No business plan is complete until it contains a set of financial projections that are not only inspiring but also logical and defensible.
If you're raising capital, odds are pretty good that you're writing a business plan. And no business plan is complete until it contains a set of financial projections that are not only inspiring but also logical and defensible.
Therein lies the great challenge when developing a financial forecast: while the numbers need to look promising enough to pique an investor's curiosity, they also need to be realistic enough so that you don't get laughed out of the room (assuming that you get invited into the room to begin with, but that's another article).
Venture Capitalists vs. Angel Investors
Venture capitalists are very similar to angel investors in how they analyze businesses, but there is one notable exception. All venture capitalists are interested in one thing and one thing only: how am I going to unload my stake in this company in the next few years? On the other hand, some angel investors are happy to own small pieces of good businesses for many years and have no interest in selling.
Having said that, if you're looking to raise traditional venture capital, your projections will need to show that you have the potential to grow into a business generating between $25 million and $50 million within the next three to five years.
Venture capitalists pray for "liquidity events," meaning that their investments in private companies, which are not immediately convertible into cash (hence the term "illiquid"), are transformed into cash or public stock, typically as the result of a merger, acquisition, or initial public offering. A company generating more than $25 million in sales is far more likely to undergo a liquidity event than one having only, say, $5 million in sales.
So how do you arrive at a solid set of projections? Start by making sure your financial projections show investors that you really understand what makes your business tick.
Are Your Numbers Based in Reality or Fantasy? Investors will use your financials to determine whether your expectations are realistic. Is your sales forecast plausible? Are your projected margins achievable? Are you taking into account your working-capital needs? How about capital expenditures?
There is a lot more to developing a plausible, defensible set of financial projections than just "guesstimating" your future income and expenses. You cannot take the haphazard approach and simply increase revenue by "X% per year" and then make assumptions such as, "Our gross profit margin will be 65%, and we will spend 28% of our revenue on payroll and 12% on marketing and advertising ..." Business just does not work that way.
Instead, you should use your financial projections as an important opportunity to show investors that you really understand your business. That doesn't mean that you need to use extraordinary precision when figuring how much you're going to spend on paper clips, but you certainly want to be thoughtful, accurate, and realistic when it comes to forecasting revenues, expenses, and cash flow on your income statement and balance sheet.
Forecasting Revenues When putting together your income statement, revenues should show more than just the projected sales figure for each year. You should also show how many units you plan to sell, as well as the mix of revenue (assuming that you have more than one product or service). If you have a service business, you may also want to show how many customers or clients you will have each year. Investors will look at that number to determine whether it's realistic for you to sell to that many customers. For example, if your plan is to go from 12 customers in the first year to 36 customers in the second, can the sales team you've built accomplish that goal? What about marketing and advertising? Does your budget account for the money you'll need to spend to support such an effort?