Written by Katherine Hague
Welcome to a new BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
Even at the early stage when there is little historical data available to act as a basis for projections, the process of creating projections can help founders better understand the inner workings of their business, and how it scales.
While the structure of projections will vary greatly between startups, there are some common mistakes, over exaggerations, and omittances that entrepreneurs tend to make in their financial projections. These mistakes not only mislead less savvy investors, but they can also woo entrepreneurs into a false sense of security — showing the future as being more profitable or certain than it in fact is.
Adapted from the financial projections section from my book Funded, in this post I’ll lay out from an investor’s perspective the most common mistakes entrepreneurs make when preparing financial statements — and how you can avoid them.
1. List deferred revenue separate to other revenue
Deferred revenue is a liability that is created when monies are received by a company for goods and services not yet provided. Deferred revenue can help inflate a startup’s numbers early on. It is important that financial projections be clear about whether there is deferred revenue included in financial projections. If it’s not made clear, investors will likely ask.
2. List one-time revenue separate from other revenue
Sometimes startups make money through hosting events, doing services work, getting sponsorships, and other one-time activities in order to keep their company afloat. These one-time revenue sources can be very misleading if they are not separated out from monthly recurring revenue.
Let’s say a company made $40,000 in August. You may assume they will make that in September. But if $30,000 of that is from a one-time contract, their revenue may drop back down to $10,000 next month. Make sure financials clearly list where revenue is coming from.
3. List booked revenue separate to other revenue
Many companies will count revenue before it’s actually in the bank. This could be services that the company hasn’t been paid for yet, or the pre-sale of a product that hasn’t shipped yet. This type of revenue has some risk that it won’t be collected and should be listed separately to revenue that has actually been received.
4. Pay close attention to cash flow.
Make sure the financial projections include cash flow, not just the balance sheet or projections. In startups, cash is king.
5. Be conscious of over-spending
A lot of founders get caught up in the hype of what it means to run a startup. Beautiful offices, expensive perks, catered meals, team retreats – creating the Google experience.
While all of these things have their time and place, many companies introduce these perks when they simply can’t afford them. This type of spending can drastically increase a company’s burn rate — and should be avoided. Make sure the expenses listed in financials are reasonable for the geography and stage of the company.
6. Properly handle assumptions
Startup financial projections include assumptions — assumptions around growth rates, pricing, costs, and many other factors affecting the state of the company. Financials that do not openly list assumptions are red flags to investors.
The financials should include an extensive written explanation that explains the assumptions listed and how the entrepreneur arrived at those assumptions, including any evidence or supporting information.
Make bottom up assumptions
You should understand the company’s revenues and profits from the bottom up. The price of the product, the margin per unit, and the number of units sold should all match up to a revenue number.
How were the assumptions arrived at? Were they pulled out of thin air? Or is it based on past growth or industry averages? Was the bill of material cost a guess? Or did it come from actual quotes? Numbers that come from credible sources will make for much more accurate projections and signal a more sophisticated entrepreneur.
Include scenario analysis
The only thing we know is true about a startup’s projections is that they are wrong. It is a red flag if a startup doesn’t include multiple possible scenarios in their calculations. Anyone reading the projections should be able to plug different numbers into the startup’s assumptions, generally listed clearing in the top left of a spreadsheet, and see how different conditions might affect the company.
7. Understand the cost of goods sold
Almost all companies have a cost associated with the sale of their product. Cost of goods sold (or COGS) are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good, along with the direct labour costs used to produce the good. Any costs associated with delivering a product or service should be included as costs in your projections.
8. Address bad debt expenses
Most businesses, including software businesses, will experience customers not paying for a product that they have already received, leaving a bad debt. A great example is Uber. Have you ever taken Uber and been notified that your credit card payment failed to go through at the end of the trip? When this happens, Uber asks you to settle the debt before riding again. If you don’t, they are out of pocket for your ride. Bad debts can have a material impact on financials and should be addressed in financials.
9. Show loan payments
Has the company taken on any loan obligations in its previous funding? If so, are these loan repayments shown in the financials?
10. Include taxes and benefits
Many companies forget to include company taxes as a future expense (mostly because they are losing money and don’t need to pay taxes now). But taxes can be a huge expense, particularly for a profitable company. Depending on where you are located and your corporate structure, you might expect to pay 25 percent or more in taxes. This can drastically affect projected profits. Many companies similarly forget to factor in the fully loaded cost of employee salaries, once any benefit costs and employment insurance are factored in.
11. Include wiggle room
Ensure some margin for error is factored in for both revenues and expenses. Again, the only thing you know about projections is that they are wrong; in one direction or the other, be sure the company is prepared for that reality by either listing a margin for error in your expenses or slightly over estimating costs.
The ultimate goal of a company should be to turn a profit for its shareholders. Yes, startups that take on venture capital choose to run a loss to scale, but they should have a good understanding of when the company plans to reach a break-even point.
This shows the entrepreneur has an understanding of the ultimate objective of the company. Reaching break-even also means that even if the company chooses to raise another round of funding in the future, the company’s fate would be in their own hands. In this case, failing to raise money would not kill the company, and they would be able to continue operating the company indefinitely.
13. Include the founder’s salary
Founders often forget to include themselves in the company’s expenses. While it’s fairly common for a founder to pay themselves little or nothing in the very early days of a company, this is generally not sustainable and not in the long term interest of the company. Investors don’t want someone running the company if they are so desperate for money personally that they might accept the first acquisition offer — or worse yet — job offer that comes their way.
Make sure reasonable compensation is included in projections. Geography and company stage tend to be large factors in how much a founder will be compensated. Compensation will be lower at the seed stage than during a VC round of financing and higher in more expensive regions like Silicon Valley. For more discussion on founder compensation, check out our post on the topic.
14. Include both historical and projected data
Many founders begin projections at month one, leaving out all historical data. This can be very frustrating for investors who have no context for where your initial numbers are coming from. Rather than separating your historical financials from your projections, consider bridging the two statements by including them on the same spreadsheet. It will paint a much more compelling story for prospective investors.
15. Output key metrics
While most entrepreneurs output financial statements from their projections showing total revenue or cost analysis, few output any other key metrics that might be related to the financial projections like acquisition costs or lifetime value. Outputting these numbers as part of your projections will show that you understand how all of your metrics play in together, and will make it easier for investors to skim your projections for key insights.
Do you have any financial projection pet peeves you’d like to see added to this list? Comment here or let us know on Twitter by tagging #AskAnInvestor.
Editor’s Note: Part of this entry is an excerpt from Katherine Hague’s new book – Funded: The Entrepreneur’s Guide to Raising Your First Round. The book is now available through O’Reilly Media.
As a VC, financial projections are essential information for me in mainly two scenarios: when I am evaluating a startup for potential investment, and when I am on the board of a company after I have made an investment in them.
When evaluating a new investment, projections are a key piece of diligence for VCs. As Katherine mentions, it is important to put care and thought into what you are building into your projections. Remember that many VCs, myself included, will keep your pitch deck and supporting materials on hand to refer to in the future. We do this regardless of whether we actually end up making an investment or not. In the case where we don’t invest and you come back to us in the future to provide an update or seek a new round of financing, you can be sure your friendly neighbourhood VC will pull up the files they have on you from their firm’s share drive. We do this to see how you have performed relative to what you told us you would do.
Of course, we understand that things can change, product launches are delayed, customer sales cycles elongate etc. However, it’s just human nature to refer back to what you gave us previously, and you will be judged on it — trust me. In the case where we do end up investing, we (and our partnership) will constantly refer back to your original projections to evaluate how you are doing relative to “what we invested in.” This information can often influence decisions to provide follow-on on bridge financing. So, again, plan and predict your projections carefully.
Ownership levels matter to VCs. Most will want to own at least 10 percent of your company.
When pitching your projections as part of a financing round, it’s important that they reasonably show a scenario that is matched to your investor audience’s outcome and horizon goals. What I mean by that is, can your company reach a certain revenue run rate within a certain number of years in order to properly satisfy the return expectations of the investors you are targeting?
For VCs, you will often hear feedback from them that they want to see you reach $50 to 100 million in revenue within five to seven years. If you can do this, you will likely be a very valuable part of their portfolio and have a chance to provide a “fund-maker” return to your VC’s fund. Make sure that your projections match the needs of the investors you are targeting. If you realistically building a business that tops out at $15 million in revenue, you still can generate a great return for yourself and your investors, but you may want to think about targeting investors other than VCs (e.g. angels or debt providers).
Also important is to properly project how much money you will need to raise over the next five to seven years in order to execute on your business plan. This input helps VCs understand the capital intensiveness of your company. For example, some VCs will shy away from certain ecommerce or hardware companies simply for the fact that they don’t have enough money in their fund to achieve and protect a material ownership position in these companies over time. Ownership levels matter to VCs. Most will want to own at least 10 percent of your company — usually more — and if they can’t see a way to protect their ownership over at least a couple of rounds of financing, they will pass on your deal. By projecting your capital formation plan you can target your pitch to the VC firms and fund sizes that make the most sense for you.
Importantly, when doing diligence on a new investment opportunity, VCs will regularly discount the projections provided to them by management teams of companies they are looking to invest in. Take this into account as you put your projections together. It’s not uncommon for VCs to discount your revenue projections by, say, 25%, and increase your expense projections by the same amount, in order to provide themselves with what they see as a more realistic operating scenario. VCs will often build their own projection models (yes, some of us can actually build in Excel also!). Be aware of this and be ready to defend your own projections.
Let’s switch now to the scenario of your VC as a board member of your company after they have made an investment.
Your annual budget is critical because it will often have compensation increases and bonus payouts for the founders and their team attached to it.
Once your VC has invested and you have a history of actual financials after your funding round, you will work collaboratively with your lead VC and board members to monitor and adjust your projections ongoing. At a minimum you will discuss projections at every quarterly board meeting. Also, you will have many discussions around projections as you prepare to raise future rounds of financing. The most important exercise of the year with regards to projections is your annual budgeting process which results in a board approved projection (or “plan”) for your company’s upcoming fiscal year.
At a simplistic level, your VC is going to want to see a minimum of 40 percent YoY growth for your startup. One way to explain this number is that we use this number to match the return expectations on our own fund. We are targeting that neighbourhood of return on our fund itself, and therefore look for our winning companies to achieve and hopefully surpass this. We also know that VCs you pitch in the future will be looking for this type of growth so we push founders hard to achieve this.
Your annual budget is critical because it will often have compensation increases and bonus payouts for the founders and their team attached to it. For this reason, it is important to put even more care and thought into these than the projections you make for your funding round deck.
Your VC and board members will also help you build what is known as “stretch” projections for your annual budget. In fact, this will likely be the budget you actually share with your team in order to motivate them to their fullest. This budget is, as it name describes, a budget that stretches everyone outside their comfort zone to achieve great quarterly and annual results for the company. So, just when you think you have a plan that you can defend, your board will come along and ask you to stretch it! Keep this in mind as you build your projections.
My final thought on this topic is around projecting your burn rate and cash out date. Startups take venture capital in order to focus on scaling their business and put off profitability for strategic reasons. For this reason, especially for seed and Series A stage startups, your burn rate and resulting cash out date should be the most important projection you monitor, adjust, and communicate. Watch your cash closely, constantly project how many months of cash you have on hand, and communicate often with your investors to optimize your runway.
StartUp HERE Toronto is a publishing partner of Betakit and this article was originally published on their site.