There are some general approaches that one can apply to ensure that you don’t make the common financial errors as outlined in an earlier post. In that post, I listed eight mistakes commonly made by founders as they work to understand the mechanics of their business model. As I always state, projecting the financial performance of a new venture is challenging. One of the main difficulties is estimating quantifiable outcomes with limited to no history.
Over the past few years, I have honed in on a series of steps that founders can take to build effective financial projections and requisite documents, from financial statements to dashboards. In this series of posts, I will begin with some introductory comments on the role assumptions play in creating compelling financials.
An Influential Mentor
One of the personal anecdotes I like to share with students is the experience of working for a large public retail company in an earlier part of my career. I had the experience of working with a gentleman called Harold Geneen. Harold was chairman emeritus of ITT Corporation. And in the 1980s, he started creating holding companies that would acquire and merge companies in verticals or similar business models. Harold combined these like organizations to improve their performance. Over the years, he developed this talent by managing a large conglomerate with multiple divisions.
One of the first things that he did as chairman of this new holding company was to mandate that every division transition to unit accounting. At least by his definition, unit accounting was for every operational unit. So retail locations had to maintain line-by-line profit and loss statements.
This mandate placed an immediate strain on our financial and IT departments, as you can imagine. But eventually, we had very detailed profit and loss statements for each retail unit within all divisions. In addition, each month, we would receive the last period’s statements in what we referred to as “blue books.” These paper statements provided reports by individual units and aggregated regional and division totals.
Harold would come to the board room a few minutes early during each monthly board meeting and review each division’s numbers. He would check each blue book in just a few minutes and draw a little circle with a red pencil focused on some number. We had four divisions, so Harold would do this for each division. He had this uncanny ability to go through each division and ask a question about the highlighted number. Sure enough, Harold would have found something worth discussing. He had an incredible talent for finding something amiss in your business or at least an opportunity for improvement.
I quickly learned how important it was for a senior leader to understand what was behind every financial number in these sessions. Deeply understanding each number leads to you truly understanding your business. And doing this every month forced us to create a habit of genuinely digging in deep and understanding our numbers. It was a fantastic experience. I’ve always said it was like a Rhodes scholarship in finance.
I like to apply these concepts to founders. I think that this is a vital thing to do. And in one sense, while it is challenging to start from scratch, as I’ve mentioned earlier, I mean you have no history, you have to search down appropriate benchmarks, and there are many challenges we will talk about in these posts coming up. But for the most part, just the fact that if you start by thinking about every number, you need to document, consider and begin to put down your assumptions and thoughts behind it. You will create a much stronger financial model as a result of this. So I have taken this early experience to heart and tried to replicate it for startup founders.
So for the post, I want to focus on the assumptions founders make about their business model and how these pre-conceptions translate into financial projections. Throughout this article, I want you to learn how to consider and articulate your assumptions behind each financial number. Next, you need to determine what estimates are included in each assumption to do this effectively. Finally, for each assumption and its underlying estimations, you will look for any inherent biases in the projections and potential ramifications of these biases.
Making Reasonable Forecasts
In a startup context, founders make many assumptions and estimations to provide an intelligent picture of how their business model will translate into financial performance. Unfortunately, you assume just about every aspect of your financial documentation due to the lack of any economic history. Nevertheless, you should be ready to document your assumptions and underlying factors in detail for each line of the significant financial statements – Income, Cash Flow, and Balance Sheet. Let’s start with some general guidelines.
One of the first things you should list all core financial assumptions related to each major financial statement. These core assumptions run the gamut from customer acquisition rates to cost of goods to various operating expenses. The more information you provide about your assumptions creates, a transparent view of your financial statements’ underlying factors. In addition, it allows investors and other important stakeholders to assess the economic feasibility of your projected financials and provide additional information that can validate or invalidate your assumptions.
For each line of your financial statements, I suggest that you document the assumption behind the stated numbers, including additional estimates made as part of the assumption and what, if any, outside sources to support it.
For example, you should clearly show what promotional strategies and associated costs are driving the monthly numbers if you estimate month-by-month sales figures. Promotional strategy assumptions include what specific channels you plan to use, how much you plan to spend each month per channel, and how many customers you estimate to make actual purchases based on industry conversion rates. In documenting these assumptions, ensure that you provide the industry sources used to make these conversion estimates per channel.
I know this sounds like a good deal of effort. But in the above case, you are demonstrating a reasonable approach to sales projections. Still, you are also setting up the assumptions for your marketing costs, typically a significant cost area for startups.
Applying Industry Benchmarks
One of the essential aspects of documenting your assumptions is connecting them with specific industry benchmarks. There are many ways to apply industrial benchmarks to validate your financial assumptions. The application includes 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.
With a bit of research, you can find many benchmark sources, from competitor information to industrial trends accumulated by government agencies, trade associations, and market research organizations. You can find a considerable amount of this data in free public sources. For example, you can find financial statements from any publically traded company via SEC.gov. While these are typically much larger than any early venture, they can provide you a sense of where you need to be in a specific cost area or growth stage. For example, checking several companies in your industry regarding the percentage of marketing expenditure to revenues may give you a benchmark to strive towards as you grow. If the industry average for marketing is 20% of sales, you can assume that you will want to achieve a similar percentage as you grow.
Many industry experts provide useful benchmarks through various publications. For example, David Skok is a venture capitalist and serial entrepreneur in the SAAS space. He writes a blog “for entrepreneurs,” which is replete with various metrics that you can apply to start a SAAS venture. For example, David illustrates that a SAAS business should look at their customer acquisition cost to generate at least 3X customer lifetime value in most circumstances. He backs this up with examples and helpful spreadsheet templates. Every industry has its experts who willingly provide a great deal of information to help you validate your assumptions.
Many students ask me about these “expensive” industry reports and if there are ways to find funding to purchase them. I am sympathetic as many of these reports have everything you need in one document. Remember, the company selling these reports had to do the same research as anyone to get the results. Therefore, they may have access to studies that are not public. However, you will find that universities (and sometimes corporations) will have licenses for specific databases and reports. I always suggest that founders check with their current or former university librarians and see what information is accessible to them. Most universities will have paid for licenses and provide access to both students and alumni.
A good starting point to identify which reports might be most helpful is to check Business Valuation Resources. This platform provides a comprehensive free online guide for business valuation resources. The search protocol applies the NAICS codes and drills into subsections in every significant category. Additionally, you will find lists of the most recent paid reports. I take this list of premium reports and then check what you can get from the university or corporate partner.
Some paid reports are reasonable and may be worth the expense. For example, the Risk Management Association produces annual statement studies for major industries. They also use the NAICS and provide a good deal of information compiled by commercial financial institutions to review financing applications. One individual industry report statement costs under $200 and covers balance sheets, income statements, and financial ratios.
Bottom-Up Analysis Methods
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, don’t apply a growth percentage when projecting monthly revenues because it sounds reasonable. Stating that you expect a 10 percent growth rate on monthly sales is a top-down assumption. Why 10% versus 5% or 20%? A bottom-up approach would consider each revenue driver and its operation each month. For example, one of the main revenue drivers is your promotional strategies to acquire new customers. So stating, with your promotional approaches and the amount you plan to spend each month, you can work the sales conversion rates and make a better estimate of how many new customer sales you will have each month. Of course, you might not get it right the first time. Still, as you learn more about actual customer acquisition rates, you can adjust your customer acquisition cost assumptions in future financial models.
Another example of a bottom-up approach is to look at the actual productivity you expect from employees over a certain period. For example, suppose you wish each sales employee to generate a specific revenue per month (and you have compared this to industry benchmarks). In that case, you can estimate sales based on the hiring of new employees and the time it takes to reach optimal productivity levels.
The bottom-up analysis takes advantage of your knowledge of industry benchmarks. Then, you integrate these comparison data points into the in-depth analysis assumptions. For this reason, you must list all the sources of your benchmark data to support the credibility of your overall financial projections.
Detailed assumptions regarding both revenues and costs are critical to providing robust financials. Therefore, you should give as much detail as possible. You can create various forecast scenarios. This kind of analysis can be helpful, especially for investors to see the “worst-case” and “best case” revenue forecasts. In addition, income statements and cash flow analysis statements should be for three years, month by month. This level of analysis will help you in estimating the capital requirements.
In a typical scenario analysis, you select the forecast period you want to illustrate. Then, you choose which financial assumptions you want to create the scenario ranges for the specified period. Typical assumptions for this type of analysis include various percentages for revenue growth, costs of goods sold, marketing expenses, and salaries.
You set up the numbers the same way in a separate worksheet area for each scenario. So each scenario covers the same period and lists the same variables, revenue, costs of goods sold, salary, etc. In excel, you can establish up to 5 scenarios. So number them, and then you can use specific excel functions to choose a scenario and see its impact on your financial statements. It takes some time to set up but is well worth the effort. You can find several tutorials online to explain how to set this up in excel.
Typically, you create 2-3 scenarios. Many financial planning experts suggest these three situations: base case, worst case (or downside), and best case (or upside). As the labels imply, you are generating three sets of calculations. In the base case, you are looking at what you expect on average to happen, usually based on other underlying benchmarks and your expectations on how your business model will work. In the worst-case scenario, you would look at slow growth rates in conjunction with unexpected costs, such as higher costs of goods sold due to supply chain shortages, as an example. Finally, the best case is the most optimistic scenario, where you base your calculations on everything going right.
When I worked for Harold Geneen, we provided two sets of forecasts, what we expected to happen (base) and what he called our “stretch” goals (extreme upside). We all understood that he expected us to hit the best-case scenario every year.
There are many benefits to performing a scenario analysis. For founders, predicting the future performance of their new venture is risky. Looking at various situations that can influence performance facilitates a disciplined view of your financials that enhances your ability to be proactive in decisions before problems occur. Additionally, if you are soliciting outside funds, it gives potential investors a better sense of the expected risks and returns.
There is a complementary process called sensitivity analysis. It works similar to scenario calculation but focuses on one assumption variable at a time. Then, you change the variable amount and see how it impacts your financials. So, for example, you use this analysis technique to see how changing the price of your product impacts various financial outcomes, like breakeven point.
Projection Time Frames
Harold had us generate five-year rolling financial projections.
I have startup founders start with one-year model development, followed by three-year, 36-month forecasts. Three-year financials allow the founder and team to consider short-term tactics and early growth strategies. However, estimating beyond the three-year mark is difficult without any history.
It is less overwhelming to focus on the first 12 months as a starting point. Then, you can think about the essential assumptions associated with your business model.
You can certainly start with an off-the-shelf template. There are many good options from which to choose. My students tend to favor the templates from SCORE. But no one template will align with how you plan to run your business. The essential elements are present, but you inevitably have to customize your spreadsheets. For example, many templates provide one revenue line and the associated cost of goods sold. But what if you have multiple revenue streams (hopefully), and each revenue carries a different set of costs? Here you will need to add several lines both for revenues and product costs.
It is easier to build out the next two years after you have your model and assumptions set up for 12 months. I suggest that you have each year listed horizontally, one year, followed by the second, and then the third. This format allows room at the end of the 12 months for yearly totals and percent of revenues for each line item. The percent of revenue is a critical data point that many founders skip. However, those percentages allow you to compare your annual statements and industrial benchmarks. How does your cost of goods as a percentage of revenues compare to competitors?
In the next couple of posts, I will outline the steps to build an integrated set of financials for your startup. Starting with the three significant financial statements, income, cash flow, and balance sheet, we will walk through each one and how they work together to support strategic decisions and management of your venture.
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