Fortune Telling Putting together financial projections that attract investors

In every company's life, there comes a time when it mustlook into the future and try to imagine what its financialprospects are. Often this occurs right at the point when theproduct or service is fully developed but not yet launched.It's at this moment that most entrepreneurs--faced with theenormity and cost of evolving from a product development company toa sales and marketing giant--seek outside financing.

Naturally, the first question would-be investors ask is"What do your financial projections look like?" Thereason investors ask this question is simple: Companies are valuedin relationship to their earnings. Hence the future value of theinvestment depends on how the company performs down the road. As aresult, access to growth capital depends in large measure on theentrepreneur's ability to paint a credible and compellingpicture of his or her company's financial prospects through aprojected income statement.

But how to do so effectively? "It's naive to simplystart with baseline sales and apply a formula that increases themby 20 percent per year," says venture capitalist Fred Bestewith Mid-Atlantic Venture Funds in Bethlehem, Pennsylvania."It's probably even more naive to suggest that the marketis a certain size and the penetration will increase a certainnumber of percentage points each year. The fact is, there'snothing formulaic about projecting future sales. It requires goingthrough 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 toexamine every single detail of your projections. But at first pass,they'll look at just five items: sales; cost of sales; grossmargins; selling, general and administrative costs; and operatingincome. So what should each of these items include, and how shouldthey be structured to avoid immediate rejection?

• Sales: The most effective sales projections forpre-revenue-stage companies, says Beste, rely on original marketresearch 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 theprojections out of the realm of fantasy and into the world ofreality.

For instance, an entrepreneur offering pet-grooming services cantest potential customer response through a direct-mail campaigneven though he or she is not yet in business. Once the responserate is determined, projected sales are figured as a percentage ofthat response. This approach also begins to lend some credibilityto the expense side of the equation since you now have hard factsto base your projections on.

The great thing about using other people's money to build abusiness is that it's other people's money. The bad thing,says Beste, is it takes a lot of work to make investors believe youhave a worthwhile investment. Using this financing method, it'snot hard to see that building a credible case requires some testingand a little bit of extra work on the entrepreneur's part.

• Cost of goods sold: Compared to sales, the cost of goodssold is much easier to determine. After all, while projected salesrequire the entrepreneur to consider where, when and how long itwill take to open new stores, the cost of goods is a faitaccompli because much of it relies on the calculations behindprojected sales. When sales are known, the cost of goods sold ismostly just a case of plugging in the right figures.

But you can only plug in the right numbers if unit costs areknown with some degree of certainty, which for many companies isthe fly in the ointment. Pinpointing unit costs requires you to dosome homework to determine the cost of materials and time that gointo producing the unit or service, as well as any other expensesinvolved. These estimates are sometimes referred to as costschedules.

If an entrepreneur is unwilling or unable to make detailedsupporting schedules for the cost of products or services, it canbe the kiss of death. After all, who would invest in a companywhere not even the founder is sure what it will cost to produce theproduct or provide the service?

• Gross margins: Gross margin is defined as sales lesscost of goods sold, and the investor usually looks at it as apercentage. So what must the gross margin say or not say?

First, the gross margin should not be too far out of kilter withthe average for the industry. (For industry figures, contact atrade association.) For instance, according to statisticsmaintained by the National Restaurant Association in Washington,DC, gross margins for so-called full-menu table-serviceestablishments are about 36 percent. If you're opening arestaurant and your financial projections show a 25 percent grossmargin, up goes the red flag. If your projections show a 45 percentgross margin, up it goes again.

While the former deviation is a tough sell, the latter ispossible to overcome--with a plausible explanation. In fact, with areally good explanation, it's a selling point. After all,breakthroughs in technology, manufacturing techniques, ormanagement styles can change the economics of doing business andcreate exciting investment opportunities. So if you've got it,flaunt it. But be prepared to offer lots of evidence thatillustrates why your operation breaks the mold.

Another important strategy for computing the gross margin is topull it back a bit from what might be suggested by the numbersalone. For instance, if your actual projected gross margin is 45percent, it's wise to increase the cost of goods sold so thatthe gross margin in the projections you show investors is a morerealistic 40 percent. "Most of the time when you'retalking about gross margins," says Beste, "you'retalking about utopia with no stockouts, absenteeism, shrinkage orteamsters strikes. But let's face it, Murphy's law runsrampant in most small businesses."

• Selling, general and administrative costs: If ever therewere a place in the projections to simply let costs increase eachyear by a set factor, general and administrative costs are it.Supplies are not expensive. Calculating the cost of runningcentralized operations is fairly straightforward.

Estimating selling costs, on the other hand, can be a bear ifthe entrepreneur is uncertain how products will be distributed. Andif the entrepreneur suggests too many different types of sellingmethods in the financial projections, investors will know he or sheis clueless about how to sell his or her product or service.

Specifically, if the selling costs include advertising, tradeshows, manufacturer's representatives, sales staff andtelemarketing, it could be an indication that the distributionchannels are unknown and thus overstated. There are legitimateinstances where the precise distribution channel is unknown and asa result, so are the precise selling costs. But the burden ofselecting the most likely channel, based on experience or duediligence, rests with the entrepreneur, not the investor. When thefinancial projections indicate a shotgun approach to selling, theentrepreneur is saying, in effect "I'm going to try allthese things to see which works," which often prompts theinvestor's response "Not with my money, you'renot."

• Operating income: As far as financial projections go,operating income or the operating margin, which is defined as grosssales less selling, general and administrative costs, is the bottomline. Many of the guidelines for projected gross margins apply tooperating margins as well. For instance, be conservative ratherthan extreme in your estimates so you leave yourself room to exceedthe projections rather than fall short of them. Where operatingmargins exceed industry averages, provide a tenable explanation. Inthe same way technology, management style and manufacturingtechniques can cause a breakthrough on gross margins, so too canthey have a healthy effect on operating margins.

Another important aspect of the operating margin is its absolutevalue. In general, a small operating margin, as a percentage ofsales, is a turn-off for most investors; it leaves little room forerror, and it's harder to create the kind of profits that offeran opportunity for investors to cash out.

For many businesses, however, thin margins are just part of theterritory. Where they can undermine a small business, according toBeste, is when projected operating margins are thin because of alow-cost pricing strategy. "If the underlying assumption isthat profits come with volume," he says, "the questionbecomes, Does the organization have the skill to generate therequired volume?"

More important, what kind of cash is going to get eaten ininventory purchases (if there are any) and in carrying a largebalance of accounts receivable that come part and parcel with alarge sales volume? "You have to question the wisdom of anentrepreneur who is using a low-cost approach," says Beste,because it's not really dependable or maintainable on anongoing basis without becoming costly to the business.

A complete financial forecast includes projected cash flowstatements and balance sheets as well. But these statementslogically flow from the income statement. Conventional wisdom saysthat if the projected income statement is right, everything elsewill fall into place. But the flip side, says Beste, is that if theprojected income statement is off, it's unlikely financing willever get off the ground.

David R. Evanson, a writer and consultant, is a principal ofFinancial Communications Associates in Ardmore,Pennsylvania.

Contact Sources

Mid-Atlantic Venture Funds, 125 Goodman Dr., Bethlehem,PA 18015, (610) 865-6550

National Restaurant Association, (202) 331-5900, http://www.restaurant.org