and Business Resources
magazine - September
By David R. Evanson
Putting together financial projections that attract investors
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
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
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
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
- 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.
Mid-Atlantic Venture Funds, 125 Goodman Dr., Bethlehem,
PA 18015, (610) 865-6550
National Restaurant Association, (202) 331-5900, http://www.restaurant.org
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