I recently met with a successful former venture capitalist and an active participant in raising capital for promising new ventures. He shared with me an interesting perspective that comes up frequently in discussions with investors. The issue is that most savvy investors feel that start-up financial projections are completely unreliable. In other words, very few start-up companies come close to achieving their early financial projections. Even among companies that eventually became highly successful, early stage financial projections were not closely adhered to. Many deviations were necessary to ultimately become successful. So the big question is – how useful are early stage financial projections?
The answer depends on many factors, but I’d like to focus on what I believe are three critical aspects; 1) how well developed the revenue generation model is, 2) how reasonable the key financial assumptions are, and 3) how the management team views the numbers.
Projections that are based on capturing “just 1% of the market” are the mark of a novice entrepreneur. Projections of generating X million dollars of revenue in the first year will be greeted with questions about what the company will do to achieve that revenue volume. The action plan for generating sales prospects and converting them to orders should be outlined and quantified in a good revenue model.
There are multiple benefits to this approach. First, you demonstrate an understanding of the marketing and selling processes by which investors can assess your ability to oversee these key aspects of a business. Second, you create an action plan that will be easier to implement upon funding. And third, you generate leading indicators which can be used to manage the business. This enables you to seek resolution to problems that arise before the company starts missing revenue targets several weeks or months later. I believe the revenue model is the foundation for the entire business. If done well, it will demonstrate your business expertise to investors, thereby engendering confidence and moving you toward funding success, as well as creating a useful tool that will help you manage the growth of the company after funding.
In your financial model, the assumptions used should have a reasonable basis, something that is relatively easy to justify for a company at your stage of development. For example, if you are a start-up, it would be unwise to use conversion rates or success factors of well-established competitors. Your numbers should be reasonably lower. Though it does not always work, I try to use assumptions that investors will acknowledge are reasonable after a brief explanation.
When talking with investors, “reasonable” is not a specific number, but rather a demonstration of your perception of reality. Are you a pessimist, an optimist, a pragmatist, or a starry eyed dreamer? As you explain your assumptions, investors get a read on you personally, as well as on the business opportunity. What will they see? In my experience, entrepreneurs that are pessimists and dreamers don’t generally get funded, and optimists have limited success. Most successful investors are pragmatists, and optimistic investors generally have limited success.
Management Team View
Does your management team believe that your projections are cast in stone, are lofty goals, or are performances to manage by? Clearly the best answer is the last. Is your management team expecting things to go awry as you start to implement your plan? The odds are very high that this is what will happen. A solid management team that is experienced in dealing with such challenges (making lemonade from lemons as it were) can use a good projection tool to manage by. Assumptions may change. Revenue streams may be significantly altered or fall by the wayside. If your financial model enables you to enter actual data in the place of assumptions, you can see what the effect will be on the business, and make appropriate course corrections faster and with better visibility.
Perhaps you noticed a common theme in this brief discussion about financial projections. The exercise shows investors how you approach complex challenges, and how you view a good financial model as a flexible navigational aid rather than a definitive road map. I like to use the analogy of a commercial jet flying from Los Angeles to New York. Before departure, the pilot files a specific flight path. During the flight, weather conditions, winds, and other issues arise that cause the plane to deviate from the flight path more than 90% of the time. However, a good pilot can still arrive at the destination specified on time. This is similar to the mission of the management team. The development and presentation of a good financial model helps quantify a business while demonstrating the perspective and capabilities of the management team – a key factor in most investment decisions.