April 30, 2015 | 4-minute read (633 words)
One question everyone asks is what investors look for when deciding whether or not to fund a startup. Having a high-caliber team with a good track record and a clear value proposition are givens. But the bottom line is that it comes down to the numbers. VCs are looking to make investments that pay off big. That means you need to develop credible financial projections that demonstrate the viability and future potential of your target market and clearly spell out how investing in your business will achieve their return targets.
But it’s not a question of just throwing something together. You need to really dig into your numbers and develop enough fluency to articulate and support your underlying assumptions. Here are three signs you’re on the wrong track.
Financial Projections: The Red Flags
1. Your numbers don’t add up — VCs are interested in funding companies with large potential markets...enough to provide them with a ten times return on their investment. Of course you want to show large numbers. One way to do this is by presenting a top-down financial model only. But skewing your financial projections to paint an unrealistically rosy picture of your prospects won’t do you any favors. Experienced investors can see through this gambit. And if you somehow manage to get seed funding on the strength of unrealistic numbers, it will come back to haunt you when you’re trying to raise your next round and haven’t met your targets.
The best way to arrive at realistic numbers is by building a bottom-up financial model. In this approach, you build your financial projections from the ground up by developing detailed spending plans based on your sales targets, anticipated hiring needs, and budgets for rent, product development, and other major cost categories.
2. You can’t justify your assumptions — Your financial model is only as robust as the inputs (your assumptions) built into it. Do your financial projections assume you have next to no competitors? Or are you seriously underestimating key metrics like customer acquisition costs (an extremely common mistake)? Make sure you can identify and back up all of your major assumptions.
This means being realistic about costs, thoroughly researching the market, and using comparables where you can to provide benchmarks. Run what-if scenarios, and sensitize each input so that you know which factors have the greatest sensitivity.
3. Your numbers don’t fit your story — I love this quote from Guy Kawasaki: “The point of financial projections is to tell a story with numbers.” What story do your numbers tell? Do they meander all over? Can you distinguish the main characters from the bit players?
Your forecasts should reflect your financial model, your market, and your business, not someone else’s. And of course, make sure that they support the rest of your business plan.
Business conditions change, strategies shift, and financial projections need to be reworked. Those are all givens. But if you keep these guideposts in mind when building your forecasts, you’ll be in good shape to thrive. And when you do, you’ll have a much better understanding of your business and what things to focus on to make it successful.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.
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