DFN: In a previous life, I managed the group at SBC which evaluated all new business opportunities. Mr. Hill’s comments regarding good, fact based assumptions are ‘spot’ on. Also, the tell-tale signs of overly profitable targets, eg, 80% pretax margins, are a dead give away for either too optimistic revenue forecasts, to optimistic expenses estimates, or worse, both. In addition to this thought let me add a ROR (rate of return) greater than 40%, a DPP (Discounted payback of less than a year) and / or a MPI (modified profitability index) exceeding 2 are additional tells regarding over-optimism. FYI MPI, is the present value of the positive after tax cash flows divided by the absolute value of the negative after cash flows (> 1, good, < 1, bad).
As a reviewer of many models supporting new products, processes or services, I want to echo Mr. Hill’s thoughts of how important a well thought financial model is to building a credible business case. A model that is riff, with hard coded numbers, inconsistent calculations, wrong calculations should be treated with suspicion. Heaven forbid, your model ‘blowups’ or is questioned in front of potential investors. This happened recently to one of my clients (I didn’t develop the original model), the CFO presented financials to the Board on Saturday, it ‘blewup’, I came in on Sunday to meet the Chairman and CFO; by Wednesday, we were back in front of the Board, with a credible model, and business plan, which they then approved as a vehicle for securing "C" round funding.
HOW TO WRITE A BUSINESS PLAN WITH REALISTIC PROJECTIONS
By Brian E. Hill
Entrepreneurs are frequently advised to make sure the financial projections in their Business Plans are "realistic" before they present them to potential investors. But what does that really mean? Some entrepreneurs interpret that advice to mean their projections should be ultra-conservative. Taken to an extreme, this means you are presenting what amounts to worst case scenarios to investors, which isn’t exactly the way to draw their interest.
And that brings up another frequently used strategy: to prepare two sets of projections, the best case and worst case, or conservative case and aggressive case. Presenting two sets of numbers just invites investors to conclude you are unsure of your forecast. They want to put their money behind sure-footed entrepreneurs who present an image of confidence.
These two points need to be taken into account when building your financial models and developing your projections:
1. Investors know that most entrepreneurs inflate the numbers, due to the naturally optimistic nature of people who start companies. There’s nothing wrong with that optimism. Pessimistic individuals would never take on the risk of starting a business. Given this optimistic bias to the numbers, investors discount the profits in the forecast, sometimes by as much as 50%.
2. Sophisticated investors know that the risks inherent in early stage companies are so high that results inevitably vary from forecast. Happily, in some cases the company exceeds their forecasted results. But in many cases the results fall short of expectations.
Let’s suppose you reviewed 100 Business Plans from start-up companies. You would find most of the projections fall into the aggressive or best case categories. Some might even be outlandish, a forecast of $1 billion in revenues in three years, for example. So if nearly everyone is sending out forecasts that would be very difficult to achieve, and investors know this, how do you separate your company from the pack and demonstrate your numbers at least have some shred of realism?
You do this through the assumptions you present. Financial models for the Profit and Loss Statement are based on certain assumptions about unit sales, sales price, margins, number of customers, marketing cost per customer-there are many different types of assumptions you can use. What impresses investors is the logic you used in selecting the assumptions. Can you show your assumptions are based on the real world of your industry or niche, or were they just pulled out of the air? The more details you can present about how you arrived at your assumptions, the more realistic they will seem to the investors to whom you are presenting your plan.
One of the easiest red flags to spot in a financial forecast is pretax income as a % of revenues that looks outlandish, say 80%. That tells the reader of your plan that you have either grossly underestimated your costs of doing business, particularly marketing cost, or you have been wildly optimistic in your estimates of how quickly your revenues will grow. You need to scale your pretax income back to a number that companies similar to yours have been able to achieve.
With a start-up company there is no way you can prove that you will be able to achieve the forecast results. There are too many risks, too many variables outside your control. Thoughtful assumptions for your financial models-meaning you can show where the numbers came from-go a long way to reassuring potential financial partners for your company that your P&L forecast is realistic.
Get your free business plan format. Brian Hill is the author of the novel, Over Time, and several nonfiction books, "Inside Secrets to Venture Capital" and "Attracting Capital From Angels." He is a well qualified business plan consultant as well as 58 Ways to Find Money for Your Business.