Entrepreneurs are a courageous bunch—except when it comes to math. I've seen many notoriously tough senior executives shudder at the prospect of running financial projections for their business plans. So I've developed a much kinder, simpler guide to help you crunch the numbers that matter most.
The most important numbers for a start-up are often the most basic. Among them: Predicting what it will take to have more money coming in per month than going out. Get that wrong, and you could find yourself out of cash, and out of business.
Start by estimating the revenues generated by an average sale. Then subtract the costs that change with each transaction, like sales commissions and costs of producing the products sold. The result is your "unit contribution." Next, predict your monthly overhead, or expenses that don't vary directly with sales volume, such as rent, salaries, utilities, legal fees, and accounting expenses. Finally, divide your monthly overhead by your unit contribution. That number will tell you how many transactions you'll need per month to break-even.
Now for the analysis. Is that a realistic sales target? When do you think you'll hit it? What resources will you need to get there? How much cash will you burn through in the meantime?
If you reach customers directly—as opposed to selling your products to a wholesaler or retailer that will then sell to customers—then make sure each of them brings in more money than it costs you to get them in the door. Get that basic number wrong, and no amount of sales volume will save you.
First, estimate the cost of acquiring one customer, by researching similar companies, and forming a hypothesis you'll test and hone over time. Then, estimate the lifetime value per customer. Predict how long an average customer will stick around, and how much unit contribution they'll generate during that time. Ideally, the lifetime value of a customer should be three or more times greater than the cost of acquiring a customer.
Projecting your financials will help you develop a sense for how to expect money to flow in and out of your business over the first few years. The numbers here are very difficult to predict, so don't waste too much time on them. Instead, run the numbers in a simple way, and adjust them as you get real revenue and expense data. If you don't understand the basics of finance and accounting, or know how to use a spreadsheet program like Excel, you should probably get help. But make sure you understand how the equations work, and what they mean for your business. Here are the most important takeaways from your financial projections:
- Opportunity to scale: While it's nearly impossible to predict how big your company can get, it's helpful to make an order of magnitude estimate (Are you shooting for sales of $1 million, $10 million, or $100 million?). That will help investors, partners, and other stakeholders grasp the attractiveness of your opportunity and help them know that if things go well the rewards will be worth the risks. Also, make sure your scale is reasonable. One way to do this is to look at comparable companies. How long did it take them to reach a similar size, and how much did it cost them?
- Capital requirements: It's important to estimate how much money you'll need over the course of the next year in order to break-even. That way, you can get enough cash in the bank to allow you to focus on running the business for a while before needing to spend your energy lining up more financing.
You can always go deeper, but understanding these basic numbers will help you make smarter choices without getting bogged down in analysis-paralysis.
Got other advice on start-up financials? Add a comment below.