You are spending a good deal of research time validating various parts of your business model. Your early research includes extensive engagement with the target customer (primary research) and investigation and monitoring of your competition (secondary research). Hopefully, you have acquired some early knowledge about how important the problem’s solution is to the customer and how dissatisfied they are with current marketplace options. In addition, from investigating your competition, you know something about their business model, how they see the solution to the problem, how they reach out and engage the customer, and how they operate to achieve optional business results.
With this preliminary knowledge, it is the right time to organize the financial assumptions about how your business will achieve profitability and growth. This effort is the best way to consider each part of your business model and how the elements work together to create a repeatable and sustainable venture. By quantifying each aspect of your plan, you understand the intricacies of the transaction and economics of your venture.
I cannot emphasize enough how important it is to explore the financial ramifications of each aspect of your business model. This effort forces you to think about each step in the transaction, how it works, and whether the outcome is income or cost.
The Challenge
Developing financial projections for a new venture is hard. You are making assumptions based on limited information and a high degree of uncertainty. These factors are two leading causes of errors in judgment. So you are starting from a challenging base. That said, there is no need to despair. As you see, there are actions you can take to mitigate these challenges.
Here is a list of common mistakes made by founders as they build a financial plan to demonstrate the economic feasibility of their venture. For each error, I discuss some corrective actions.
Error #1. Overestimating demand for your solution
From experience, estimating customer demand for your solution is highly challenging. Many factors influence customer demand for a product ranging from urgency, timing, pricing, other options, etc. So it is understandable that early demand forecasts are fraught with difficulties. In many ways, this is the number one most common cause of the error. However, founders can mitigate challenges in forecasting product demand solid due diligence about the customer’s purchasing behavior. If you have conducted a substantial number of customer discovery interviews and surveys, you will have a good sense of their journey to solve the problem. This knowledge includes how customers currently solve the problem, how they decide on competitors’ products, and how much they spend in the process.
Your customer demand forecasts should take several things into account, including the catalysts that drive revenue. Your sales do not grow automatically, so it is vital to identify what actions will generate revenues. Revenue drivers include how your marketing strategy will “drive” customers to your business. You want to consider all the steps and actions to move a customer from awareness to purchase. When you estimate the cost and timing of each stage of the sales cycle, you can better project how many customers may purchase at any given period. You will want to apply published and benchmarked conversion rates for this aspect of financial planning, showing how many customers you can expect from your marketing dollars. You want to calculate this for each revenue-driving activity. Without this understanding, you can easily underestimate the time it takes to generate revenues or overestimate the pace of customer acquisition and sales.
Error #2. Underestimating resource requirements & costs
I always state during my financial lectures that estimating your resource requirements and costs is much easier than projecting customer demand. I should probably stop saying it. At first glance, predicting how much you will spend to run your business seems straightforward.
You can readily determine certain expense areas with some focused research. For example, if you require office space in a specific geographic region, a few calls to real estate agents will give you a good sense of current rental rates by square footage. Likewise, salaries, one of the more significant cost areas for startups, can be determined by analyzing current pay rates for similar jobs. You can readily find salary data by occupation and industry through trade association reports or scanning the classified listings online.
However, there are two common ways that you might underestimate costs. First, there may be hidden costs that are not readily apparent, especially to someone who lacks the experience or expertise in a specific industry. For example, many consumer product startups rarely understand all the costs of managing suppliers and distribution channels.
The second primary reason for underestimating costs is the assumption that economies of scale will automatically increase profit margins. And in some cases, it may be true, such as when you can negotiate better deals for larger quantities of raw materials or inventory. However, many founders fail to understand that some costs rise at a greater rate as the company grows. For example, you may need more sophisticated technologies to manage customer data or add additional resources to train employees on expanding product and service offerings.
Error #3. Miscalculating capital required to operate your venture (burn rate)
Knowing how much money you need to operate on a month-to-month basis is critical to venture sustainability. Many ventures stop operating and close because they have run out of funds. They have burned through their cash before hitting the subsequent revenue or investment milestone. Of course, if your assumptions about customer demand and resource requirements are off, then your estimate about how much money you will need to stay in business and grow beyond breakeven will be incorrect as well. The fact is the rate at which you “burn” cash may very well dictate whether your venture succeeds or fails.
Two analyses help avoid this mistake: conducting a breakeven analysis and establishing a detailed cash flow statement. Performing these two analyses will help you to monitor your cash position in a timely fashion.
Break-even analysis and its underlying unity economics are essential metrics to establish and monitor. It is crucial to know when you can expect to break even in the early financial planning stages. The breakeven point occurs when contributing gross profits from sales exceed fixed operating costs, increasing, month after month. Establishing a clear understanding of how much each customer transaction contributes to profitability is a crucial startup metric. Suppose each transaction is not contributing the expected amount to the gross profit (revenues – costs of goods sold). In that case, the startup needs to reassess either pricing or the variable costs associated with the sale.
The other essential analysis is establishing a monthly cash flow statement. Conducting a detailed cash analysis, projecting in and outflow of cash month by month will help. But cash analyses are subject to the same poor sales (inflow) and costs (outflow) assumptions. One way to at least give you some assurance is to create a couple of different financial scenarios. Before you have any sales or cost history, one way to enhance your estimates is to run a few scenarios using various sales and cost rates, ensuring that you generate some conservative estimates. This way, you can see how different growth rates impact cash on hand and overall capital requirements under each scenario.
As you project your cash flow, remember that the timing of revenues and the receipt of cash will most likely be different. While every business is different, sometimes payments are received a month or more than when the venture accounts for the sale in your financial statements. This situation is prevalent when your customer is a business. Depending on industry practices, you may be in a position where payment comes 30-90 days from the original transaction. You must account for this timing difference in your cash flow statements. Additionally, you should leave some room for late or delinquent payments.
Error 4. Misjudging the time it takes to secure venture funding
Even if you have a good handle on your cash needs and the timing of required capital investments, there are no guarantees that the funds will be available when needed. There will be limited funding sources for many startups, each funder having a long line of eager founders requesting funds. You will need to resign yourself to the fact that soliciting outside funds is an ongoing task, one that takes a good deal of time. Each source will have its process for conducting its analysis and deciding who to fund and when.
While there is no way around this, you will need to be smart about the timing of funding rounds, considering it early in your analysis. In the best of circumstances, you will want enough upfront to provide time to gain traction towards profitability. But there will be plenty of times where this won’t be an option. One of the top reasons for business closings is that they run out of cash.
While there is no guaranteed approach, you should plan a schedule with specific goals aligned with your funds. Give yourself a 24-month runway minimally between each funding round. Establish clear milestones during each period. These goals reflect what you plan to accomplish with the current financing in your possession. While working toward those specific achievements, you need to look for the next round of funding actively. Plan to ramp up the fundraising activity in the last six months of the allotted period. With the 24 months, you need to have enough cash to meet your milestones and have a buffer between fundraising rounds.
Error #5. Applying top-down versus bottom-up forecasting
An adage goes like this: Build your financials from the bottom up and validate your assumptions through top-down analysis. An excellent way to start a bottom-up analysis is to think about your business model and create a step-by-step outline of how you plan to serve one customer. For example, how is the product built, marketed, sold, delivered, and serviced? Then, by looking at the transaction details of one sales unit or customer, you gain a deeper understanding of how your business model works.
As part of building your financial story, you should apply bottom-up analyses as much as possible instead of a top-down approach. Don’t be afraid to make specific assumptions about core revenue drivers and cost factors. For example, when projecting monthly revenues, don’t apply a growth percentage because it sounds reasonable. Stating that you expect a 10 percent growth rate on monthly sales is very much a top-down assumption. Why 10% versus 5% or 20%? A bottom-up approach considers each revenue driver and how it will operate each month. One of the main drivers of revenue is your promotional strategies to acquire new customers. So starting with your promotional approaches and the amount you plan to spend each month, you can apply sales funnel math to a better estimate of how many new customer sales you will have each month. You might not get it right the first time, but as you learn more about actual customer acquisition rates, you can adjust your sales funnel assumptions in future financial models.
This exercise helps bring some rationality to your estimations and shed light on your assumptions, along with feedback from customers and industry experts.
Error #6. Not employing benchmarks and comparisons from similar businesses
One of the many challenges of projecting startup financial performance is the lack of any specific historical data to reference as part of your judgment. This lack of historical information makes it necessary to look for comparable business data that you can use to extrapolate your estimates. There are many sources of such information. For example, you may look for similar products to better understand pricing, costs of goods sold, and sales trends. In addition, by looking at substitute products, you can gauge demand or adoption rates. It is not an exact science, but it should give you a good base for estimation.
Once you identify the industry, marketplace, and overall ecosystem for your venture, you can begin to collect industry-specific metrics, ratios, and percentages that you can apply to your financial model. Examples include: What are the historical new customer acquisition rates of this type of business? How much do companies spend on research and development as a percentage of sales? What is the typical gross margin for the product category?
There are many ways to apply industrial benchmarks to validate your financial assumptions. These comparisons include comparing revenue projections to industry metrics or cost percentages to averages of similar size companies or checking with suppliers about the timing of cash receivables and payables within your industry. Validating these kinds of assumptions allows you to calculate monthly income and cash flow associated with the projected sales and costs reasonably. You will also run various scenario analyses to see how different growth rates change your financial projections by visiting these assumptions.
Error #7. Lacking internal consistency across planning documents
In general, it is essential to focus on internal consistency in your business planning process. When I provide feedback on a venture team’s plan, I always examine how the “dots are connected.” I look to see if the numbers presented across statements are internally consistent and aligned with the various aspects of the venture’s business model. Each element of your business model influences the economics of your venture. By looking at your business model as an exploded diagram of your customer transaction, you can identify where there will be either revenue-generating activities or cost drivers.
For example, I take the available market sizing data and the customer acquisition strategies to assess whether the initial revenue projections make sense. There should be an alignment between the size of your served available market, customers actively looking for your solution, and your strategy to reach them. Then, you demonstrate how each promotional activity contributes to the venture’s revenue and costs. Using sales funnel math, you can estimate how much you need to spend to reach and acquire your customers. This quantification shows how you plan to use your promotional channels to acquire the number of customers necessary to meet revenue targets. There are many such paths that you can follow to see there is alignment between strategies and financial outcomes.
Error #8. Presenting data without clearly defined assumptions
While you do not have to be well versed in accounting practices, you should present your financial models in a way that makes them easy to understand to both informed experts and the general audience. On the other hand, you don’t want to make it difficult for anyone to decipher your financial statements. When your financials are hard to read and comprehend, they will not be as credible.
One of the first things you should do is list all core financial assumptions in a separate worksheet. These core assumptions can run the gamut of important business model attributes. For example, customer acquisition rates, customer attrition, retention rates, detailed cost assumptions like material and labor costs that make up your costs of goods sold, various operating costs estimates such as employee hours and rates, rental prices per square foot, etc. The more information you provide about your assumptions creates the transparent view of the underlying factors driving your financial statements. In addition, it allows investors and other important stakeholders to assess the economic feasibility of your projected financials and provide additional information that can eatery validate or invalidate your assumptions.
As part of this assumptions section, you should be clear on how you calculate the data is and what outside resources support these assumptions. For example, suppose you list the conversion rates you are applying to your various promotional strategies. In that case, you can provide the industry sources of the conversion rates applied to your financial model.
Concluding Thoughts
Detailed assumptions regarding both revenues and costs are critical to providing robust financials. Therefore, you must give as much detail as possible. I recommend that you analyze various forecast scenarios. This kind of scenario analysis can be helpful, especially for investors to see the “conservative” and “optimistic” revenue forecasts. Founders should forecast income statements and cash flow analysis for a minimum of three years, month by month. This degree of financial data will help you in estimating the capital requirements.
Make sure that you review your financial plans regularly. During your research, you will acquire new knowledge about the market that can quickly impact your economic models and performance estimates. In addition, once you launch, you can compare projections to actual data, thus improving your ability to better predict performance over time.
Startup performance is difficult to predict, and there can be variability where you least expect it. For this reason, you don’t have the luxury of reviewing financials quarterly. Instead, minimally, you should check your actual performance to the projected amounts every month. Additionally, you will want to monitor specific performance metrics on a daily or weekly basis. For example, you want to monitor customer metrics like results from lead generation activities more frequently.
For more on this subject and other entrepreneurship topics, get a copy of Patterns of Entrepreneurship Management, 6th Edition.
If you enjoyed this post, subscribe to the Venture For All® Newsletter with exclusive video commentary by Dr. Jack McGourty.
© 2021 Venture for All® LLC. All rights reserved.
Venture for All®️ LLC 