Entrepreneurs often ask me why investors expect financial projections for a new startup even before the product is built and while the market is still being defined. I tell them that the projection process and results are most important for you the founder, to evaluate if there really is a business that can be built from the idea. You shouldn’t invest in an undefined business.
Investors can’t really evaluate any new business, but they can assess the logic behind your numbers, and compare that logic to their experience and rational business norms. Most have developed their own financial “rules of thumb” that will help them decide if your startup is fundable, in conjunction with their assessments of your team and your basic business concept.
Related: How to Make Debt Work For You
If you are lucky enough to not be looking for an outside investor, meaning you are bootstrapping the business, the secrets that smart investors use to evaluate startups can help you understand your own risks and help you set reasonable expectations for yourself. Here are some key rules of thumb from my own experience:
1. Financial projections must show a rational business strategy.
I recently saw a startup projecting $50 million in revenue for the first year. Even Google couldn’t do that, so I would deem that not a credible strategy. I recommend five-year projections, to show the evolution of revenues and expenses and funding and profitability expectations over time.
2. Target a company size that can produce premium returns.
My rule of thumb is that startup-revenue projections in the fifth year better be between $20 million and $100 million. Less than $20 million implies a small potential investor return, and more than $100 million implies a very high risk or irrational exuberance.
3. Growth projections should be aggressive, never conservative.
Premium startup-acquisition targets usually at least double revenues every year, so conservative 20 percent yearly-growth projections will not win accolades. There is no startup premium for acquirers looking back in five years at exceeded conservative projections.
4. Revenue projections show penetration of target opportunity.
Some projections I see show a huge opportunity with trivial penetration, or vice versa. Neither extreme is good. Five-year revenues, based on your volumes and prices, should penetrate at least 10 percent of the target market segment.
5. Gross margins should be in line with the industry.
For most industries that means projected margins greater than 50 percent. I continually hear founders assert they will compete through lower margins and harder work. They haven’t yet faced the realities of new employee benefits, escalating salaries and the true overhead of scaling the business.
6. Base your funding requests on projected cash shortfalls.
If your business projects a negative cash flow of $800,000 before breaking even, it’s fair to buffer that amount by 20 percent and ask for a $1 million investment to cover contingencies. Think about the valuation implications and equity you are willing to give up for each investment amount.
7. Explicitly include funding expectations as a line item.
Funding inflows are not revenue, and should be listed under the year needed. Don’t show projections with no red ink, implying that no funding is required, or you won’t get any investor interest. Investors don’t like funding requests to buy you a building or put money in the bank at no interest.
8. Show a liquidity event and investor return at the end of the period.
If you are expecting outside-investor interest, you need to show a financial path to a satisfying return, in the range of 10 times their investment. This means an acquisition or initial public offering that will generate at least five times your fifth-year revenues, at a commensurate equity ownership.
Of course, if you are an entrepreneur with a track record of billion-dollar successes, all rules of thumb are irrelevant, and neither you nor investors need projections to test your credibility. For the rest of us, no credible projections will likely elicit the dreaded investor response of “come back when you have more traction.” That means they don’t like your projections and will wait for results.