FINANCIAL PROJECTIONS
1. Why Build Financial Projections?
a. Converting a product/service concept into a potential business
You may tinker with a device prototype at home in your leisure time and you are quite pleased with the result. Inevitably you envisage how it could help hundreds, thousands or millions of people if they could use it. You then face two options: the first one is “go, do it”, i.e. launch a business hoping to make money from it; the second is to talk to family and friends who bounce back all the reasons why the prototype is cute but no one will ever need it. My advice is to trust your guts more than the outside world. Most innovations that gave birth to what became mainstream products were once deemed to be ludicrous ideas of no interest. So, go, do it, until you find serious reasons that the endeavor is going to fail. Your first task is to validate a market, by talking to hundreds of individuals and/or businesses and explain what your product does that no other one does and how it meets their needs. If the response is positive and a handful of prospects show an interest in principle, it is time to assess how you can move from there to building a lasting business. This is when you gather intelligence and provide data estimates. Your first shot will be undeniably overoptimistic, nevertheless a place to start. From then on, you will validate numbers, refine assumptions until you feel confident that the opportunity is worth taking the risk of diving, create the minimum business structure and set shop, so to speak.
b. Understanding the drivers of the business
Preparing financial projections forces you to ask relevant questions at each level. It is of the upmost importance that you nail down what the drivers of your business are. What will drive the demand, per market segment, for your product? The potential integration with another equipment? The sudden increase in the number of technical people able to use it? Its price? Its long lifecycle? A change in regulations? Its potential position in a nascent ecosystem? The knowledge of the main drivers is a good foundation to soundly estimate a market.
c. Detecting the risk points
Reid Hoffman, founder of LinkedIn, once said: “Starting a company is jumping off a cliff and assembling the airplane on the way down.” It is the best image to describe the process. You dive into an uncertain world with a high risk of crashing. Your role is to reduce as much as possible the level of uncertainty. You must identify the areas where the risk is still high and thrive to find ways to mitigate each risk.
d. Simulating scenarios
Once you have set up the model with its key variables, it becomes simple to test alternative scenarios. The “what if” exercise has two facets: one is based on potential events not under your control, such as What if a new competitor in stealth mode comes out with a technology outdoing your product? The second is based on your strategic options, such as What if you penetrate a market slowly with high sales prices? The latter gives you a picture on how resources can be ploughed differently with success, sometimes leading to select one funding strategy over others.
2. Who Builds the Financial Projections
At inception, financial projections are one of the founder’s tasks, accomplished with or without a professional help. There is a lot of available expertise in crafting the right architecture of a financial model, among chartered accountants or CPAs, and auditors. Their contribution however must be the result of a long dialogue with the founder(s) who is the only one able to convey the specificity of the business and how the adopted business model is expected to operate. Founders should progressively learn how to navigate proficiently through financial projections. It is time well spent.
3. Stepping Stages: From the Basic to the Highly Developed Financial Projections
Founders can start with a simple assessment of input and output and, with assistance, later develop a more articulated model.
a. The starting point:
An estimate of revenue and all expenses, operating and capital, is a good start. You are eager to know what amount of cash this anticipated business can burn or generate. The difficulty resides in estimating all the data. The probability of accuracy is very low at best. Revenue is the major variable as well as the one based on the least information, hence closer to a shot in the dark than the outcome of a logical construction. The result of this basic exercise gives you an apparent cash balance. This is the first step.
b. Integrate the payment lags
Businesses with products with a high sticker price, selling to other businesses find that granting generous payment terms may improve the selling proposition. Likewise, you may try to demand from your suppliers, mainly fixed assets suppliers, some payment conditions other than cash on delivery. A startup unfortunately has little leverage. Thus, a gap between what you commit to spend -payables- and the money you expect to receive -receivables- decreases the cash balance initially calculated. This gap, the working capital requirement, needs to be funded.
Now, you have a better appreciation of how money can be generated with the business you envision to create. Yet, it still is a blurry view of the future as so much unknown remains. You must aim at reducing the unknown before you consider your foundation good enough to move to the third and last step.
c. The last stage: producing pro forma financials
Assistance is definitely required at this last stage of building your financial projections, unless you, the founder, have a serious background in finance. The purpose is to set up the three pro forma main statements of accounts, Profit and Loss, Cash Flow, and Balance sheet. Based on the product developed in step 2, it is only a matter of accounting (and logical) mechanics. Once the first iteration is complete, you end up with a financial model that will serve for a long time. You may add or retrieve lines as your business evolve. The general structure will not vary. You will essentially focus on improving on the degree of uncertainty of many variables.
4. Where to Start? The Logic of the Process
a. Revenue
It is common for founders to spend half an hour imagining (the right word!) the amount of prospective revenues, and days to try to apprehend each cost with accuracy. All startup financial projections tend to give an optimistic view of revenue. Both volume and prices are overestimated. Scores of entrepreneurs dare believe that their product can “reasonably” take x% of a market in two years and then grow from then regularly. Such assumption cannot be seriously defended. First, they do not know what the market acceptance for their product will be at launch; second, they have not tested any price point; and third they cannot tell what will make an actual buyer of a potential prospect demonstrating interest in their product. Getting the answers to these questions requires validation, and often a tweak or two on the product. Validating price point and assessing the capability of accessing and delivering a market is a very difficult task. Even with a unique product, communicating the value proposition to the potential early adopters takes time as entrenched competitors fight against the potential disruptor. I recommend entrepreneurs spend a long time on estimating revenue. This is not a task to accomplish in an ivory tower.
Then estimating a volume growth from a handful of units to hundreds or millions, whatever the case may be, is another hurdle to jump. Even if you err in the most conservative estimates, the real world will prove you wrong and overoptimistic. The point I am making here is that the top line, revenue, is the most illusory variable. And yet, changing it by 10% (if not 500%) up or down may show a sharp difference in the value of the opportunity.
b. Costs:
All other data, that together form operating costs and capital costs, are generally apprehended with more certainty. At least information is easily available to make that part of your model credible, if you do not forget any cost, as evidence you know what it takes to produce, market and sell your product. One big issue to spend time on is the Marketing and Sales cost. Often, I hear founders explaining how many salespersons it would take to sell x products a week or a month, underestimating the sales cycle, as well as the quasi certainty that a high proportion of the sales team will not fit the profile and will have to be replaced. Focus on a smart business model ( see our blog Your business model is more important than your technology ) that makes a difference in marketing and sales cost, as these costs can be anywhere between 20% and 80% of revenue in revenue generating startups. Relying on the scaling factor to anticipate lowering M&S cost is wise in some cases. Make sure you do the math accurately, though, and know the drivers of your market. Otherwise, it remains a moving target.
c. Capital Expenditures
Quotes on capital expenditures are easy to obtain. The question you must ask yourself is where you should look for quotes. A small machine shop in a low-wage region may give you a quote that is half what a market leader will give you. It is up to you to check the reliability of each, the time to delivery as well as the level of perfection for the job. Your RFP must leave no room for error.
d. Payment terms
You will undoubtedly find that the cash balance initially derived from the first simple approach is quickly depleted by the working capital requirement. Worse, growth in the business, if payment terms cannot be altered more favorably, will create a chasm in cash requirement. Many fast-growing profitable industrial companies can get in trouble when capital requirement grows as fast as revenue. It is good to keep in mind that growth can be costly.
e. Profitability and the growth paradox
Yet, without growth, survival is a challenge. You must first reach profitability. The financial projections help you understand that reducing the weight of fixed costs is necessary if your business is not cash flow positive. Volume growth is the only answer, together, but to a lesser extent, with a potential improvement of some variable costs, as your business purchasing power gets some clout. Hence growth is a fundamental goal. What better tool than a good financial model to experiment what the ideal growth rate is. Navigating the growth paradox properly is critical, unless an exceptional opportunity for a temporary high growth, knocking down competition, is worth an external financing and dilution. One should never fear dilution, except in cases when the power to decide shifts away from the entrepreneur.
f. Profitability is the goal, not selling an unprofitable business to a competitor.
At a time when acquisitions and IPOs of unprofitable companies have become frequent, I would still advise founders and their team to reach sustainable profitability before merging with another company or raising funds on a stock exchange. I’d rather see value based on a mix of profitability and future growth than on growth alone. As is customary at J&M Lab, my purpose does not relate to some short cycle industries.
5. What Horizon to Adopt?
The rule of thumb is to stick to a period with some visibility ( see our blog A Business Plan, What For? ). If you are developing a new space telescope, for instance, a long period is the obvious choice. It is common to develop five-year pro forma financial projections, the first two years with detail, while the numbers for the subsequent years are based on assumptions that can be drastically changed within one year. As projections are periodically updated, more visibility comes into what was the third year etc.
6. Refining Financial Projections with External Feedback
What has started as an exercise in solo becomes a document to validate with third parties (mentors, business friends, angels...). It is the only way to find whether your financial projections make sense or not. It does not mean the numbers are right yet.
7. Financial Projections are not a Crystal Ball
You must always consider that financial projections are an abstract model, therefore it will never become 100% true. They are as good as the estimated input you feed into the model. It is a tool and not a blueprint. After two or three years of operating the business, historical data will be relevant to improve on estimating the future. You have then acquired a repository of knowledge, by learning from customers, team members, suppliers etc. You’ll put it to use in making more accurate projections, yet you will never read the future. Moreover, as the environment is not a constant, you must be ready to repeatedly revise estimated data, following any significant unanticipated event.
8. Financial Projections as the Unparalleled Business Simulation Tool
You are able to simulate different growth rates and explore the frontier between manageable and unmanageable growth. If you are a category disruptor ( see our Blog Unicorns: the end of the Momentum? ) you go full throttle, maximize your growth rate, spend as quickly as possible, as investors will flock to fund your enterprise, under the belief that, by taking over your market like a storm, you will control it and then set prices and broaden your offer to ultimately become a huge profitable company. In spaces J&M Lab follows, the long development cycle makes this model unrealistic.
Developing a reliable financial projection model tailored to your business is not only a useful endeavor that entices you to raise questions and seek solutions but also a necessary practice when you look for investors. Having thought through all aspects of your business and projected a credible scenario illustrating a most likely path to success is highly valued by quality investors. Though it requires discipline to build the model and maintain it updated, it is based on simple logic, fact-finding process, and attention to detail.