The world of startups is fast-paced, unpredictable and constantly evolving. The same goes for my choice in breakfast cereal. This is not the case for large corporations where dramatic and unpredictable shifts are much less frequent. So why enforce and advocate the use of institutional financial modeling to startups? It makes no sense I tell you.
A large corporation that has been around for as long as horses, is able to produce much more realistic projections due to it’s substantial operational history and because large corporations deal with less uncertainty on a day-to-day basis. When it comes down to it, projections are projections, so some amount of guesswork comes into play even if you are at the reins of a blue chip, but to compare the two is pure folly. While Wall Street analysts come within a hairs breadth of predicating Apple’s third quarter earnings, how close do you think they’d come to guessing the performance of imastartup.com next year?
WHY DO STARTUPS USE THE SAME MODEL?
Investors make calculated decisions. They do their best to make sure their money is in the right hands. Preparing financial projections allows investors to analyze the entrepreneur, their assumptions, their ambition and their understanding of the market. However, it should have less to do with the actual numbers and more to do with how the team has interpreted the data and how they perceive the potential of the market. When looking at your projections, investors should be thinking, “Are the right assumptions being taken into consideration? Is the target market share a reasonable objective? Is the team driven to be profitable? Are they basing the projections on the right metrics? Are they preparing for alternative outcomes?
Investors can gather a lot from your projections and can easily assess whether the assumptions you’ve made are sensible and more importantly if you can justify them when confronted. This is an essential part of the process and can help investors weed out the good projects from the bad.
It’s also important to consider that these projections are just one model of the way things could go for your business. What happens if six months down the line you need to employ 10 more people? If your customer acquisition costs increase dramatically? If you’re competitors suddenly triple their adverting spend? If sales in new markets don’t grow as quickly as you had thought? If your payment cycle doubles? If the viral coefficient drops by half? If any of these variables change, is the money you’re trying to raise going to support you through the turmoil? Understanding the possible outcomes and the weaknesses of your business are fundamental and also something that investors will want to see you have considered.
THE NEED FOR A CHANGE
Putting that to one side, early stage startups have limited operational history to go on, and in some cases, no history at all. Even with a year or two behind you, things can change so quickly for young ventures that it’s impossible to predict what will happen 6 months down the line, let alone 2 years. Projections for conception and seed stage startups are essentially works of fiction. In fact, I can’t think of any early stage startups I know that have followed their financial model without any large variance.
The numbers in these projections for seed startups are not only irrelevant for investors but often become a source of discussion which future decisions and performance can be based upon. This becomes even more concerning further down the line, after your startup raises money, when you could become accountable if things don’t go as planned in these figures.
With more and more startups adopting the lean method (build, measure, learn), being able to iterate and change course quickly is a fundamental element, which means things could drastically vary from the projections you have prepared. Just as certain metrics that were driving your business today might not be the same ones driving them tomorrow, the same should be applied to the financial projections.
For me, the main issue comes when you raise money. Understandably, investors want a return on their investment so they have to include certain clauses related to performance and how the funds are distributed (if they don’t you could decide tomorrow that you need a wage of €300k and bleed the company dry). However, in more than a few cases I have seen these clauses related to the “fabricated” financial projections.
Given that these numbers are based in guesswork, I don’t think they’re the correct variables that should be used to rate the businesses performance nor for how the funds should be allocated. Having your hands tied at this stage when you need to make vital decisions quickly can be suffocating and have a negative effect on the business. What happens if you suddenly need to double your advertising spend which goes over the 20% stipulated in the financials? It’s likely to require an emergency board meeting. Having to follow such outdated rules can prevent young startups from making these effective decisions on time. I completely understand that systems need to exist to protect investors but at the same time give those systems flexibility that allow for the entrepreneurs to make crucial decisions quickly.
Financial projections should be used as a test to ascertain if a great team with an innovative idea has the business sensibility to match their enthusiasm. Then use the factual data that actually exists about the company to determine how much funding is required for this team to pivot on their strategy 3 times before running out of money. In other words, which would you rather invest in: Three chances for a great team to find a successful business model – or – a great team burning through cash trying to make their original business model work?