I was once being pitched by a very smart entrepreneur who, when he got to the slide about his companies financials, said "I made all of this up, but here you have it." On the one hand, it was an pretty flippant approach to a relatively crucial aspect of his business. On the other hand, he was saying what ever other early stage entrepreneur was thinking when describing to me the financial outlook for his or her extraordinarily risky and unpredictable business. So why bother with a slide on your financials when pitching a VC?
It is well understood by entrepreneurs and VCs alike that the specific numbers an entrepreneur pitches when describing her early stage business are completely made up. Most early stage CEOs are lucky to have visibility into the next 6 months, let alone the next 3 year that are reflected in their financials (and the 5 year forecast is mere fortune telling). Nonetheless, there is a huge amount of information about a business, and about an entrepreneur, that is reflected in those financials. The key is not to focus on the numbers themselves but, rather, to focus on the assumptions in those projections and the points of leverage for that business.
It is almost assuredly the case that a early stage company's projections are wrong. In the last decade I have only seen one company actually hit the numbers they pitched me on. The rest of the companies have missed by varying degrees of big time. But the real question when listening to a pitch isn't whether the company will actually hit the numbers they are projecting, but rather what those projections say about the entrepreneur and the business? Is the entrepreneur focusing on the right things? Do the financials make reasonable assumptions? If the assumptions are anywhere close to right, is there a big interesting business to be built? Smart investors will dig into your financials to get a better sense of how you are thinking about your business.
Company financials are rife with assumptions. Entrepreneurs can easily gain or lose credibility based upon the assumptions that are embedded in their financials, their understanding of those assumptions, and their ability to justify them. How long will it take to hire the people you need? How much will you pay them? How much will it cost to acquire a customer? How many engineers will it take to build your product? What is your margin (are you selling software, hardware, a cloud service)? What is the length of your typical sales cycle? How long will it take for you to collect earned revenue? How much are you spending on marketing? What is the expected return by channel? If you are pursuing a freemium business model, what percent of your user base do you expect to pay? How much will it cost you to support the free members? How much money will your company make, if any, and when? How much more money will it realistically take before you get the Company cash-flow positive? What will you achieve with the money you are raising now? These are all incredibly important questions for any startup and how you are thinking about them will have a huge impact on the success or failure of your business. No one will have perfect answers but an entrepreneur's ability to be directionally right will often be the difference between success and failure.
Not only will it be important to understand the assumptions built into your financial plan, it will also be crucial to appreciate the sensitivities of your model. There are often single variables that make the difference between a good business and a great business (or, more likely, between a viable business and a failed business). If the cost of acquisition is off by 50%, do you still have a viable business? If free customers only convert at 1%, can you support the 99% who will always be free? If the viral co-efficient of your service is 1.2 instead of 1.5, what does that do to growth? What if it takes 90 days to collect on billings rather than 30 days? These "what if" questions are critical to the understanding of your business. You should appreciate the places your business has leverage, and the places that your business has potential vulnerabilities, and be ready to engage in an honest conversation about those pivot points.
I will be the first person to acknowledge that early stage financials are a work of fiction. But some fiction has the ring of truth, while other fiction is so outlandish that it is impossible to suspend disbelief. It is an entrepreneur's job when pitching her business to convince an investor to suspend disbelief. The better you understand the underlying assumptions in your plan, the more effectively you'll be able to do just that. So embrace the opportunity to build credibility. As an investor, I'm happy to buy into your fiction, I just want to avoid unbridled fantasy.
Great post - thanks for that.
As you have seen quite a few pitches (and number from quite a few businesses), it would be great to see a post to help inform entrepreneurs seeking to build a less-than-total-BS-plan.
E.g. for a SaaS business, what are middle-of-the-road cost of acquisition cost? Churn/renewal rates? For any business, how long does it realistically take to hire new engineers? Sales reps? How long does it take the average sales rep to ramp up to his/her "on-par" performance? What percentage of sales hires don't work out and need to be replaced? Can you assume to take payment up front for consumers? And is expecting to defer payment for 30 days realistic in B2B or should you model in 90 days?
I realise that there is no golden rule that applies to all startups and/or businesses, but understanding what is "outlandish fiction" versus "fiction with a ring of truth" would be exceptionally valuable. And would also get you better pitches, one would assume.
Posted by: Peter Schlegel | 10/28/2011 at 03:03 AM
All excellent points on the importance of the process of creating financial projections for a start-up. The outcome of the process is less important than the thinking the goes into it. I agree that it tells you a great deal about the founders.
Posted by: Bpkeil | 10/28/2011 at 08:39 AM
All starts with a big dream and it is very difficult to get financials to create the road map but that is where entrepreneurial ability is brought into play to be successful.
Venture capitalists with much larger understanding of eco-system around the entrepreneur have to help the entrepreneur to define the road map much more sharply to realize the results at the end of the tunnel.
I have seen venture capitalists who claim credit for the success and dump the entrepreneur when in trouble.
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Posted by: Air Max | 11/02/2011 at 02:10 AM
Dude, after reading "Venture Deals" I walked away thinking why the hell do we bother making hockey stick revenue projections if VCs know they are way off? This definitely explains the importance of justifying a burn rate. Most of the stuff that you posted concerning assumptions has more to do with the burn rate than revenue projections. I guess the best justification for including the hockey stick is to provide insight into how passionate/optimistic/stupid you may be.
I also get that having us work through cashflow issues and break even estimates will demonstrate prowess or lack thereof but man, there's gotta be a better way. It would be interesting to study the company that hit their projections and see what they did differently.
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