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Introduction to Financial Forecasting for Startup Founders
Posted by Early Growth
March 19, 2019 | 6-minute read (1113 words)
Financial forecasting typically comes up when founders are considering fundraising. Investors want to know that you have a plan to not only recoup their investment, but also make them a profit. They need to be confident that the money you’re asking for will be used efficiently.
Successful pitches outline the opportunity and have a strong, well thought out ask. Even if you’re not ready to start pitching, it can be helpful to analyze your business through a forecasting lens to ensure you’re investing your time, energy, and money into the areas that will help you scale quickly.
EGFS CFO, Sirk Roh, walked us through his process for helping CEOs build their financial plans to give us an introduction to financial forecasting. As relatively new companies, financial forecasting for startups requires a lot of assumptions. In fact, according to Sirk, about 90-95% of the numbers come from 5-10 assumptions. The rest he calls “fillers” – as they are necessary but don’t drive outcomes. These key assumptions are made based on market data, industry standards, and your experience thus far.
Top-down vs. bottom-down approach
Product-market fit is imperative to impressing investors. Are you solving a real problem? More importantly, how many people are experiencing this problem? Even more importantly, how many of them are likely to buy your product?
This is why a top-down approach is important for fundraising, but less useful from an operational standpoint. Both top-down and bottom-up approaches are needed to paint the complete financial forecasting picture.
Start with top-down, because it’s easier and can help you identify variables for the bottom-up approach. The first step is calculating the TAM (total addressable/available market) – the total opportunity if you were to capture the entire market. One popular method is to look at how much revenue your specific industry is generating annually. You can also look at studies that look at how much people and organizations spend in different areas.
From there, you funnel the numbers by geography or other demographics to establish the SAM (serviceable addressable market). Then, you calculate SOM (serviceable obtainable market) – the percentage of the SAM you plan to capture. Having traction (proof that people will pay the price you’ve used in your calculations) is a must for many (but not all) investors. Many companies use the image below to depict these figures in a pitch deck.
A bottom-up approach is the complete opposite. You likely won’t outline it in your 10-minute investor pitch, but it will come up at some point. Using different variables like production capacity or department-specific expenses, this requires making assumptions about staying within budgets and maximizing production.
Articulating your revenue model is more than just saying how you will bring in revenue – selling goods and/or services. You want to give a clear picture of the resources you need to create your product including staffing. Is the product ready to go or is there further development or manufacturing needed?
If so, what’s the timeline and what’s it going to take to get to market? Your marketing and sales plans are directly related to your revenue model and should be detailed. If you already have sales, you should have an analysis of the tactics you’ve used so far, as well as your plans moving forward.
Three-pronged approach to financial planning
At Early Growth, we believe in a three-pronged financial plan that includes:
Income statement (aka P&L profit and loss statement)
Cash flow statement (essentially marries the information from the P&L and balance sheet)
1. Income Statement (P&L)
An income statement is the basic breakdown of a company’s revenue and expenses during a specific period time. If you subtract your cost of goods sold and expenses from your revenue and the number is positive, congrats, you’ve made a profit. If not, you would report a loss on your taxes for that period. There are two main approaches to preparing an income statement: departmental and activity-based.
You may not have true departments, but you can batch items based on classic departments like General & Administrative, Research & Development, Sales & Marketing, etc. You can also track expenses by activity like salaries and wages, benefits, payroll services, other professional services, office expenses, monthly tool subscriptions, etc.
Eventually, you will want to do both, because they give you different perspectives on your spending. Tools like QuickBooks and even a simple spreadsheet are great for creating an income statement.
2. Balance Sheet
The balance sheet outlines and categorizes your company’s assets and liabilities as a whole, including breaking down ownership equity. You can think of it like a snapshot of your company’s financial position – what you own and what you owe. Most people leave this tedious work to their accountant, but CEOs should be very familiar with the balance sheet and understand how to analyze it.
3. Cash Flow Statement
Did you know that a company can be profitable on their income statement, but actually be floundering when it comes to cash flow? It’s possible and Sirk has seen it over and over again, because the CEO is not looking at the full picture. Companies that require high levels of operating assets such as inventory, accounts receivable, or high levels of fixed assets can find themselves in this situation. The cash flow statement shows how changes on the balance sheet affect your income statement.
Making the ask
Building a comprehensive financial plan will help you create guidelines operationally, as well as present a solid case to investors. You don’t want to mess up the one and only shot you’ll get by not being prepared. Because you’re not just forecasting for fun, you’re trying to get funds!
Pick a milestone and use the information you’ve gathered to determine the resources you need and the timeline. Keep in mind that a big chunk of your spending will be on talent. Make sure you’re thinking through when you need to hire and consider if you need a full-time employee or temporary contractor.
Think about how other expenses will grow as your revenue grows. Leave no stone unturned as you calculate what you need. A financial services expert can walk you through this process and ask the right questions to help you make sound decisions and increase your chances of securing investment.