In every company's life, there comes a time when it must look into the future and try to imagine what its financial prospects are. Often this occurs right at the point when the product or service is fully developed but not yet launched. It's at this moment that most entrepreneurs--faced with the enormity and cost of evolving from a product development company to a sales and marketing giant--seek outside financing.
Naturally, the first question would-be investors ask is "What do your financial projections look like?" The reason investors ask this question is simple: Companies are valued in relationship to their earnings. Hence the future value of the investment depends on how the company performs down the road. As a result, access to growth capital depends in large measure on the entrepreneur's ability to paint a credible and compelling picture of his or her company's financial prospects through a projected income statement.
But how to do so effectively? "It's naive to simply start with baseline sales and apply a formula that increases them by 20 percent per year," says venture capitalist Fred Beste with Mid-Atlantic Venture Funds in Bethlehem, Pennsylvania. "It's probably even more naive to suggest that the market is a certain size and the penetration will increase a certain number of percentage points each year. The fact is, there's nothing formulaic about projecting future sales. It requires going through a spreadsheet cell by cell and thinking about each quarter. It's damn hard work."
When investors get close to doing a deal, they'll want to examine every single detail of your projections. But at first pass, they'll look at just five items: sales; cost of sales; gross margins; selling, general and administrative costs; and operating income. So what should each of these items include, and how should they be structured to avoid immediate rejection?
- Sales: The most effective sales projections for pre-revenue-stage companies, says Beste, rely on original market research or test marketing conducted by the company's founders. Neither of these activities needs to be exhaustive or expensive. But they are important because empirical data will move the projections out of the realm of fantasy and into the world of reality.
For instance, an entrepreneur offering pet-grooming services can test potential customer response through a direct-mail campaign even though he or she is not yet in business. Once the response rate is determined, projected sales are figured as a percentage of that response. This approach also begins to lend some credibility to the expense side of the equation since you now have hard facts to base your projections on.
The great thing about using other people's money to build a business is that it's other people's money. The bad thing, says Beste, is it takes a lot of work to make investors believe you have a worthwhile investment. Using this financing method, it's not hard to see that building a credible case requires some testing and a little bit of extra work on the entrepreneur's part.
- Cost of goods sold: Compared to sales, the cost of goods sold is much easier to determine. After all, while projected sales require the entrepreneur to consider where, when and how long it will take to open new stores, the cost of goods is a fait accompli because much of it relies on the calculations behind projected sales. When sales are known, the cost of goods sold is mostly just a case of plugging in the right figures.
But you can only plug in the right numbers if unit costs are known with some degree of certainty, which for many companies is the fly in the ointment. Pinpointing unit costs requires you to do some homework to determine the cost of materials and time that go into producing the unit or service, as well as any other expenses involved. These estimates are sometimes referred to as cost schedules.
If an entrepreneur is unwilling or unable to make detailed supporting schedules for the cost of products or services, it can be the kiss of death. After all, who would invest in a company where not even the founder is sure what it will cost to produce the product or provide the service?
- Gross margins: Gross margin is defined as sales less cost of goods sold, and the investor usually looks at it as a percentage. So what must the gross margin say or not say?
First, the gross margin should not be too far out of kilter with the average for the industry. (For industry figures, contact a trade association.) For instance, according to statistics maintained by the National Restaurant Association in Washington, DC, gross margins for so-called full-menu table-service establishments are about 36 percent. If you're opening a restaurant and your financial projections show a 25 percent gross margin, up goes the red flag. If your projections show a 45 percent gross margin, up it goes again.
While the former deviation is a tough sell, the latter is possible to overcome--with a plausible explanation. In fact, with a really good explanation, it's a selling point. After all, breakthroughs in technology, manufacturing techniques, or management styles can change the economics of doing business and create exciting investment opportunities. So if you've got it, flaunt it. But be prepared to offer lots of evidence that illustrates why your operation breaks the mold.
Another important strategy for computing the gross margin is to pull it back a bit from what might be suggested by the numbers alone. For instance, if your actual projected gross margin is 45 percent, it's wise to increase the cost of goods sold so that the gross margin in the projections you show investors is a more realistic 40 percent. "Most of the time when you're talking about gross margins," says Beste, "you're talking about utopia with no stockouts, absenteeism, shrinkage or teamsters strikes. But let's face it, Murphy's law runs rampant in most small businesses."
- Selling, general and administrative costs: If ever there were a place in the projections to simply let costs increase each year by a set factor, general and administrative costs are it. Supplies are not expensive. Calculating the cost of running centralized operations is fairly straightforward.
Estimating selling costs, on the other hand, can be a bear if the entrepreneur is uncertain how products will be distributed. And if the entrepreneur suggests too many different types of selling methods in the financial projections, investors will know he or she is clueless about how to sell his or her product or service.
Specifically, if the selling costs include advertising, trade shows, manufacturer's representatives, sales staff and telemarketing, it could be an indication that the distribution channels are unknown and thus overstated. There are legitimate instances where the precise distribution channel is unknown and as a result, so are the precise selling costs. But the burden of selecting the most likely channel, based on experience or due diligence, rests with the entrepreneur, not the investor. When the financial projections indicate a shotgun approach to selling, the entrepreneur is saying, in effect "I'm going to try all these things to see which works," which often prompts the investor's response "Not with my money, you're not."
- Operating income: As far as financial projections go, operating income or the operating margin, which is defined as gross sales less selling, general and administrative costs, is the bottom line. Many of the guidelines for projected gross margins apply to operating margins as well. For instance, be conservative rather than extreme in your estimates so you leave yourself room to exceed the projections rather than fall short of them. Where operating margins exceed industry averages, provide a tenable explanation. In the same way technology, management style and manufacturing techniques can cause a breakthrough on gross margins, so too can they have a healthy effect on operating margins.
Another important aspect of the operating margin is its absolute value. In general, a small operating margin, as a percentage of sales, is a turn-off for most investors; it leaves little room for error, and it's harder to create the kind of profits that offer an opportunity for investors to cash out.
For many businesses, however, thin margins are just part of the territory. Where they can undermine a small business, according to Beste, is when projected operating margins are thin because of a low-cost pricing strategy. "If the underlying assumption is that profits come with volume," he says, "the question becomes, Does the organization have the skill to generate the required volume?"
More important, what kind of cash is going to get eaten in inventory purchases (if there are any) and in carrying a large balance of accounts receivable that come part and parcel with a large sales volume? "You have to question the wisdom of an entrepreneur who is using a low-cost approach," says Beste, because it's not really dependable or maintainable on an ongoing basis without becoming costly to the business.
A complete financial forecast includes projected cash flow statements and balance sheets as well. But these statements logically flow from the income statement. Conventional wisdom says that if the projected income statement is right, everything else will fall into place. But the flip side, says Beste, is that if the projected income statement is off, it's unlikely financing will ever get off the ground.
David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania.