful ones.
Make sure that you define the most crucial KPIs for your company. They differ per industry and company, so put some thought in which measures are the most vital ones for you specifically (e.g. active users, burn rate, revenue/sales, customer acquisition costs, customer lifetime value, etc.). Create targets for those KPIs and start tracking them. This does not only surface the performance of your firm, but also the performance of the people you work with. If you assign responsibilities regarding targets to your team members based on their role/expertise you can periodically check whether targets are met. This creates accountability amongst your team members. You might not expect it, but in this way KPIs can propel your firm!
Do #7: Create different scenarios of your forecast
Entrepreneurs can be overly optimistic, which is a good characteristic to have to keep up the energy and push through when others might quit. Unfortunately, in many cases, the life of an entrepreneur tends to be a bit more disappointing than it seems (at least from a financial perspective, don’t get too depressed now).
Therefore, it could be useful that next to your default financial plan (called your ‘base case scenario’) you also prepare a scenario which is a bit less optimistic (your ‘worst case scenario’). What if you launch 6 months later? What if sales do not ramp up as expected? What if your costs turn out to be double of what you expected? Answering such questions helps you anticipate how your cash flow, profitability, and funding need are impacted in a less optimistic scenario.
Do not forget to create a ‘best case’ scenario as well. Why? You can give potential investors a sneak preview of the upside potential of your company and most importantly: it is fun to see the financial impact of aiming for the moon!
Do #8: Struggling with your market research? Use Google Adwords Keyword Planner!
Sometimes you want to use top-down forecasting (see Do #3) as a way of creating, for instance, sales projections. However, in some cases it can be difficult to come up with useful market research, for instance when it’s difficult to perform surveys yourself or when there are no industry reports available online.
In that case you might want to consider using Google Adwords Keyword Planner. If you create an Adwords account, you can use this savvy tool to get an image of the demand for your offering. Using the Keyword Planner, you can check how many times people search for keywords in Google, per city, country, continent or even globally. Fill in a keyword that relates to your product/service (e.g. “buy smartwatch”) and see how often this keyword is looked for.
That’s all for the do’s! We’ll now continue with common pitfalls to look out for: 8 don’ts for startups preparing financial projections…
Don’t #1: Overoptimistic or pessimistic revenue projections
It is difficult to strike a balance between optimism and realism. On the one hand you do not want to be perceived as the cowboy who thinks he/she will generate hundreds of millions of revenue within just a couple of years after your company’s foundation. On the other hand, you do want to present an attractive business case, especially when you aim to attract venture capital. Also, important to keep in mind is that once you do lock in that investment, your financial forecasts become your targets. It is a sure bet that investors will hold you responsible for reaching those targets. Therefore, you should always question whether your forecast is achievable.
Hereby we provide you with two tips:
· Find an investor that suits your business case. E.g. a subsidy provider is mainly interested in whether your plans are in line with the goal of the subsidy fund (such as the development of innovative technologies or increasing employment). Banks might not require very ambitious plans either but, are more interested in whether you are able to repay the loan and interest costs. Because of that reason banks prefer to finance working capital, inventory or capital expenditures such as machinery and buildings. On the other side of the spectrum we have angel investors and venture capitalists who look for steep growth curves in terms of both sales and profits, to cover for the risk they take in financing early stage companies. This makes them particularly interesting for high growth potential startups and scale-ups.
· Combine the top down and bottom up approach when building your revenue forecast. See ‘Do #3”.
Don’t #2: The funding need is not adequately explained
For what reason do you actually need funding? If it takes you more than a few seconds to answer this question you are in trouble. (Potential) investors want to know precisely what you want to do with their(!) money and what you plan to achieve with it. So, ask yourself the following questions:
· Which milestones do I want to achieve and when?
· What activities do I need to undertake in order to arrive at these milestones?
· What are the costs of executing on these activities?
When you are able to answer these three questions you are also able to compose a break-down of your investment need, to clarify what you aim to achieve with the respective funds and to explain when you will reach your milestones. On the basis of this information an investor can determine whether your firm is an interesting investment opportunity.
Always try to step in the shoes of a potential investor and ask yourself whether you are offering an attractive business case for that particular type of investor. If you want to raise €800,000 but will only hit €1 million in revenues in five years from now, it is a waste of time to approach venture capitalists or angel investors.
Don’t #3: Team size is way too small
This mistake is closely related to Don’t #1. Not only the revenue forecast is often far from realistic, also the personnel forecast is regularly too optimistic. More than once we have reviewed financial projections in which an entrepreneur expects to generate millions of revenue within a few years with a team comprising just the founders and sometimes some developers. Make no mistake, no matter how scalable your product or service is, you will need to invest significantly in sales and marketing personnel if you have the ambition to build a million-dollar business in just a couple of years. Add your production staff, research and development employees and back office support and your team will grow even bigger.
To test how realistic your personnel forecast is, you can divide your projected revenues in a given year by the number of planned employees (‘FTEs’ or full-time equivalents) for that year. This tells you how much revenue you expect to generate per employee and provides a solid basis for comparison with competitors and industry leaders.
When your revenue per employee is at a similar level of the top twenty tech companies already in just a few years (see the graph below), this is a strong indicator that you are too optimistic regarding your expected revenues or that you might invest insufficiently in personnel.
Don’t #4: Having unrealistic salaries.
Make sure you take a good look at your personnel costs. When you have just started your own company, it is unwise to grant yourself an astronomical salary from the first day onwards as this is not what investors are looking for. Moreover, be careful you do not underestimate the cost of skilled personnel. For best in class personnel you will compete with industry leaders that have much deeper pockets than you. It is therefore good to think about salary alternatives such as employee stock ownership plans (ESOPs). These might enable you to attract talent without having to pay extremely high salaries.
Don’t #5: Revenue forecasts that are not aligned with the market size
Many entrepreneurs adopt the TAM/SAM/SOM model to estimate the size of the market and the targeted market share. TAM (total available market) represents the total worldwide market without considering the niche market you are targeting with your product or service. SAM (serviceable available market) provides you with information on the market considering your geographical reach, your type of product or service and (niche) clients. SOM (serviceable obtainable market) is the percentage of SAM which you estimate you can acquire as market share within a reasonable timeframe.
Since SOM represents the percentage of market share you aim to capture, it should be equal to your revenue forecast. Do you mention somewhere in your business plan, investor memorandum or pitch deck the percentage of market share that you hope to acquire? Then make sure that this is reflected in your revenue projections.
If you want to know more about the TAM/SAM/SOM model have a look here.
Don’t #6: Operational expenses that are being left out
Besides revenue forecasts also operational expenses are estimated too optimistically in many cases. Costs are oftentimes forgotten or are not aligned with the overall business plan. Short example: when your sales strategy is mainly dependent on online marketing you would also expect significant costs related to online marketing.
If you take some time to search the web you will easily find some lists of typical operating expenses for startups. Check which costs might also apply to your business. There is no need to include every post stamp in your forecast, but make sure that you include the most significant cost drivers for the growth of your firm (such as the marketing costs in the aforementioned example).
While you’re at it, check whether you are not including operating expenses as direct costs or vice versa as this will affect your gross margin. For an overview of definitions of direct costs and operational (indirect) expenses you can check out this article.
Don’t #7: Capitalizing R&D costs (while you shouldn’t)
Entrepreneurs often come with the question on whether they can capitalize their R&D costs. This means that spending on research & development is not incurred as an expense (reducing profits in the profit & loss statement), but “capitalized” or in other words: added as an asset to the balance sheet. In this way pressure on earnings is relieved as there are less expenses in the P&L. This smooths out profits over the years ahead and might mean a startup reaches a positive net income on a shorter term, which could lead to a more positive image towards externals financers.
However, rules regarding capitalizing R&D are rather strict according to accounting standards. Also, it can be tricky to estimate for how long a product or technology will generate benefits for the company (its economic life), which is needed to calculate depreciation/amortization.
Therefore, it might be wise to simply include R&D spending as expenses; hence not capitalize them at all. In this way you are sure you show expenses in the year in which they actually take place and do not try to hide their timing by adding them to the balance sheet. This could prevent any potential discussions with investors who might be surprised in a later stage that spending was actually higher than expected.
Don’t #8: Disregarding the importance of working capital
Working capital is the capital that you need in order to sustain your daily operations. In order to assess your (future) liquidity you should not only steer your company based on revenue targets, but also on your cash flows. Forecasting for cash flow provides you with an overview of the timing of incoming and outgoing cash flows.
Why is this important? Well, when you focus only on costs and revenues and not on the timing of receiving and sending payments you could end up in serious trouble. Consider that a large firm orders one hundred 3D printers at a startup producing a new type of 3D-printers. The client expects the printers to be delivered within one month. As large firms often use long payment terms it might take up to 90 days before the startup receives the actual payment for the order. This means that our 3D-printer startup needs to finance the raw materials and production process itself. After all, the company has to deliver within 30 days, but still has to wait for 90 days before the payment is received. If the funds required for production are not available for the startup then the order might be cancelled leaving both parties unsatisfied.
Fortunately there are alternative ways to cope with a shortage of working capital (such as factoring as explained in section 8 of this article). However, when you start approaching investors it is clever to include potential shortages in working capital in your investment need to avoid finding out afterwards that you run short of cash.
Want to look like a finance pro? Then make sure you check your financial projections against these do’s and don’ts next time you work on your investor deck!