"I don't believe your 2012 revenue numbers AT ALL," Steve Harrick said to us during a meeting in 2010. Harrick is a general partner at Institutional Venture Partners (IVP) and perennially on the Forbes Midas List, recognizing the top venture capitalists. The competitor in me quickly wanted to challenge his assertion but alas he was right. As 2012 passed, the numbers originally forecasted were comically incorrect, and the acclaimed investor needed only a glance to live up to his billing. One of my co-founders and I still laugh about it.
Having previously worked for a publicly-traded real estate company, I was experienced in creating financial models for billion dollar assets, but startup forecasting is unique and considerably harder. For you may not know who your customers ARE let alone how much they'll pay or when, among a slew of other variables that can sabotage your financial projections. Not to mention that even public companies, generally with the most proven, scrutinized business models in existence, still routinely miss earnings! The reality is that forecasting is an imperfect science.
In our case with Mr. Harrick, we were initially going after a relatively small market. We grossly underestimated the length of the sales cycle and also the duration for implementation. All of this ultimately led to our pivoting out of an enterprise model in favor of social software-as-a-service (SaaS), which allowed our company to access considerably more revenue, faster.
Now as an investor and advisor, I often work with founders on their financial modeling, as it helps them better understand their businesses and improves alignment. In general, investors understand that your forecast won't be perfectly accurate, but they want to see how you think. And while investors are typically attracted to extremely large markets, entrepreneurs should resist the urge to make broad statements like, "Research firms Gartner and Forrester both confirm that this is a $40B market and we're confident that we'll have 3% of the market in two years," unless they can show EXACTLY how such market share will be attained.
As you build the financial model for your startup, pay close attention to these four areas:
While forecasting an early-stage company, only look ahead to the next 18-24 months not the next 3-5 years. Especially early on with your company, you'll likely be testing different products, price points, and even industries as you try to identify a product-market fit that can scale into a viable business. Make it easy on yourself by shortening the duration and focus on explaining the business in simple numbers. Ask how much revenue your business can generate versus the anticipated cost structure? Try to understand your customer acquisition cost (CAC) and expected customer lifetime value (LTV), for it is far more important than projecting what your revenue may be 51 months from now.
2. Revenue Assumptions
Early this year, a startup CEO sent me the financials for his company over the next two years. After several months of flat revenue, the forecast showed roughly 50-100% compounding monthly growth to close out the year. When I asked him about it, he explained that it was due to a new product being released but was unable to detail how the product would ultimately reach customers and yield those dollars. This type of oversight can not only be a major red flag to potential investors but can doom your company.
Whether you're selling software or shampoo, it's imperative that you know the fundamental drivers of revenue. How are your products marketed, distributed, and sold? Is there a seasonal nature to the business? Exactly who is doing the selling, to whom, and how long will it take? If there are significant spikes in revenue (or expenses), you should have a very good explanation as to why.
3. Detailed Expenses
This is the area that emphatically separates experienced entrepreneurs from novice ones. Be extremely detailed on your expenses for they are easier for you to accurately project than revenue. Why? You can control the amount of money that you spend (e.g. salaries, office space, marketing), but it's much harder to predict revenue coming into your business. Always have a grasp on your company's burn rate, for you (and your investors) must anticipate how much cash the business requires in order to remain solvent, even if revenue is zero.
4. Strategic Alignment
Make sure the numbers that you forecast align with your company's overarching strategy. As you add overhead costs (e.g. staff), how will it impact your numbers? Will the business be cash-flow positive (earning money), or will you be forced to raise more capital to keep the lights on and fuel growth?
Lastly, keep in mind that early on expenses will often drastically outpace revenue. Especially when you're young, it can be odd to spend the first $1 million dollars on your company. But be confident in money spent with purpose and sound judgment. It takes time to hire people, get them acclimated and then see results.