How to craft your startup’s financial projections
Financial projections are an essential part of a startup’s pitch to investors. They are a feature from the initial pitch to the due diligence process as well as valuation discussions. When we look at an early stage startup’s financial projections, we are fully aware that they may not be highly accurate.
After all, there’s usually no historical track record to act as a guide. Furthermore, the business may still be undergoing further changes and pivots.
However, achieving accuracy is not the only aim of preparing financial projections. It is the thought process involved in coming up with projections that gives a better understanding of the startup.
This process benefits both the founder as well as the potential investor. Projections help answer the question of whether capital raising is required and the amount that needs to be raised. They also guide investors on whether the investment returns justify the entry valuation.
A good starting point in looking at a startup’s projections would be the revenue forecasts. We typically begin by analysing user growth projections. To set the stage, we try to understand the size of the addressable market and find out the segment of the market to be served by the startup.
We then assess the user growth forecasts in light of this market size. We ask if the market penetration rates are in line with the market sizing and competitive landscape.
To understand more about user growth, we find out how the startup plans to secure customers. We look at what is known as the sales funnel which tracks the conversion of potential leads into customers. What is the proportion of visitors to the website that turns into potential leads? How many of these leads convert into eventual paying customers?
We also consider how long the sales gestation period is and the time it takes for a customer to make a buying decision. For instance, B2B businesses generally have a much longer sales gestation period than B2C businesses.
With this knowledge, we are able to assess if the user growth is achievable given the resources available to the startup. This can be external resources like sales channels relied on to reach customers eg alliance and JV partners, distributors, or online advertising.
In addition, we gauge if internal sales resources are sufficient to attract and convert the number of leads required to achieve the growth targets. Operationally, the company needs to show that it can handle increased users too. We examine how easy or difficult it is to scale up operations by making new hires, increasing back-office capacity, or having an overseas presence.
Timing plays a part in revenue projections. Unit sales volumes should reflect sales cycles and seasonality. In cases where the startup’s business depends on specific milestones eg first prototype, regulatory approval, or pilot production, the timing of revenue should be aligned to these milestones.
A startup’s growth depends as much on user engagement as it does on new user acquisition. It is not all about securing new customers but how existing ones behave. Delving into the revenue projections will reveal the user engagement levels that the startup is expecting. We look at the rate of users coming back repeatedly to the service, the average order value, and how long a user engages with the service before dropping off.
This is where metrics such as customer lifetime value and churn rates play a part in revenue projections. User engagement gives us an idea of stickiness, providing further evidence that the pain point exists and how close the startup is to achieve a product-market fit.
Another metric to look at is whether revenue per user is expected to increase or decrease over time. Different cohorts of users coming on board at different timing may have their own purchasing patterns. The product mix will affect revenue per user as well.
Apart from user growth, the selling price assumptions make up another side of revenue projections. We need to ask whether the prices are consistent with current as well as future competition.
Tied into pricing assumptions would be the revenue model adopted by the startup eg. SAAS, freemium, profit share, etc. This is a good opportunity to examine on paper, the viability and profitability of the current revenue model.
Aggressive growth comes with its requisite expenditure. That’s why it is important to see if the increase in Selling, General & Admin costs and R&D costs correspond to revenue growth. It will not be realistic if such costs are increasing at a drastically lower rate than that of revenue. We should also benchmark these costs against competitors’ margins.
Another relevant metric to look at is Customer Acquisition Costs or CAC, which tracks the expenditure required to secure new customers. We compare the CAC to the customer lifetime value to measure how cost-effective it is to acquire new customers. This provides an indication of how easy or difficult it is to scale the business.
Cash flow projections
After looking at things from the perspective of revenue and costs, we examine them from a cash flow point of view.
Also Read: How to impress with your startup pitch
In order to forecast operating cash flows, the company makes certain assumptions on its working capital levels. This offers a glimpse of the impact of receivables and payables on its cash flows.
Startups may forecast aggressive revenue growth but the effects of supplier and customer credit payment terms will be felt on its cash flows. This is where the timing of payments to suppliers and payments from customers becomes relevant.
Another important element in the cash flow forecasts is capital expenditure. The higher the revenue growth projected by the startup, the higher the capex and reinvestment needed to power such growth. Whether it is supported by cash flows from operations or external funding, the projections should indicate how such capex is to be funded.
The cash flow projections give us an idea of when the company will likely reach cash flow breakeven. We get to see how far the business is from being sustainable and whether a minimum volume needs to be achieved for that to happen.
Hitting the benchmarks
The projections will shed light on how much runway the company has before it runs out of cash. They provide clarity on the amount that needs to be raised in the current round of funding.
Projections should paint a picture of the startup hitting the next key milestones with or without funding. We can then see how this increases the value of the company. In the fundraising process, this allows investors to estimate the potential valuation at the exit of the investment.
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