For non-financial founders a financial forecast is one of the most dreaded and misunderstood aspects of getting their company funded. They know they need the thing, but are thinking, “What good is it? Who can predict the future? This market moves too fast to lend itself to a plan.”
But they know they need it because:
- Investors want to see one;
- My business plan template has one (because investors want to see one);
- I need to put one in my pitch deck (because investors want to see one);
- Everybody else has one (because their investors want to see one).
Yup, investors want to see one. But this is where “misunderstood” comes in. They don’t want to see one to make sure you’ve fulfilled your quota of useless work outside of your comfort zone. They want one because it’s valuable. Critical, in fact. Critical because it ultimately gets to the all-important question of “How do we make this thing work?”
If done properly, here are the questions it answers along the way:
1) Do We Have the Right Revenue Model?
You may think you know how you’ll charge for your product, but a good financial model will tell you if it will work. Maybe you plan to use a freemium model. A forecast will lay out the resources you’ll need to service your free customers, what you’ll need to provide additional value for your paying customers, how much you’ll charge, and what conversion rate will make it all work. Related, of course, is how you’ll acquire a customer and how much you’ll pay to acquire one. If you don’t have a way to acquire customers or you don’t have a way to get enough money from them to more than cover your costs, you don’t have a business.
2) Are My Core Assumptions Reasonable?
In any financial forecast you have to make some assumptions. If your business is pre-revenue, those assumptions are often difficult to develop, key drivers of the forecast, and ultimately picked apart by investors. For these reasons, you need to drive your assumptions down to their most basic level. By that I mean that if an assumption is disputed, it’s not disputed by a fact, research, or empirical evidence. Rather, it comes down to someone saying they simply believe something different.
Let’s take a simplified example in which you arrive at a certain number of customers by applying a conversion rate to your assumed number of website visitors. You’ll be asked why you assumed that number of visitors. You now have to go another level deeper so you say w% come from AdWords, x% come from affiliate marketing, y% come from email marketing, and z% come from organic search. But you’re still not deep enough because you need to apply a click-through rate (CTR) to your AdWords buy, to your affiliate marketing impressions, and open rates and click-throughs to your email campaigns. And they all need to be justified by some market comparables. Your core assumptions are inputs, and the rest is math. Now, an investor may say that he or she doesn’t agree with your use of that comparable, but you’re down to a core assumption and you can have a discussion about it.
Suppose you’ve developed your core assumptions, done the math, and discovered that the only way your model works is by applying unjustifiably high conversion rates. You’ve found that your marketing plan doesn’t work. You need to revise. On the other hand, if it all looks reasonable, you can feel confident in your plan. You may still find someone to disagree with you about your assumptions, but now you’re arguing about the right things.
3) What Levers Have the Biggest Impact?
As you drill down to your core assumptions, you’ll begin to see the impact a change in those assumptions has on your business results. Understanding what these business drivers are is critical to your ability to manage your business. They tell you what’s truly important to making it all work. This is what your investors want to know and it’s what you want to remember as you develop, price, and customize your product. And then as you launch your business and begin to bring in revenue, you’ll know what levers to pull to adjust your results. Does a small change in your AdWords CTR bring a large revenue increase? Then get to fine tuning your keyword buys and ad copy. When things don’t go according to plan, and they won’t, you’ll be much better able to diagnose the problems and figure out what to do next.
4) What Resources Do I Need?
A good financial forecast will tell you how much funding you need and where to apply it. As you work through the forecast, you’ll find that some things worked as you hoped, while others didn’t. As you adjust for those that didn’t, you’ll find that your needs have changed. Maybe you need more engineers, or product development people, or social media experts. Whatever it is, you adjust because your forecast told you that your original plan is unlikely. As you settle on your base case forecast, you’ll see the deepest cash hole you dig – that’s your funding need.
5) Is It Working?
Once you launch your business, make sales, and produce your product, you’ll use your forecast to gauge your progress. But more than just a tracking tool, that forecast is a performance improvement tool. Remember all of those core assumptions you made? Are they accurate? If not (and something will be off), you need to adjust. Remember the business drivers you discovered? Those are the levers you pull to adjust. And if worse comes to worst and you have to completely pivot your business, you now have the ability to start over and build your new best friend – a financial forecast.