As an investor, being able to conduct your own due diligence is a crucial skill. Part of this process includes examining a potential investment opportunity’s financial projections. A company’s financial projections will give you hard data to consider. Still, as an investor, you must discern whether those lofty sales projections are grounded in reality or if they’re simply wishful thinking.
While financial projections will never be completely accurate, there are a few considerations investors can make to determine if they’re even possible. Before we delve in, it’s important to remember that financial projections beyond five years may be less reliable or even unreasonable, and forecasts should be of a company’s operating metrics – never investment performance or return.
Do the financial projections match up with the business plan?
Financial projections should reflect the story being told in a startup’s pitch deck and overall business plan. The deck and business plan will likely weave a story about how the technology, team, value proposition, roadmap, market, etc., all position the business for success. Financial projections are the complement to this–taking this information and making it measurable. For example, suppose a company’s product roadmap includes the launch of a new product next year. In that case, its financial projections should include the costs associated with bringing a new product to market. Realistic financial projections should reflect the startup’s business strategy.
Do the financial projections align with historical expenses?
Two key areas to look at here are operating expenses and gross margin projections. Ideally, operating expenses will decrease, but if there are no concrete plans in place to reduce these, operating expense projections should remain relatively flat. Similarly, gross margin fluctuations can usually be attributed to changes in input costs. If nothing is changing on the production end, this number shouldn’t be deviating significantly.
Do the projections support customer behavior?
It’s imperative for any company to understand the cost of their customer base and how well they’re retaining those customers. Four critical metrics to note here are customer acquisition cost (CAC), the CAC payback period, the lifetime value of each type of customer, and churn rate. If these numbers are projected to change, the company should be able to point to specific initiatives they’ve got in the pipeline to make that happen. If the company is pre-revenue, are customer acquisition and sales forecasts reasonable in light of the larger market for the company’s product or service?
Do the projections take seasonality into account?
It’s normal for any business to have some bumps in its sales/revenue graph. These predictable fluctuations can often be attributed to seasonal things such as weather changes, holidays, etc., and will also vary depending on the regions the business operates in. Sound financial projections will take these seasonal dips and rises into account–be wary of a chart that becomes suddenly becomes completely smooth.
Do revenue projections resemble historical bookings?
Oftentimes, early-stage startups haven’t begun to make revenue yet, which is where bookings can be helpful. A precursor to revenue, bookings can be a good preliminary measure of future revenue, depending on the startup’s business model. Because of this relationship between bookings and revenue, a clear pattern should emerge between historical bookings and projected revenue.
More generally, are growth and margin forecasts aligned with the company size and type and with the company’s overall industry? No startup will ever be able to make financial projections that are entirely accurate; there are simply too many variable components. Projections are targets, and even if founders attempt to run with the most conservative assumptions, factors outside their control may make them difficult to meet. As an investor, it’s essential to view these projections with a discerning eye to determine whether or not the future the founders are working toward is even possible with the plans they’ve laid out.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.