One of the most critical pieces of information that you provide to prospective investors, and that you use to manage and monitor the progress of your business, is your financial model. An essential part of the model is your revenue forecast, and it needs to be based on a set of assumptions that you can easily explain and defend to investors and your board of directors.
I've found the best way to do this is by looking at the forecast from a few different angles and working to create a forecast that converges within a reasonable range. I think it is best to look at the forecast from at last three different angles: tops-down, bottoms-up, and stream-based analysis.
1. Tops-down forecasting (the marketing approach)
In a tops-down approach to forecasting revenue, you look at the projected market size and growth, and then project your market share.
Developing a tops-down market model that supports your revenue projections will add significant credibility to your forecasts. In an emerging market, where there isn't good market size information, I have found that it is best to look at your solution as a replacement for the inferior substitute product being used today. The idea is that the customer base will adopt your solution based on its superior price-performance.
A solid tops-down forecast does not just look at the market size and assign a percentage. Even in tops-down analysis, you need to look at potential customers from an opportunity standpoint, even if they have not entered your sales funnel. After all, target customers are what make up your market. In a solid tops-down forecast, you need to answer the following:
- How "big" can each customer be?
- What is the average deal or transaction size?
- How many customers will you need to win to achieve a certain level of sales?
- Do you have the sales and support reaches to convert that many customers?
- Do you have the market channels to win and support that number of customers?
- What is your conversion rate, also known as success rate, "hit rate" or "flow through rate"?
- What is the churn rate, as a percentage, for those customers?
Don't be the entrepreneur who says, "All I have to do is get three percent of this $1 billion market, and I'm golden." Instead, understand and explain what defensible niche you can dominate, and then how you'll expand into adjacent parts of the market over time.
2. Bottoms-up forecasting (the sales approach)
In a credible bottoms-up forecast, you are looking at the customers in your sales funnel--specifically, what is going on with them at each phase. Key questions you should answer include:
- How many customers are you reaching in the awareness phase?
- How many of those are showing interest by asking more questions and seeking out information?
- How many of those are asking for product samples or evaluating the product?
- How many of those are resulting in sales?
- What is the potential revenue per customer in the initial transaction?
- What is a customer's lifetime value?
Bottoms-up analysis is essential for any credibility in short-term forecasts. Many product companies require backlog - orders that customers have already placed with your company--to have any standing in short-term product revenue forecasts. There's a huge credibility gap that happens when you are forecasting revenue within the lead-time of your supply chain with no inventory to service customer demand.
3. Looking at the stream of adoption (the strategic product approach)
Reasonable revenue projections should also account for your solution's product development cycle and the sales cycle--two factors that deal with revenue timing. The product development cycle is the time that it takes from your product development kickoff to the actual production state. The sales cycle is the timeframe from engaging with a customer for initial samples, initial trials or demonstrations to the point where they are buying the product in volume production.
Another component is how quickly new customers can ramp into volume and what run-rate revenue each can sustain. Again, basing this analysis on customer feedback, and analysis of how those target customers traditionally ramp to production, makes it more credible. If your customers are servicing their own customers that are downstream from you, it is also critical to understand the buying behavior and product adoption timing and cycle time for your customers' customers.
A solid triangulation of tops-down, bottoms-up, and stream-based forecasting will add significantly to your credibility with your board and investors. It will also dramatically improve your chances of hitting your forecasted numbers for how much money you're going to make, which will make everyone happy.