Entrepreneurs need to be able to plan operations and evaluate decisions using projected financial information. Therefore, annual budgets, cash flow forecasts, and breakeven analyses are essential financial tools for founders to apply to their new ventures. Still, they provide the required information for potential investors or lenders when needed.
After reading my posts on startup finance, you are well aware of common errors and critical assumptions making financial planning for startups challenging. There are many reasons for this, but you start with no historical data, and making several assumptions with underlying estimates creates difficult conditions.
As with many venture realization activities, I always try to make the steps as simple as possible for founders. Creating a new enterprise from scratch requires searching for a great deal of further information about the problem to be solved, your target customer, and the marketplace. And if this is not enough, you are challenged to create a business model and translate it into a robust set of financial statements.
Startup financial projections are important as they reflect the underlying business model in a standard quantitative language that all stakeholders can understand. Creating these financial projections requires founders to consider each element of their business model in an internally consistent manner. I think of it as a transaction between the venture and the customer, looking at each relationship aspect translated in quantitative terms. It facilitates an understanding of the feasibility of the business model in terms of its repeatability and sustainability. Detailed financial modeling allows the founder to assess the strengths and improvement areas of the venture’s business model.
In this post, I will provide the basic steps to create a robust set of financial projections to serve as your foundational quantification of your business model. I refer to them as foundational because these early financial documents will change as you learn more about your business and, after you launch, generate actual historical data. In addition, you test and revise your assumptions as you gather information from the research and existing operations.
Basic Steps
I break the basic steps to building robust startup financial projections into four stages: revenue forecasts, cost estimates, proforma financial statements, and critical metrics. Several elements require research, assumptions, and underlying estimations with each step. So let’s work through each step and essential elements.
Revenue Forecasts
I suggest that founders start the planning process by tackling what many consider the most challenging aspect of startup financial planning – the sales forecast. In other words, estimating the amount of sales dollars your business model generates each month over a specified period.
You make several decisions before you can forecast your venture’s revenues. These include selected revenue models, sales cycle, pricing, customer acquisition rates, and operational capacity. As you will see, you need all this information to be able to conduct a bottom-up analysis for your revenue projections.
From experience, estimating anticipated revenues for a new business is highly challenging. So, it is understandable that these early forecasts are fraught with problems. However, founders can mitigate these challenges in revenue forecasting by solid due diligence about the customer’s purchasing behavior, including how long it takes for a customer to decide to buy a product from initial interest.
Your sales forecasts should take several things into account. These include: how your marketing strategy will drive customers to your business, what are the typical conversion rate from customer interest to the actual purchase, the efficacy of your distribution channels, and customer acceptance of price based on the value placed on a solution. Without this understanding, you can easily underestimate the time it takes to generate revenues or overestimate the pace of customer acquisition and sales.
It is important to remember that your revenue models will change and probably expand as your business grows. Successful ventures rarely stick with one revenue model without modification or expanding to multiple revenue streams. For example, many e-commerce ventures begin revenues directly from the sales of their products. As their customers grow, the web presence will become more attractive for potential third-party advertisers, affiliate programs, and e-mail list rentals. Founders are encouraged to think ahead about how their revenue models will change and encourage them to consider how these changes will affect future financial outcomes.
When you are ready to start building the revenue side of your financial model, you can follow these five steps. First, start discussing your revenue model and pricing strategies, then research outlining the sales transaction process in detail and ascertaining benchmarks for customer acquisition and retention rates. Then, you should have a good amount of information to build a monthly revenue forecast.
- Select revenue model
- Determine pricing strategies.
- Visualize the sales process and sales cycle.
- Estimate customer acquisition and retention rates.
- Calculate revenues: bottom-up method.
Revenue Model Selection
Let’s start with selecting the revenue model that best fits your product and customer. When choosing what the transaction between your business and customer will look like, there are many considerations. First, you want to determine your customer’s current purchase behavior related to existing solutions as a starting point. As stated in earlier posts, you can evaluate customers’ current behavior during customer discovery. What do they do now, and what are they used to when it comes to similar products? Market research will also provide important information about what competitors currently apply revenue models.
Revenue models come in many forms, from traditional transactions such as paying a one-time charge for a product or service to digital transactions such as a monthly or annual subscription to use a software application. As stated above, your choice of revenue model will depend on several circumstances, and your eventual selection will significantly rely on the customer’s current purchasing behavior and standard practices in the marketplace. In the worksheet below, you will find many common categories of revenue model transactions. But founders should not just check a box. Instead, you may choose several models or a hybrid of transactional approaches. For example, you may charge a one-time, upfront fee for a product and then provide payment options for additional services or extended maintenance or warranties.
While there are several revenue models to choose from, don’t be afraid to innovate. Creating a new or hybrid revenue model can differentiate your offer from what is currently in the marketplace. In addition, testing a new approach during early market testing can help validate if the customer finds the model attractive and of better value than the competition.
Pricing Decisions
In conjunction with selecting your revenue model, you should determine your pricing strategy. How much will you charge the customer for your product and service? Additionally, how will the customer pay, and within what time frame? Will they pay the whole amount at the time of the transaction? Or will customers be able to pay over a certain period? For a software product, will the subscription be monthly or annual? Will they get a discount if they pay upfront instead of monthly?
As you start considering various pricing strategies, you must consider what value customers will derive from your product? Startups need to stay focused on the value they provide to the customer no matter what other objectives they are hoping to achieve through pricing. You are trying to accomplish different goals through pricing. For most startups, the primary aim is reaching breakeven and becoming cash-flow positive. In many cases, customer acquisition rates may be a key strategy if you engage with outside investors. If you are offering something new to the market, you will want to build market share quickly to take advantage of being first to market. The business objectives may vary, but customer value is always the priority. Your final pricing decisions are driven by what the customer is willing to pay based on perceived value.
As a starting point, startups want to balance two pricing methods – Cost-plus and value-based pricing. The cost-plus approach is determined by considering the costs to produce your product and then adding a sufficient margin to offset fixed costs. I encourage knowing your unit economics. Startups must understand how much an individual transaction contributes to the venture’s profits. Focusing solely on product costs for determining price is a significant mistake. The principal argument against this approach is that it leaves the customer out of the equation.
Value-based pricing is more challenging to get right, but the process necessary to calculate it is priceless. The process begins by quantifying the value you are providing to the customer. Once you determine the dollar amount of the customers’ gains, you will charge a certain percentage of the value amount. How do you come up with the value amount? During customer discovery and MVP testing, you have many opportunities to assess the value while engaging your customers. You should be inquiring how much they believe they are saving by using your product during these engagement points, for example. In a B2N context, you want to learn how much the enterprise values your solution. They will be looking for at least a 5X to 10X return. If they pay $100 for your service and it enables them to sell $1000 of product to their customer, you know you have provided good value to the enterprise. The customer’s perceived value will determine how much risk they are taking upfront. For example, offering a subscription model with cancellation provides less risk than paying the annual cost up front.
There are other methods to determine the value placed on your offer by the customer. Your market research into available options in the marketplace will provide important comparative information. Learning how customers currently pay for solutions is a critical data point. In conjunction with this knowledge, understanding the degree of satisfaction with current options will add to your understanding of the value difference between your product and existing solutions.
Another factor in the value calculation is determining what different customer segments are willing to pay. Many founders are surprised to hear that they can have different pricing strategies for different segments. While it takes research to learn these differences as you enter the marketplace, one segment is willing to pay more. Your primary target customer, the one you know who is absolutely in need of a solution and is extremely unhappy with all options, will be willing to pay a higher price. Your early enthusiasts and adopters are less sensitive to price, either because of need or passion. These early customers will help you determine the value of your offer while you continue to build and test your products. They can give you the traction to move towards more significant segments, where pricing sensitively increases, as does your marketing efforts.
Determining Sales Process | Sales Cycle
Another critical step related to revenue and sales projections is determining the sales process and cycle. It is vital to map out your sales process and determine how long it takes from when you first engage a customer until the purchase is final. Start when the customer first becomes aware of your product as a solution to their problem. From this first awareness, how long does it take for the customer to gather enough information to decide to buy the product? Finally, how is the final sale made, and how is the payment collected?
This step is crucial for B2B enterprises. As discussed in my post on B2B customer discovery, there is a great deal to consider to ensure that you understand what it takes to complete a successful sales process. For example, I recently consulted with a B2B enterprise whose primary customers are large global corporations. In these corporations, every division had its own set of decision-makers and procurement processes, each with a different number of steps and timelines. One of the first things they did was build out a detailed step-by-step sales process. Then, together we looked at each step in detail, examining how we could expedite the sales process, shorten the life cycle, and increase revenues. For example, one of the significant steps in the sales cycle was establishing a trial period where the customer would receive a free product for testing. By isolating a specific phase, we could brainstorm optional ways to expedite trial periods or possibly charge for more extended trial periods. These ideas arise when you dissect the sales process, looking for new ways to deliver value to the customer while improving your business model.
From a forecasting point of view, founders need to know how long each sales process step takes to estimate the timing between marketing activities to booked sales to payment. This information allows you to make credible estimates of how much new customers cost to acquire, when sales are acknowledged, and when payment will occur. Knowing when to expect payment is critical to projecting and managing cash flow.
Estimate Customer Acquisition & Retention Rates
The next task in your sales forecasting activity is to estimate the rate of customer acquisition and, if applicable, retention rates. There are several factors to consider to determine better the rate and cost of acquiring new customers. Understanding the length of the sales cycle includes understanding if the decision-maker is different than the user, the time from decision to purchase, and identifying potential obstacles that inhibit sales or payment.
Based on your understanding of the customer’s full-cycle usage of the product, you should be able to answer such questions as how customers determine that they need/want to purchase your product (change from the existing solution)? How do customers find out about your product? How do they acquire your product? How will they pay for your product?
To estimate your customer acquisition rates, you start by determining how many customers you will need to hit your revenue goal. Next, calculate the revenue goal divided by average sales per customer for a specified period. Once you know how many customers you need to reach your revenue target, you can calculate how many potential customers you need to get via your marketing channels. Finally, by applying what is commonly called “sales funnel math,” you can estimate each sales channel. How many qualified leads do you need to achieve your sales goals? Important: You will need to research the sales funnel conversion rates applicable for your specific industry, market, and product area.
Once you have determined how many customers you can acquire per marketing channel, you should create a promotional calendar, month by month. Along with your knowledge of the sales process, you can project a campaign’s impact on sales and when the transactions occur. Estimating the effect and timing of a marketing campaign comes with its challenges. You must create opportunities to experiment and test promotional channels during minimal viable product iterations.
While you are thinking about the impact that marketing has on customer acquisition, you should also consider any factors that influence customer retention. Customer retention can play an essential role in your success, depending on your revenue model. For example, if you offer your customers a monthly subscription model, you can expect some attrition throughout the year. Sometimes, you may be able to gather some early attrition data during customer discovery and product testing. Here is an excellent opportunity to apply industry retention benchmarks to your financial model.
Applying the Bottom-Up Method
There are two ways to approach revenue projections, top-down versus bottom-up. While I highly encourage you to analyze the bottom up, there is value in doing both.
The top-down analysis builds on market size and demand estimates. As discussed in an earlier post, you begin to determine the size of your market with a focus on your primary target customer segment. Your central emphasis will be on your served available market (SAM). The SAM is the number of potential target customers that meet the demographics and behavioral characteristics demonstrating their intense interest in having your solution combined with a deep dissatisfaction with current options. The top-down method adds value when the target market is well defined. If the market is fragmented or in an early stage of adopting a particular innovation, this approach proves less valuable.
The startup can begin to develop its go-to-market strategy to capture a portion of the SAM from this point. The capture rate or share of the market (SOM) will depend on several factors, including the efficacy of the marketing plans and the operational capacity of the venture. The transition from SAM to SOM is where you shift your analytic approach to bottom-up. The bottom-up approach asks the founders to realistically estimate how much product they can produce and sell during a given period.
The starting point for a bottom-up analysis is the definition of each unit of sales. Some new ventures start with only one product to develop and sell. This situation makes the analysis more straightforward (though no less challenging). When will the product development be completed? What is the timing and capacity to produce the product? What is the promotional calendar and sales cycle? Answers to each of these questions will help determine the number of units sold daily, monthly, and annually.
As you will see in the future post on financial statements, you need to identify all sources of revenue. Each revenue source should have its line in the income statement. There are many reasons for this practice. Each product will most likely have different pricing & discount strategies, costs of goods sold, launch dates, and growth rates. All these variables make estimating sales all the more challenging.
Determining growth rates is one of the more difficult factors to estimate. For this reason, one typically sees founders falling back on top down estimates by using industry benchmarks to apply growth percentages to product sales. Unfortunately, this method does not consider either your marketing plans or your capacity to achieve this growth. Therefore, it is essential to identify your revenue drivers and do your best to invalidate the assumptions and estimates behind them.
Next Steps
In the next post, I will discuss the second step of the startup planning process, identifying and estimating key cost areas in your business model.
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