A startup’s financial projections can tell you a lot. Beyond the raw data, projections can tell you how the founders view their business. Sure, their projections for sales and revenue are going up and to the right, but are they realistic, or are they pie-in-the-sky? Are the founders justifiably optimistic – or are they merely projecting what they want to see?
Below are four questions we like to ask as we’re looking at financial projections. Investors and founders alike can use these questions as a starting point for approaching financial projections.
- Do the projections accurately reflect the company’s historical performance? For example, if gross margin projections reflect a dramatically lower cost of goods sold (COGS) than has historically been reported, we would automatically ask about production or input cost changes that explain that kind of deviation. The same goes for operating expenses – it’s tempting to assume they’ll be lower going forward, but without a specific plan for reducing them, the projections should track closely with historical OPEX.
- Do the projections reflect a solid understanding of customer behavior? For example, if a company has had 10% customer churn for the past six months, it should be a red flag if their traction projections suddenly assume 3% customer churn. Projections should also reflect the company’s understanding of different customer cohorts – which cohorts are most valuable, the customer acquisition cost (CAC) for each, and the CAC payback period for each.
- Has a historically bumpy seasonal sales graph magically smoothed itself out? Many businesses experience understandable and predictable sales and revenue fluctuations based on holidays, weather patterns, or even changes in sports seasons, and these fluctuations can have different impacts on different geographic regions that the startup operates in. While some yearly averages are helpful and appropriate, projections should always reflect the impact of annual seasonalities.
- Does the projected revenue curve resemble the historical bookings curve? We know many early-stage startups are not going to be cash flow-positive yet, so we look instead to revenue and its predecessor, bookings. Bookings are a strong indicator of future revenue and revenue growth, and they tend to lead revenue by a few weeks, if not months, depending on the business model. As a result, we often expect to see similar patterns across historical bookings and near-term projected revenue.
Financial projections are always going to be incorrect – always. They’re based on multiple moving parts that are influenced by factors beyond anyone’s control. Can new markets be entered as quickly as planned? Will staff (and therefore OPEX) have to grow in order to meet sales projections? Founders can attempt to answer these questions by playing with various scenarios and running with the most conservative assumptions. And by examining the resulting projections, investors can discover not only how a founder feels about the company’s future but also whether that future is in the realm of possibility.