In this lesson, I'm going to talk about preparing financial projections. Once you've decided on an appropriate revenue model and pricing strategy to bring your idea to market, it's time to start making assumptions about sales, income and expenses, and cash flow. It's time to start building a model to forecast the financial result that you and your stakeholders can expect from the business. I frequently hear startup entrepreneurs complain that they think the whole process of preparing financial presentations is a waste of time. After all, nobody can predict the future. Most startup companies don't do as well as they predicted. A few do much better than anyone could have expected. There are so many variables and so much uncertainty. The only thing you really know for certain is that your financial projections will turn out to be wrong. But that's not the point. Nobody expects you to be able to accurately predict the future. Financial projections and the process of preparing them can still be very valuable. Even before you start, the work that you do to prepare financial projections can force you to take an objective look at the opportunity which will help you make an intelligent decision about whether or not to proceed. That's the go or no-go decision. For other stakeholders, including investors, key employees, strategic partners, that you want to bring into the business, your financial projections will tell them a lot. They demonstrate your aspirations for the business. What are you really trying to build? A fast-growth market-dominating company? A stable and profitable lifestyle business, or something in between? What will you as the founder of the company consider to be a success? They demonstrate the extent to which you've thought through and understand what the key drivers of growth and profitability will be. Are you able to identify the areas in which you need to invest in order to maximize the potential of the business, sales, operations, technology, channel development, customer support? Similarly, they demonstrate the extent to which you understand the key drivers of return on investment for investors in the company. They'll be trusting you with their capital. They need to be confident that you have a plan to maximize their returns. Finally, they help a potential investor quickly determine whether or not the business fits their profile so that they can quickly decide whether or not they want to learn more about you and your opportunity. Here's some quick advice before you start. While it's perfectly acceptable for you to use top-down thinking when you're estimating your market size, it's not appropriate to build your financial projections that way. Even though that's what a lot of entrepreneurs do. This is one of the differences between a good business plan and a bad business plan. By top-down, I mean a financial projection that's based on an assumed market share. There's a really big market out there, and we're assuming that we're going to get a 1% market share and that will result in millions of dollars in sales revenue per year. This is a pretty big turn-off for most investors. I've also seen some forecasters use a sales-based approach. This is a forecast is based entirely on the number of salespeople that they can hire. The projections will essentially say that each of our salespeople will close a certain number of sales per month and will grow the business simply by adding more and more salespeople. The problem with both of these approaches is that they completely lose sight of the customer and the value proposition that you're offering. The best way to build a financial projection is to develop a customer pipeline made up of potential early adopters, at first, and then expanding into the broader market. Your business plan has to explain the strategy that you've developed to convert these prospects into customers and why you think your assumptions about sales conversion rates and customer acquisition costs are reasonable. If you can do that and base your financial projections on those assumptions about customer prospects and sales conversion rates, then you will have a solid financial projection. As I said before, this is one of the differences between good business plans and bad business plans. So, let's get started. The first thing you need to do is build your revenue projections. What is your revenue model and what's your pricing strategy? How many customer prospects can you reach in your first month, or quarter, or year? What percentage of these prospects do you think you can convert into paying customers? As your business gains traction and you learn more about your customers, you should be able to grow your sales, both by reaching more prospects and by improving your conversion rate. How fast do you think you can grow your revenues on a month-to-month, quarter-to-quarter, or year-to-year basis? As we've already discussed, most of your predictions about the future will turn out to be wrong. Most projections are too optimistic. So, where do entrepreneurs usually guess wrong about their revenue? In my opinion, the biggest errors that entrepreneurs make are about customer adoption rates and the sale cycle. Your customers are busy, and it'll be hard to get their time and their attention. The status quo can be your most formidable competition. Even when you do have their interest, it can take a long time to move a customer prospect through your sales pipeline, especially when you're making a business-to-business sale. Your end customer may not be the final decision maker, and they may have to get a lot of additional people involved before they can purchase. Even when you think the purchase decision has been made, your contracts may be tied up in a legal review for a long time. You should make sure that you have a solid understanding of typical sale cycles in your industry. The government, hospitals, and academia, for example, are all notorious for having very long sale cycles. As you're building your revenue projections, you also have to be estimating the expenses you'll have to pay. How much will it cost you to make and deliver your product, acquire customers, and maintain your business infrastructure? These are your cost of goods, your sales and marketing expenses, and your general and administrative expenses, or corporate overhead, respectively. You should be able to get a pretty good handle on some of these expenses. You can make accurate estimates of what you'll need to pay for office rent, equipment, software, and so on. You can estimate how many people you'll need, and what salaries you'll need to pay to recruit and retain them. You can get quotes from the suppliers of raw materials or finished inventory. You can research what you'll need to pay for a website, online and offline marketing and advertising, commissions to resellers, etc. For other expenses, you may have very little information to work with. Fortunately, there are places you can go for guidance. You can look at financial statements for public companies that are comparable to your business in some way. Same industry, same business model, similar customer targets, etc. SEC filings are available on both paid databases and free websites, like Yahoo or Google Finance. You can also look at published industry averages which you can find in most business libraries, or by working with your local small business development center. Risk Management Associates, for example, publishes annual statements studies which include dozens of financial ratios for over 500 lines of business. These are taken from tax returns, and they include both public companies and small and mid-sized businesses. So, where do entrepreneurs usually go wrong when they estimate their expenses? In my opinion, the two biggest areas are general and administrative and selling expenses. You may think you've identified everything you need to operate the business, but things happen, and you'll need to be prepared. Legal, accounting, travel, employee health care: these can all add up quickly. You may also find that you need more people than you thought or you may need to spend money to replace employees that aren't working out. Entrepreneurs often underestimate the cost of building and maintaining a direct sales force in particular. Some salespeople will be more effective than others, and it can sometimes take months before a new salesperson is truly up to speed and meeting his or her goals. If they aren't effective, you'll need to replace them and that starts the whole process over. Profits are nice, but ultimately, you and your investors care about cash. So, how do you go about building a cash flow forecast out of your revenue and expense projections? Here are some of the things you need to forecast. Your average collection period. If you're going to offer credit terms to your customers, you're going to have to estimate how long it will take them to pay. Remember that this is something that is outside of your control. You can't write the check for them. Another name for the average collection period is days receivable: the average number of days that it takes to collect your accounts receivable from customers. How much inventory will you need to carry, and how much will it cost? It's not revenue until you sell it. Inventory turnover is a measure of the number of times that you turn over your inventory in a given year. The faster you sell your inventory, the less cash you'll need to have tied up in it. Will your vendors offer payment terms to you? They may very well not when your business is new and lacks any sort of a credit history. If and when you're able to get credit from your suppliers, you should be able to use these terms to improve your cash flow. Days payable is the average number of days that your accounts payable are outstanding, the length of time that you're able to take between purchasing and paying for your inventory. These short-term assets and liabilities, accounts receivable, inventory, and accounts payable will be the primary drivers of working capital in your business. Moving beyond working capital, you need to estimate the amount you'll have to invest in fixed assets or capital expenditures. This includes real estate, including any improvements you have to make to lease property, machinery, office equipment, vehicles, and so on. Finally, do you need to invest in intangible assets like patents or copyrights? For many of these you can look to comparable companies and industry averages for guidance. Cash is king, and entrepreneurs often guess wrong about how their revenue and profits will translate into cash. They underestimate the amount of time that will elapse from the time they purchase inventory to when they collect cash from the customers that buy that inventory. This is the company's cash-to-cash or operating cycle, and it's an important metric to understand. A lengthy operating cycle means that the company will have to have a lot of cash tied up in inventory and accounts receivable. The need to invest in working capital, tying up cash in the process will increase directly as your sales increase. You'll need to plan for this to make sure you have enough cash available at all times. So, what will you ultimately have to have in your financial projections package? Ideally, your projections can all be built in a set of linked worksheets and Microsoft Excel, or some other spreadsheet software. Keep it as simple as possible. You want them to be easy for both you and others to review and understand. You'll need at least 3 years' worth of projected income statements, projecting revenues, expenses, operating profits, and net income. You'll need to have projected balance sheets listing assets, liabilities, and net worth, dated as of the end of the same 3 years. You should also have projected cash flow statements for 3 years. All of these, the income statements, the balance sheets, and the cash flow statements should be prepared in a format that's consistent with generally accepted accounting principles. It's also a good idea to have a monthly forecast of cash inflows and outflows for the first year, also called a cash budget. This is what you use to determine your cash runway and the amount of cash you need to raise from investors or lenders in order to avoid running out of money. Finally, you should have a separate list of the key assumptions that are driving the most significant numbers in your projections: sales, sales growth, profitability, cash flow, and so on. If you prepare all of these projections with linked worksheets, you should be able to quickly do a sensitivity analysis. That's where you change a couple of key assumptions, keeping everything else the same, and see what the bottom-line impact will be. A sensitivity analysis is a good tool for helping you understand which assumptions matter the most and where you should focus if you want to maximize profits or cash flow. Fortunately, you don't have to build all of this from scratch. You can download a free financial projections template from SCORE, or you can buy a set of templates from vendors like Foresight. Foresight also provides some great information on best practices for financial projections even if you don't buy their templates.
