Out there talking to entrepreneurs, I often get asked about what investors are looking for in a five-year financial forecast. First off, what is a five-year forecast? Your first reaction is probably, “It’s impossible to predict.” Startups are volatile; there’s risk, and it’s heightened. So, yes, it’s not possible to predict, but that’s not the purpose of a five-year forecast.
Five-year forecasts communicate your strategy
The purpose is to communicate your business strategy and your execution plan as it relates to key things like hiring, marketing, and liquidity. Too often, I see entrepreneurs pitching — pitching all the time — with market data. There’s the slide about the team, the addressable market, the problem they’re trying to solve, and the market strategy. Yet when it comes to financials, they’re an inch deep and a mile wide.
Show investors cash flow in and out
Now, you may be saying to yourself, “I’m not an accountant or financial whiz.” You don’t have to be; I get that all the time. Think about your financial models from the perspective of cash coming in, cash going out, and how much cash you need to keep this afloat until you make money. Since businesses start with customers and their willingness to exchange some value for a product or service, we need to understand the customer’s needs and the market potential. Before you even sit down and make an attempt at a financial model, make sure that you’ve thought about some of the following things.
Your Audience, Market Segmentation, and Customers
1. First, know who you’re selling to. This is by far the most important building block of a financial model.
2. Do some market segmentation. What is your addressable market? How big is your market? This comes down to how many marketing dollars you have to deploy and where you’re going to deploy them. Let’s face it, if you only have $100,000 in marketing dollars, there are only so many customers you can market to.
3. Penetrate the market. This is the end result: the number of customers you’ve got, or said another way, this is how successful your marketing dollars were in converting those people into actual paying customers.
Identify what drives revenue
Let’s start identifying the drivers of your income statement. Let’s start at the top: revenue. What drives revenue?
Who are your customers? Are you business to business? Business to consumer? Small businesses or enterprise customers? How much can you sell today? Or better yet, how quickly can you capture market share?
Product mix also drives revenue. What are you selling? Are you selling one product, five products? What are you selling today? What are you selling next year? Make sure that you’re thinking about your customer acquisition strategy and your customer acquisition cost by keeping in mind that these costs will appear most likely in the operating expense section of the profits and losses, not in costs.
Pricing obviously drives revenue. Ask yourself, what is your pricing model and why? Are you a fee-for-service? Are you fixed price? Recurring revenue versus transactional revenue? Do you offer value-based pricing? And how does pricing evolve over time? Are competitive forces driving long-term pricing down? Revenue is simple. How many widgets do you sell, and at what price? Just be prepared to defend and discuss your volume assumptions, your pricing model, and why you’ve done what you’ve done in your business model.
The Income Statement
Now let’s work our way down the income statement, taking a big-picture look at what investors will be expecting in your cost of goods sold, gross margin, and operating expenses.
Cost of Goods Sold
Your cost of goods sold is, in essence, what it cost you directly to produce your product or deliver the service. In this section of the financials, investors are looking for a few things. They will be looking for whether you’ve clearly thought about your sourcing and production strategy and if it’s realistic. For a product company, where will you be getting your materials? How will they be transported? Where will the inventory be kept? For a service company, how much do your people cost? Is your staffing plan lined up with your volumetrics?
Your gross margin is, of course, what’s left over to pay for everything else. So ask yourself, is gross margin expanding over time? That’s a metric that investors will want to see. Gross margin and gross margin expansion are telling them whether you can afford to run and scale your business.
As we keep moving down the income statement, the next section is your operating expense. This section is really where you show investors whether you know how to scale your business and what it takes. Investors are reading your story through the numbers. Investors are aces at this. You need to make sure that the story that you’re telling them verbally lines up with the story that you’re telling in your financials.
Net Operating Profit
The bottom line of the income statement is your net operating profit. This is what’s left over net after deducting operating expenses from gross margin.
So that gets us to the bottom of the income statement. And those are some of the big-picture items investors are looking for and want to be able to marry up with your pitch and your financials. But it all starts with the answering the question, who is your customer? How many of them are out there, and how do I get them? Once you know those things, you have to scale your business, whether by insourcing or outsourcing certain functions.
The single most important element for investors is liquidity. What are the liquidity needs of the business? How much money do you need to execute your business plan? Building your financials will tell you what your cash position is each month so you can see what your cash flow point is, and when. Your liquidity plan also gives you insight into your anticipated cash burn. How much and how fast do you use cash? How long is the plan? What is the liquidity inflection point? When does this business start making money?
As you can see, a financial model is more than just numbers on a spreadsheet. It’s a communication tool. It’s really all about tying and threading your story from your pitch into thoughtful, grounded, realistic financials.
Steven Byler is the COO and a Co-Founder of GrowthLab Financial Services Inc. He and his company are dedicated to serving the financial needs of entrepreneurs, small- and mid-sized businesses, and financial/private equity sponsors.