Some practical tips on financial projections

Financial projections from a startup are, essentially, a paradox. Almost everything is an assumption, and there aren’t any historical trends to project outward. Furthermore, if you could produce believable industry averages to build from, I’d assume either you’re in a relatively mature market or you’re a “me too” company—and neither is of much interest. Your goal in this delicate balancing act is to find the investor’s “Greed-spot” . . .

In creating your financials, you have three decisions to make—one relatively simple, and the other two quite complex.

 

  • How Far Do You Project? First of all, you need to decide how detailed to make your financials and how far into the future to carry them out. A simple guideline to use is: long enough to pique interest, but short enough to not make you look ridiculous.

What does this mean in practical terms? The investor will want to see ratios and patterns, not office supplies. If I’m an investor, I’ll concede to you that you already have all the backup spreadsheets I need (which I can later force upon some unfortunate associate). But for now, I just want to see that you have some basis in reality in areas like cost of sales, R&D, marketing expenses, etc.

Furthermore, there’s really no need to carry out your projections beyond three to four years. Ideally, as an investor, I want to see two years of projections, built from the bottom up, followed by two more years of reasonable extrapolations—this is more meaningful than one year extrapolated to year 10. The investor will really be looking for things like operating margins, numbers of employees, and other metrics that can be used for comparison.

 

 

 

  • What Is the Basis for Your Projections? How you build your sales projections dwarfs everything else in importance. Whether you drive figures from the number of salespeople, named customers, sales through specified channels, or any other factor, just show me that you’ve thought this through and can defend your thinking.

Caution: No matter what, never base sales projections on market penetration (e.g., telling an investor that you need to, or plan to, get 2.7% of the market). This is simply taboo by custom (like wearing a button-down collar with a double-breasted suit).

 

  • Dreamer or Conservative? Finally, you have to decide how far to push the needle. I’ve never met anyone who claimed to use anything other than “conservative” projections, so don’t make that statement—it’s meaningless. In fact, investors don’t want your low-end model—now is the time to show us the top of the line. You’re asking me, as an investor, to share in a fantasy or dream with you. Why make it gray when it can be in living color?

On the other hand, every investor will put all of your claims through the “face validity” review (which is just a technical term for the “smell test”). In other words, profit margins that are greater than Microsoft’s and growth that’s faster than Google’s will leave you with some ’splainin’ to do.

The reality here is that a potential investor will eventually probe more deeply into your bottom line than is comfortable—but that comes later. Your job in the initial pitch is to show that you too are a bottom-line person—and that, yes, you have some clue about how this will look for your company over the next three to five years.

Suggestion: Unless you (a) have done this many times before, (b) are an accountant who has also studied many startups and knows the ratios and comps, or (c) don’t mind risking looking foolish, get some help! Find someone who knows this stuff to review your projections and challenge them for accuracy, for believability, and even for presentation. It’s a good use of your limited funds at this time.