What Exactly are “Realistic Projections” in a Business Plan?
Entrepreneurs are frequently advised to make sure the financial projections in their Business Plans are “realistic” before they present them to potential investors. But what does that really mean? Some entrepreneurs interpret that advice to mean their projections should be ultra-conservative. Taken to an extreme, this means you are presenting what amounts to worst case scenarios to investors, which isn’t exactly the way to draw their interest.
And that brings up another frequently used strategy: to prepare two sets of projections, the best case and worst case, or conservative case and aggressive case. Presenting two sets of numbers just invites investors to conclude you are unsure of your forecast. They want to put their money behind sure-footed entrepreneurs who present an image of confidence.
These two points need to be taken into account when building your financial models and developing your projections:
1. Investors know that most entrepreneurs inflate the numbers, due to the naturally optimistic nature of people who start companies. There’s nothing wrong with that optimism. Pessimistic individuals would never take on the risk of starting a business. Given this optimistic bias to the numbers, investors discount the profits in the forecast, sometimes by as much as 50%.
2. Sophisticated investors know that the risks inherent in early stage companies are so high that results inevitably vary from forecast. Happily, in some cases the company exceeds their forecasted results. But in many cases the results fall short of expectations.
Let’s suppose you reviewed 100 Business Plans from start-up companies. You would find most of the projections fall into the aggressive or best case categories. Some might even be outlandish, a forecast of $1 billion in revenues in three years, for example. So if nearly everyone is sending out forecasts that would be very difficult to achieve, and investors know this, how do you separate your company from the pack and demonstrate your numbers at least have some shred of realism?
You do this through the assumptions you present. Financial models for the Profit and Loss Statement are based on certain assumptions about unit sales, sales price, margins, number of customers, marketing cost per customer—there are many different types of assumptions you can use. What impresses investors is the logic you used in selecting the assumptions. Can you show your assumptions are based on the real world of your industry or niche, or were they just pulled out of the air? The more details you can present about how you arrived at your assumptions, the more realistic they will seem to the investors to whom you are presenting your plan.
One of the easiest red flags to spot in a financial forecast is pretax income as a % of revenues that looks outlandish, say 80%. That tells the reader of your plan that you have either grossly underestimated your costs of doing business, particularly marketing cost, or you have been wildly optimistic in your estimates of how quickly your revenues will grow. You need to scale your pretax income back to a number that companies similar to yours have been able to achieve.
With a start-up company there is no way you can prove that you will be able to achieve the forecast results. There are too many risks, too many variables outside your control. Thoughtful assumptions for your financial models—meaning you can show where the numbers came from—go a long way to reassuring potential financial partners for your company that your P&L forecast is realistic.
Don’t Let the Capital Raising Process Get You Down
Entrepreneurs who are new to the process of raising capital almost always get discouraged at some point along the way. They become frustrated with the lack of positive reaction from investors. They really get frustrated with how slow the process is. Eventually they may even start to doubt themselves and the viability of their venture. Here are some things to keep in mind:
1. Nearly every entrepreneur has had the same experience when they first enter the market for venture capital. No matter how frustrated you might feel, you are not alone. You should never let a lack of immediate positive response shake your confidence, or take it personally.
2. The venture capital industry is not at all an efficient market. No matter what the venture capitalists might say, the best deals do not necessarily get the capital. If you are not getting a positive response, it may not have anything to do with your venture but everything to do with: VCs are swamped with business plans and contacts from entrepreneurs. It is very difficult for them to give every entrepreneur a fair hearing, or any hearing at all in many cases.
One trend in recent years is venture capital firms having websites with e-mail addresses for entrepreneurs to contact them. Sounds good, right. Saves the cost of mailing the materials and allows for immediate contact. Maybe not. The e-mail is often to a blind address, such as: Submissions@bigbucksVC.com. You are not given a contact name, or any means to follow up. They do this on purpose. If the volume of submissions to too heavy to deal with, they can always just employ the “delete” key. Your goal is to develop a relationship with a decision maker in the firm, not just be in a slush pile in some junior assistant’s e-mail box.
NOTE: never send your full business plan to these blind e-mail addresses. Only send it to a partner in the firm who has requested it, so you have a record of who has read your confidential information.
3. So who succeeds? The entrepreneurs who persevere. If you contact them by e-mail and hear nothing, look up their phone number, the name of a partner in the firm and call them. If they don’t call back. Try again. Use any an all means to get referrals to investors, through any of your associates or colleagues, which has a higher probability of success than cold calls.
4. Be wary of criticism. Investors may give you reasons for declining the investment in your company that don’t make sense to you. You might even start to doubt your Business Plan or whether your venture will succeed. There’s an old expression, consider the source. How do you know the investor who was so critical knows what he or she is talking about? How do you know they actually took the time to analyze your venture beyond a superficial review of your Executive Summary?
The larger issue is, it is very difficult to figure out whether a start-up company is going to succeed. No one really knows. It’s like predicting which independent movie with score big at the box office. It is up to you, the entrepreneur to be steadfast in your belief in your venture.
5. Quite a number of investors are just plain rude. You’ll encounter some in the capital raising process. Don’t let their lack of business courtesy get you down. Just file it away as experience that makes you a stronger CEO. Be glad you found out what they’re really like now, rather than when they’re deeply involved in your company. And years later when you are a big success and in the position to help or encourage another entrepreneur, please make sure you do so.