July 11, 2005
Fiddling with Financials
I've been through two incubator programs for young entrepreneurs (back when I was a young entrepreneur), have been exposed to several other programs and have sought information from books, websites and other publications. In general, I have found the weakest link in advice to entrepreneurs to be that regarding financial projections.
Very little advice is given regarding realistic, market-driven projections. Instead, the tendency is for these projections to be based on desired profitability at some point in the future, which in turn is often based on the amount of financing being sought. This results in a circular process built largely on the entrepreneur’s belief in the project’s viability, and shored up by whatever assumptions and estimates are required to achieve financing.
This process is outlined below.
- Decide how much money you want to raise from outside investors.
- Estimate their desired returns over the timeframe you think they’re willing to wait.
- Do the math and plug that number into your spreadsheet X years in the future.
- Develop a defensible growth rate projection based on whatever data you can find.
- Plug in bottom line numbers for each year in your projected financials.
- Estimate variable costs as a percentage of gross revenue. Estimate fixed costs.
- Combine these estimates with the desired bottom line to calculate top-line sales revenues.
- Determine a market size that affords the venture enough share to achieve that sales target.
- Using this projection as the “conservative” estimate, create the “optimistic” pro formas.
This description is a little extreme (and hopefully humorous) but simply intended to illustrate why early financials are not very useful for new venture assessment. I believe that most entrepreneurs do their best to come up with realistic numbers – as long as they support their desired course of action. I also believe that the advice to work upwards from the bottom-line is partly in recognition of the difficulties inherent in measuring market potential for a new enterprise or product, especially for an organization or individual with limited resources.
The message for the entrepreneur is not to obsess on financial projections at an early stage, but to start the process of identifying revenue streams, costs, and assumptions. From there, one can subject highly sensitive projections and assumptions to deeper scrutiny – essentially using the hypotheticals in the early projections to guide and prioritize market research projects.
In addition to this sensitivity analysis, the outside investor should look closely at the assumptions underlying the projections, not the actual numbers. Before looking at the resulting projections, I'd want answers to the following questions:
- Is the entrepreneur making a reasonable effort to use realistic estimates?
- In which areas are the assumptions least defensible, and do these point to a weakness in management?
- Are assumptions and estimates clearly labeled as such?
- For bonus marks, was a sensitivity analysis included with the projections?
Most of all though, I think the key question is about #1 above - does the entrepreneur need outside investment at all? If not, they shouldn't waste their time going through the rest of the process, and should focus on bootstrapping their business instead.
Posted by kenking at July 11, 2005 5:08 PM
