Any financial plan should start from an analysis of the market. For startups, this is fundamental as product-market fit is still largely unknown or only a hypothesis until a stable revenue is achieved.
After the market analysis, validation and drawing your business model, including your potential long-term strategy, it is time to put everything to test by creating financial projections. While the future is uncertain and trends change, we have a variety of data from the past to help us. The reality is that financial projections will not ensure you that everything will go as planned: the main reason for this is the risk that founders and owners will deviate from the original strategy, and that assumptions about the market turn out to be largely wrong. This means that the initial validation was insufficient or not possible, but it does not mean that exercise of playing out future financials wasn’t useful.
The financial projections also help you validate your business model: if your profits are too high, you know that you are underestimating costs; if you’re making losses for too many years without the accompanying growth and fundraising strategy, you need to adjust your revenue model; if you’re growing much faster than competitors without a strong competitive advantage, you need to review your expectations.
It is for this reason that financial projections are important at any stage, and help you make the right decision and avoid investing in companies with low potential. Many investors claim that the right team is far more important than the product or business model, and the previous popularity of the lean startup approach in the past few years has helped consolidate this theory. Obstacles and product discovery are part of the day-to-day routine of a startup and the ability to overcome them, measure the strategy effectiveness and take measures is up to the team.
This fact is undisputable, but it’s not an excuse to ignore the numbers or the business model. The fact that the quality of the team is important, does not make the numbers not-important: this theory perpetrated by many who cannot create projections seems very simplistic. First, timing is also important: if you take too long to implement the right business model you might miss opportunities or be overtaken by a competitor, therefore preparing in advance, when possible, it’s a plus. Secondly, there are many startups that have received millions and millions in funding because of their ability to scale, but that have not yet been able to find a way to profitability or to implement an effective revenue model. I don’t believe that this is the business model that we want to see in the future.
Calculating the company’s revenue and earnings is absolutely possible. Certainly, most of those who are doing financial projections for seed startups, internally or externally, do not have the necessary knowledge and techniques to do it, generally few people can do projections right, probably no one can do it right all the time, but this does not make it impossible. There is always a deviation from how the company actually develops, but by how much is what is important here. Only those who cannot do it, and do not want to try, say that it’s impossible. This false expectation has prevented us from improving skills and methods in this field, and both founders and investors have found themselves in many cases to enter investment decisions based on hypes, presentation skills, and team background, which is important, but limits the quality of the investment decision.
In order to really know how a company will perform, 3 years are not enough. It is difficult to calculate your financials far into the future, but if you have the wrong strategy you can be completely wrong on year 2 and 3 as well. Therefore, thinking about where your company is going in the future helps you set a strategy, which can change, but it still helps the investor know how and when an exit is possible. The first 3 years do not give a good enough overview of what the company’s possibilities are.
Many high-tech companies and fast-growing startups display a fast growth during year 2-3, and then naturally growth starts slowing down. This is not a negative factor, but a natural development as triple-digit growth rates cannot be sustained in the long-term. However, because a slowdown in growth can lead to some investors rejecting an opportunity, this in turn leads to many startups presenting unrealistic financials, or incorporating impossible strategies to boost growth on paper.
In addition, using financial projection is key to understanding the potential size of an exit and valuing the company. In turn, creating a financial plan or even just revenue projections with no known strategy leads to many mistakes.
The first step to take after the market analysis and validation, is therefore laying out the expansion strategy with realistic figures.