Contrary to what most entrepreneurs believe, the most important part of a startup’s financial projection is not the proverbial hockey stick growth curve they believe all investors need to see before they will offer a term sheet.
In fact the most important part of financial projections may not even be in a spreadsheet at all.
Why do investors insist on financial projections, often for 3-year periods, but sometimes as long as five years, when everyone knows that for any pre-revenue or very early stage company these projections are largely, if not totally, wishful thinking on the part of the entrepreneurs?
One reason is that investors what to see if entrepreneurs understand the key drivers of their business: cost of goods sold, recruiting expenses, economies of scale, gross margin, lifetime customer value and a number of other metrics. In other words they want to know if a) you are thinking and planning about the right metrics for your business b) you can make the business case for your plan, and c) how it jibes with similar businesses they have seen in the past.
So what is the most important part of your financial projections? It’s the assumptions behind the numbers.
Since most investors have historically been most focused on growth, the assumptions behind your revenue forecasts are the most important: total addressable market, marketing and sales budgets, etc. But increasingly these days investors want to understand how you will scale to get to profitability. So the assumptions behind your operating costs are becoming more important. For most tech startups, staffing is the number one cost by far, so prepare detailed hiring plans, which include your assumptions for such items as salaries, recruiting costs, benefits costs, and incentive compensation.
Each major element of your income statement needs to have a short, concise and well-reasoned assumption behind it: what you will need to pay per year in rent for your office space; market rate salaries for the engineers you plan to hire; marketing expenses, health care insurance, etc.
For example, if you plan a subscription sales model you need to include not only what growth assumptions you are making and why, but also what retention or churn rates you are projecting as well. The best assumption statements will be buttressed by actual company operating data or publicly available data from similar companies. One source of this information is the annual reports of public companies, but of course be careful as these companies are far past the startup stage. Experienced CFOs for hire, who have worked for companies in your specific market be it robotics or biotech, can be invaluable in building the assumptions behind your financial projections. Your friends in the entrepreneurial ecosystem may also be able to help you.
These assumptions can either be a text document with sections that mirror the specific elements of your financial package – revenue projections, operating expenses, etc. – or if brief enough, can be added as text in a notes column of the spreadsheet. The former offers much more space for explication, while the latter syncs up the numbers and the assumptions, which can make understanding both easier for the reader.
One advantage of having a separate document or presentation on your assumptions is you can start you dialog with the investors there. Once you have had a chance to present and defend your assumptions, you can then present the numbers generated by those assumptions.
Finally the assumptions behind your numbers are not simply for investors, they are the backbone of your business operating plan. And requiring presentation of key assumptions behind any type of financial projection or expense request should become part of your company culture.
It’s way too easy to fool yourself, and attempt to fool others, by manipulating numbers in a spreadsheet. Your financial plans will be far more likely to be realistic if you start with the key assumptions behind the numbers before you launch Excel, Google Docs, Apple Numbers or whatever your favorites spreadsheet is.