Financial projections are one of the most important elements of any business plan. Even though any astute investor knows that all 5-year financial projections are just a bunch of made-up numbers, they still value it, and thus it’s all the more important than before for the founders to get right.
Unfortunately, most founders are financially naive, they really struggle with the projections and outsource this to accountants/CAs/CFAs at a huge expense.
Considering this background, this article intends to help the above founders in building their projections in a much simpler way, and to an extent cut the jargon for easy understanding.
So, Why are Financial Projections so Important?
Financial projections are important for a variety of reasons. Usually, they’re used to attract investors for equity or apply for a debt loan from banks, NBFCs, etc. Besides, learning how to make financial projections for your business, it also has a range of benefits, such as:
Translates your company's goals into specific targets/outcomes
Evaluate your business’s strengths and weaknesses versus competitors
Using it as a feedback and control tool to anticipate problems, and take remedial measures
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From an investors' perspective, they can gauge a founder's ambition from their financial projections. Remember, there's a thin line between being ambitious and being overly ambitious (foolhardy).
Consider the below scenarios for an early-stage startup, which is yet to achieve $1 Mn yearly revenue:
If the projections show $100 Mn revenues at the end of Year 5, it's considered statistically impossible, as you can't be growing faster than unicorns. Investors consider such founders to be financially naive, and won't take them seriously.
On the flip side, if the projections show $2-3 Mn revenues at the end of Year 5, then despite having a brilliant team and sound market, investors consider this to be an un-investible opportunity, owing to lower Return on Investment.
By projecting your revenues and expenses, you can give a more accurate view to the investors of how successful your business can be in the next 5-years. Creating financial projections is a key part of developing a sound strategy to achieve those numbers.
It pertains to demonstrating the relevant capabilities of your team, resources available now and needed in the future as well as a focused action plan revealing, how those revenues would be achieved both in the short term (1-2 years) as well as long term (3-5 years).
Lance Cottrell, Angel Investor, Startup Mentor.
Many investors expect the founders to show their financial projections, though fully knowing that the numbers are going to be wrong, specially when the ventures are at pre-revenue stages. At that stage, the years 3-5 projections are pure fantasy.
Show your fixed and variable costs associated with building product/service, the sale price, and the resulting gross profit margin.
Your projections should demonstrate that there is a big enough market to achieve those numbers.
Your projections for the next 12 months can be grounded in the present reality. You know your expenses and burn rate.
Short-term financials show that you can deliver on the milestones required for your next funding without running out of money. They are all about cash management and planned development or growth expenses.
How to Build Financial Projections for a Revenue-generating Startup?
To produce financial projections for startups, you’ll need key documents like a balance sheet, an income statement, and a cash flow statement. Once you’ve got these documents ready, you can then begin making financial projections. Overall, there are five main components to building a financial projection for startups:
1. Revenue (Sales Projections): Estimate the amount of revenue a company expects to earn in the next 5 years.
2. Cost of Sales aka Cost of Goods Sold (COGS), represents the direct costs related to the manufacturing of goods/services that are sold to your customers.
Gross Income/Margin = Revenue - Cost of Sales
3. Operating Expenses (Opex) is an ongoing cost a business must pay to operate, whether or not it manufactures products or generates revenue. Typically includes General and Administrative (G&A) expenses (rent, utilities, insurance payments, and wages and salaries), Sales & Marketing expenses, and funds allocated for research and development.
3a. Operating Income refers to the adjusted revenue of a company after all expenses of operation, and depreciation + amortization are subtracted.
Operating Income = Revenue - Cost of Sales - Depreciation & Amortization
EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) is a measure of a company’s overall financial performance and is a widely used metric of corporate profitability. EBITDA is also used to compare companies against each other and industry averages.
EBITDA = Operating Income + Depreciation & Amortization
3b. Net Income aka Net Earnings is gross income minus all other expenses and costs as well as any other income and revenue sources that are not included in gross income.
Net Income = Operating Income - Interests - Taxes
Earnings before Interest and Taxes (EBIT) = Net Income + Interests + Taxes
4. Balance Sheet shows the projected financial status of your business, including assets, liabilities, and equity balances.
5. Cash Flow Statement displays all cash and cash-related activities affecting your business.
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How should a Pre-revenue Startup Project its Financials?
For pre-revenue startups, it can be difficult to predict future projections. You can far more accurately assess and regulate your spending. So using bottom-up approach, calculate what you are spending on and the costs that are incurred by the business to generate sales. Once that's in place, determine your startup pricing strategy and sales volume that you'll need to be profitable in your cash flow statement and balance sheet.
According to Gale Wilkinson, founder of Vitalize VC, a VC backable startup based in the US should be able to achieve $25 Mn revenue in 5 years, at a minimum.
First-year of revenue would likely be a few $100K [min. 3X of last year]
Second-year, one should get close to or just above $1 Mn [min. 3X of 1st year]
Third-year, $3-5 Mn [min. 2X of 2nd year]
Fourth-year, $10-15 Mn [min. 2X of 3rd year]
Fifth-year, $25+ Mn [min. 2X of 4th year]
Venture Capitalists see a startup as investable if the top-line (revenue) grows 3x (in Years 1 & 2), followed by 2x (in Years 3,4,5).
Noteworthy: Your action plan should support how you would achieve these levels of revenue based on your unit pricing and the sales + support staff required to execute. Don't be too conservative in your estimates, but they should also be reasonable based on your inputs.
The most important thing about your early-stage financial model is the thought process you go through to figure out the assumptions & drivers!