The promise of exciting financial returns is an essential element when making a persuasive pitch to investors. Financial projections attempt to predict months, even years into future. For early stage companies that have yet to generate much of a revenue or expense track record on which to base trends, forecasting often becomes more art than science.
What makes the forecasting process even more tricky are the unspoken pressures from the venture capital industry — an industry that thrives on finding and backing companies with the potential for explosive growth. In this climate, many entrepreneurs feel compelled to present “hockey stick” projections to investors — forecasts that show incredibly rapid startup growth over a relatively short amount of time — which can cause them to push their projections beyond what is truly reasonable. Faced with this kind of pressure, what is an entrepreneur to do?
Begin with the end in mind
While it may be tempting to create fantastic five-year projections for your business, there’s no quicker way to raise the eyebrows of a professional investor than to uncouple financials from your business plan and market fundamentals.
Strong financial projections are only valuable if they are also tied to strong fundamentals in the business that prove the idea is truly compelling, the potential market is large and the operating plan is scalable. Think of it this way: there is an important distinction between “will they get there” and “could they get there?”
Get the near term right
Investors are skeptics by nature. With that in mind, it is important to balance an ambitious long-term vision with a sound understanding of what lies ahead in the near term.
Having realistic monthly financial projections that nail the forecast for at least the coming 12-24 months demonstrates predictability — and investors like predictability.
What investors don’t like to see are big variances in revenues and costs versus plan. Not only can these fluctuations cause major cash flow problems, they demonstrate unpredictability. After all, if the entrepreneur cannot accurately forecast the near term, what picture does that paint for the future when the company starts ramping, the stakes are higher and everything is moving faster?
Control your financials; don’t let them control you
When done correctly, forecasting can expose a great deal about the health and dynamics of a business. In many ways, the process should function like a patient’s medical chart — providing all the data to assess health, diagnose problems and treat them in real-time.
Good financial models should also be used to “stress test” a business. In fact, savvy investors sometimes like to test the dynamics of the business by pulling various levers in the financial model, i.e., manipulating the variables, so they can see what would happen under dynamic conditions.
What if the sales cycle is much longer than expected? What if customers don’t pay on time? What if cost of goods and sales is much higher than plan? What would happen if the company loses a big client?
Using forecasting to test these various “what if” scenarios not only creates a deeper understanding of the operating plan, it also provides insight needed to protect the most important variable of all — cash on hand.
In the end, it would be foolish to pretend there isn’t pressure on entrepreneurs to create impressive projections, especially when investors are so outspoken about the growth they expect to see from their portfolio.
To strike the right balance, take liberties on the long-term projections (provided there is some logical permission to believe) and build a sound, fluid short-term financial model to truly understand the dynamics of the business and navigate toward success in real-time.
This post originally appeared in Smart Business on September 1, 2016.