Effective financial projections for a startup
Get a business started with meaningful financial projections.
By Tiffany Hovland, CPA
Today's business world is bursting with startups, particularly in the technology industry. One of the biggest contributors to a startup's success is a sound business plan that includes meaningful financial projections.
Accountants have the skills to help entrepreneurs build logical financial assumptions to increase the probability of attracting investments. Refining these projections can also help startups develop a growth strategy by keeping information simple and hitting on the key metrics, such as market size.
This list of practical considerations for startups and the accountants who support them is by no means exhaustive, and for many readers the concepts may be familiar. It's meant to serve as a handy guide to key conversations that can keep a startup on the right track.
Revenue will influence the rest of the profit and loss (P&L) assumptions. So if revenue estimates are materially misstated, the company risks overstaffing or understaffing and/or purchasing assets incorrectly. Revenue is also a key metric for potential investors. Estimates do not need to be precise, but they do need to be realistic and supported by a viable story.
Step 1: Collect critical inputs
Four crucial inputs are used to calculate revenue for a new business: revenue levers, revenue drivers, activity assumptions, and pricing.
Revenue levers: Revenue levers are the various opportunities to earn revenue. Levers can include products and/or services, software maintenance agreements, channel partner sales, etc. Start with a list of all the revenue levers that will produce income over the period of the financial projections.
Revenue drivers: Revenue drivers are the activities that influence how revenue levers produce income. Each revenue lever could potentially have a different driver. Think about what activity will increase or decrease revenue for each lever.
Revenue driver activity assumptions: Activity assumptions are the inputs that will indicate how the revenue driver will act. To determine assumptions, work with marketing, sales, or the CEO, depending on the company organization.
Pricing: Pricing is a necessary input to calculate total revenue. This article does not go into detail on pricing methodology. If prices have not yet been determined, read pricing guides and/or articles to ensure effective pricing methods are being implemented.
Step 2: Convert inputs into the revenue estimate
Now that the revenue inputs have been determined, it's as straightforward as inputting the data into a model that calculates total revenue. In its simplest form, the calculation is revenue driver assumption multiplied by price for each revenue lever. If the driver is marketing spend, there will be an additional step to convert dollars spent to revenue earned.
Create revenue calculations for three to five years by year, quarter, or month. A monthly calculation is helpful if your revenue driver is new clients, as clients will be attained throughout the year and will not provide a full year's revenue in year 1. The monthly or quarterly detail should be summarized by year to report the total annual impact.
Be sure to include an estimate for churn. Revenue can be easily overstated or understated without a reasonable estimate on the business that will be lost over the period of the pro forma.
Step 3: Review the final revenue outcome
Take a step back from the detail and reflect on the total revenue result.
On the SEC's website, check the public Forms 10K of competitors or companies in the same industry and compare net revenue. If there are no publicly listed companies to provide financial comparisons, perhaps check with the potential investment banker or capital provider. It may be able to provide a range of financials that are typical in a similar industry. If forecasted revenue in year 2 is higher than the industry leader, then review the calculations for accuracy and activity assumptions for reasonableness.
Consider the growth year over year. The business should show steady growth over the years at a realistic rate. Then calculate the compound annual growth rate (CAGR) to easily identify growth over a period of time. CAGR is an easy comparison tool for investors to use.
Use a range of activity assumptions to determine a worst-case scenario and an optimistic scenario. Determine what makes the most sense within this range.
Build the revenue estimates using calculations of inputs so you can easily pivot and create new scenarios.
Show revenue increasing over time at an attractive yet realistic rate.
Don't create revenue assumptions without having a calculation or story to support the total.
Don't over complicate the calculations with additional details that do not materially change the result.
Don't forget to reflect on the result.
COSTS OF SALES
Costs of sales (COS) are the costs directly related to a product or service, and they represent the cost of producing revenue. Product costs will include raw materials, labor, production equipment depreciation, etc. Service industry companies' COS include salaries of professional service providers; software-as-a-service companies' COS include hosting fees. Measuring the gross profit (revenue minus COS) and gross margin (gross profit as a percentage of revenue) assists in determining profitability and long-term viability.
Compare margins to industry benchmarks or similar companies. COS may be higher at the start, but it is important to show higher margins over time as efficiencies are gained.
Selling, general, and administrative (SG&A) expenses include all other expenses outside of product costs and capital purchases. Consider the following major categories:
Salaries and benefits
Build a headcount plan by role for the pro forma period by month. This approach creates a hiring plan based on revenue timing to properly support the business. It also allows for quick adjustments when modeling revenue changes.
Sales staff hire dates should correspond with the sales cycle. If a full sales cycle is three months, then the headcount plan should include sales salaries at least three months before the first month of planned revenue. Ensure other variable sales expenses relate directly to the revenue estimates, including sales commissions, bonuses, and other selling expenses.
Include benefits and payroll taxes in addition to the base salary.
Business-to-business relationship building and business-to-consumer advertisement and promotions drive revenue. Marketing expenses as a percentage of revenue vary depending on the industry and the company's size, but they will typically fall somewhere between 5% and 20% of revenue. Years 1 and 2 require higher marketing spend as the company is promoting awareness; however, projections should show increased efficiencies over time.
Several one-time and recurring legal-related costs are associated with incorporating a new business. Consider the following to avoid expensive surprises:
Negotiation of customer contracts.
Business license fees.
Industry-specific state licensing.
Other legal fees relating to copyrights and/or trademarks.
Most new businesses require a website and have some technology needs, even if the industry is not technology specific. Technology ignorance is dangerous for any new business owner and can create unplanned expenses. Consider the following:
Website hosting fees.
Software and software maintenance.
Data security efforts.
Consider all other potential business expenses such as credit card fees, office rent, office supplies, etc. It is safe to create high-level estimates in this area based on revenue, location, industry, etc.
Stay familiar and current with technical terminology and cost structures to avoid expensive surprises.
Ensure the staffing plan and marketing plan align with revenue assertions.
Compare expenses as a percentage of revenue to industry averages and benchmarks.
Don't underestimate accounting and legal needs during inception.Don't forget business necessities like call centers and credit card fees.
Estimate capital investment dollars needed by year and by category between hardware, software, equipment, inventory, etc. The capital plan should:
Correspond with the revenue growth and demonstrate a return on assets.
Show that the business can scale and that the capital investments can set the business up for continual growth.
Create a purchasing plan for the business and describe to investors how funds will be allocated.
In the simplest form, cash flow equates to projected EBITDA (earnings before interest, taxes, depreciation, and amortization) less capital investments. There are many other balance sheet implications for cash flow (accounts receivable, payables, inventory, etc.). Depending on the industry and round of investing, that level of detail may be unnecessary. If the industry has an exceptionally long cash cycle or includes a large upfront inventory investment, then an annual cash implication estimate should be made on those pieces. Otherwise, EBITDA and capital investments will be sufficient for the seed round. After the seed round, working capital impact will be beneficial to get a full cash flow look.
Now that the estimates are complete, it is time to transform the work into a collection of facts that potential investors and business owners can use to drive decisions. The initial information and discussions should focus on high-levelassumptions and give confidence that the business can scale and grow as the example outlines. (See the sidebar, "Example for High-Level Projections," below.)
Item 1: Condensed profit and loss statement
Present the following sections in a P&L format for each year over the three- to five-year period:
Revenue: Include a row for different revenue levers with a total net revenue.
COS: Show total dollar amount, cost as a percentage of revenue, gross profit (revenue less COS), and gross margin (gross profit as percentage of revenue). If possible, show COS at the individual revenue lever.
SG&A: (1) Categorize the expenses into salaries, marketing, and all other. Present the category subtotals in dollars and as a percentage of revenue as well as the SG&A expense grand total; (2) consider categorizing any other major expense that may be specific to the business; and (3) do not show any expense assumption detail here.
EBITDA: Include EBITDA in total and as a percentage of net revenue.
Item 2: Cash flow
Add two rows underneath EBITDA for each year: one for total cash flow for that particular year and one for cumulative cash flow.
Item 3: Capital investments
Include the capital plan by project and year.
Item 4: Bullet points on key revenue and cost assumptions
Add key assumption points to give the reader an idea of how the revenue and costs were estimated without going into too much detail. These can be points on the same page as the P&L or on a separate page.
Revenue: Revenue drivers, churn, revenue assumptions, and how the assumptions change year over year.
COS: Significant expense drivers. This could be product-specific labor expenses or materials.
SG&A: Total marketing, selling, and administrative headcount year over year with key roles, total one-time startup expenses, and any other material expense that may be specific to the business.
Item 5: Metrics and graphs
Break-even point: The break-even point can be calculated in dollars or units and will indicate at what level of sales the company will cover all fixed costs. This metric is beneficial internally for pricing and production purposes. For external readers, it indicates roughly how long it will take before the company starts generating a profit.
Payback period: The payback period is the length of time it will take to pay back the original investment. Investments with a long payback period are undesirable; however, the required period will range by investor and business industry. Technology projects typically have a desired payback period of one to two years.
Graphs: Graphs are a great way to visually communicate financial results and tell the story of the business. Consider including the following information in a colorful graph format:
Revenue over time with a trend line.
EBITDA over time with a trend line.
Cash flow over time with a break-even point and a payback period point.
Revenue drivers and assumptions over time.
Size of the market: Give the reader an idea of the full market potential and what piece of the market the business is trying to attain.
Item 6: Presentation of do's and don'ts
Keep it simple.Round numbers to thousands or millions.Highlight the key assumptions.
Don't use decimals.Don't confuse the overall story by giving too many details.Don't request less or significantly more cash than required to bridge the business to profitability as outlined on the P&L.