By Thomas Hong
Documentation use for raising funds from investors typically consists of financial forecast for five years, with monthly projections for the first two years. The Executive Summary and PowerPoint presentation slide would provide a summary of the financial plan only with the detailed financial worksheets generated for backup information to be provided to the interested investors. A guide for the Founders on how to generate the financial projections, especially the 5 year revenue and profit plan is the objective of this paper.
FINANCIAL PROJECTIONS BASE ON MARKET SHARE
Entrepreneurs who have little business experience and have not raised funding from sophisticated investors such as professional angels and venture capital funds often use this approach. They obtain some market research data on projected market size that their products will be sold. They project increasing percentage market penetration during their 5-year financial plan. This “top-down” method usually results in overly optimistic revenue and profit projections without substantiating how these financial goals will be achieved with detail customer acquisition plans. This method should never be used for the financial plan of a startup business.
OVERLY OPTIMISTIC FINANCIAL PROJECTIONS
Entrepreneurs by nature are optimistic people and tend to project overly aggressive revenue and profit numbers. Most professional angel and venture capital investors are turn off by revenue and profit projections that are too aggressive that they do not believe could be achieved. Business plans that project revenue of several hundred millions in 5 years usually will be rejected. Entrepreneurs without significant profit and loss executive management experience sometimes develop financial plans with overly aggressive operating profit margins. If these projected profit margins are not consistent with comparable established businesses, the investors will reject these projections.
OVERLY CONSERVATIVE FINANCIAL PROJECTIONS
It is rare that entrepreneurs generate financial plans that are too conservative with very low projected revenue and profits in the 5 year plan. However, this sometimes happens when entrepreneurs have been operating a business by bootstrapping with very modest resources. They project their 5 year future plan based on their past operating experience of acquiring few small clients at a slow pace. Investors usually are not interested in investing in a startup that projects very small revenue and profits for the 5 year plan.
PREFERRED FINANCIAL PROJECTION STRATEGY
The preferred financial projection strategy is to start with the 3 Don’ts. 1). Don’t use top down market percentage method. 2). Don’t project overly aggressive high revenue and high profit margins that investors don’t believe are attainable. 3). Don’t project very small revenue and profit margins that would not be of interest to investors as they want to invest in a business that would have good revenue growth and good profit margins.
Here are some parameters for the 5 year financial projections.
- Use bottoms up approach for revenue projections incorporating products, customers, sales channels and technology licenses if applicable.
- Incorporate comprehensive expenses that are inclusive in the operation of a business, entrepreneurs often do not incorporate some of the required operating expenses of a business after the initial small startup phase.
- The 5 year financial plan could be superior to other similar businesses in growth and profit margins but if the revenue growth and profit margins are excessively superior to comparable businesses, than investors may have difficulty buying into the plan.
- Do not project the exit valuation of a business the return on investments. It is far more important to show a credible plan of strong revenue grow with good operating profit margins.