Financial Projections – Bottom-Up vs. Top-Down

Posted by on November 30, 2011

Top-down financial projections don’t work as well as bottom-up projections.  Here’s why.  Listen to how an entrepreneur might talk about a top-down projection.

  • “Our venture is selling in the <fill-in-the-blank> market.  It is <pick one: ginormous, absolutely huge, so big it’s nearly ridiculous, doubling in size each day>.  If we just get 1% of the market, we’ll all be rich and famous.  What are you waiting for?  Invest today!”
  • “We predict that within 3 months we will capture 10% of the market.”
  • “In our market in <pick a city> there are 3 main competitors.  When we join as the 4th, we should easily get our 25% of the market.”

When sophisticated angel investors, venture capitalists, or bankers hear statements like these, they know immediately that the entrepreneur is an amateur.  They will almost assuredly pass on the deal.  Why?  The entrepreneur’s top-down approach implies that he has more of a dream than a plan.

Top-Down Financial Projections

In theory top-down planning is great.  Start with the whole pie, the whole market.  Narrow it down by various means to get to the number that you’ll sell.  Sounds very logical and analytic.  What could go wrong?  Well, as it turns out, three main things can go wrong.

  1. Top-down financial projections often don’t consider the addressable market.  In other words, the entrepreneur may have found a figure citing the total market size in units or dollars.  However, that figure may include all of the US, while the venture only has distribution in the east coast (at least at first).  Because the venture doesn’t address the rest of the market, the total market number is irrelevant.
  2. Top-down financial projections often don’t consider the right market.  For example, the venture may be selling earbuds, but it may cite a market figure for the entire mobile audio market.  If it fully intends to enter every product category in mobile audio, that  figure is true.  Otherwise, it really should find the market for earbuds only.
  3. The third way that a top-down financial projection can go wrong is the most damaging in the long term.  A top down financial projection doesn’t suggest a plan of action for achieving the venture’s goals.  Instead of building a plan based on achieving goals, it focuses on subtracting the parts of the pie that it doesn’t believe it will sell – assuming that it will sell the rest.  But the projection doesn’t include the operational assumptions or metrics describing how those sales will be accomplished.

Bottom-Up Projections

A bottom-up financial projection is built on a solid foundation of measurable, tangible metrics and assumptions.  From day one, the entrepreneur knows what needs to be achieved and has a plan to achieve it.  Investors and bankers can see the venture’s operational assumptions in order to determine if they believe they are reasonable and achievable.  Maybe more importantly, the entrepreneur can also determine if he believes his operational assumptions are achievable.

Here’s an example.  One of the ventures I’ve worked with sells upscale swimwear and accessories.  Instead of starting with the swimwear market and subtracting, it started with what it planned to achieve.  Starting at launch, it forecast three metrics (plus price, of course) per month:

  • The number of cities where it would sign up retailers
  • The number of retailers per city
  • The number of swimsuits and accessories sold per month at each retailer

So, it built the revenue expectation from real goals – and made sure it felt they were achievable.

  • The entrepreneur and I discussed how many cities she could reasonably visit in a month, and listed the actual cities to be visited (by the way, this also allowed us to accurately forecast travel).
  • We looked at the cities and determined how easy or hard it would be to meet the goal for signing retailers.
  • We looked at the volume typical retailers sell for a given brand and model.

Then instead of subtracting things from a hypothetical pie, we multiplied these assumptions to determine the venture’s projection.  Instead of a dream of magically commanding some share of a total market, we now know what we believe to be a reasonable financial projection based upon operational goals we have determined we can achieve.

One final word.  What happens if we are unable to achieve the projection?  Well, since we have individual metrics we can easily determine where we fell short.  Then we can manage that by adjusting operational resources to visit more cities, visit more retailers per city, adjust our POP merchandising – whatever the numbers say is needed – or maybe adjust the projection if we determine we need to.

In other words, bottom-up projections are manageable while top-down projections are not.

 

 

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Why is Financial Forecasting Important?

Posted by on November 27, 2011

Financial forecasting is one of those phrases that send a shiver down the spine of most people.  There is a certain level of uncertainty and timidity when it comes to trying to estimate what the numbers will look like in the future.  What if I am way off?  What if I am just guessing?  This doesn’t seem like a very accurate process.

Well…the dirty little secret of forecasting is…it really is about guessing and it may not be accurate.

We don’t know what the future holds.  We may have an influx of new customers tomorrow, or we may not have a single hit.  There are so many uncertainties, unknowns, influences, changes, and unavoidable circumstances that all we can hope for is our best educated guess on what the future may hold.  That is what forecasting attempts to do.

Beyond the fact that many investors and other stakeholders require forecasts, the exercise provides many benefits:

  • Learning the industry – In order to even begin to forecast, you have to understand your industry.  How do your competitors’ financials look?  Is there public information available?  Are there changing trends in the industry?  Creating financial forecasts requires you to learn your industry, competitors, best practices, and direction.
  • Creating the revenue model – One of the most important benefits of forecasting is it helps you figure out how you are actually going to make money.  Surprisingly, this is one area that is very difficult when you are pre-revenue.  You have a great idea; how on earth do you monetize it?  Going through this exercise forces you to figure it out.
  • Developing a realistic expense outlook – Each industry has its own set of expense categories.  What supplies do you need?  How much and what type of marketing and branding need to take place?  What types of vendor/partner relationships are needed?  Forecasting helps you plan and understand your expenses.
  • Strategically planning future direction – Financial forecasting requires forward thinking.  It forces you to look into the future of your organization.  Where will you be in 3 years?  What do you think your organization will look like?  Where would you like to go?  Will your relationships and direction change?  All of these questions come into play when you forecast financials.

When prepared based on appropriate research and estimates, forecasts can be useful, informational, and valuable planning tools.  We will be writing a series of posts discussing how to forecast various accounts: Revenues, Expenses, Balance Sheet Accounts, and Cash Flow.  We will discuss other concepts around forecasting, one of the most important being the role assumptions play in the process.  We will also discuss how strategic planning leads to a focus on goals and metrics.  What are the true key factors, the true key measurements that are critical to your long term success?  What is the Financial Footprint you make in your organization?  In this manner, forecasting can be a key operational tool for leadership.

 

 

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The Three R’s of Creating Proforma Financial Statements

Posted by on November 18, 2011

When you project the financial statements for your new venture or business expansion, be sure to consider these three underlying principles. 

  1. Realism
  2. Relevancy
  3. Runway

Making Realistic Financial Projections

Realism (or lack thereof) takes two different forms in financials.

The first form is grossly underestimating.  Have you ever heard an entrepreneur say something like, “Well, actually we are sure that these financials are really conservative.  We expect to do way better than that.”  They do that for one of two reasons.  Either they want to show how good they are by beating their projections or they want to signal how confident they are.  Whatever the reason, that tactic doesn’t work.

The second form is grossly overestimating.  Every banker and investor has seen hundreds of financial projections where year one is a bit of a struggle, but years 2 and 3 show the new company magically transformed into a market share leader.  Every banker and investor has also seen plenty of financial projections where the venture started making money in month one (even if the sales cycle was 90 days long).  They know you won’t meet those projections.

Bankers and investors don’t want you to be so conservative that you are unrealistic, because that only means you are ignoring the real numbers.  Nor do they want you to project financials that are so optimistic that they are merely fiction.  They want you to be honest with them and yourself about what you will accomplish.

Making Relevant Financial Projections

Relevancy is very similar to realism in financial proformas.  It comes from two main sources.

First, it comes from detail.  If your revenue, cost, and expense projections are superficial, your financial projections are meaningless.  Lack of detail often stems from making top-down financial projections.  “The whole market is worth $2.3 billion, and we expect to capture 10% of that by year 2.”  A detailed, relevant revenue projection would start from the bottom.  What territories will you enter?  How many stores or salespeople will be employed?  How many prospects will they see each day or week?  Don’t just take a shot in the dark and throw down any old number.

The second source of relevancy is validation.  How do you know your assumptions are true?  What is the track record for closing sales that you’ve determined by testing with customers?  Have you tested different pricing models and know the customer acceptance rates for each?  Have you talked to a number of retailers so that you know they will sign up to carry your product?  Do you have contracts to back up your sales projections?  Write and project based on some sort of facts.

Bankers and investors want to have the warm fuzzy feeling that you know your market very well because you are IN it talking to customers and partners.  That manifests in your financial statement proforma by how well you can defend your projections with customer-validated and tested facts.

You Will Need Runway

No matter how realistic and relevant your financial statement proforma is, “stuff happens”.  Every startup business or business expansion encounters some level of growing pain.  Unforeseen problems occur.  Sales don’t take off as well as even your most realistic revenue projection assumed.  Unforeseen expenses knock on your door.  It may take longer to hire key staff that you anticipated.

Runway is the amount of time you can operate with zero sales.  It does not mean padding your financial estimates.  It means asking for enough money that you can cover your realistic expenses long enough to work out the kinks and get everything up and running smoothly.

Your objective is to avoid going back to your investors or banker almost immediately and saying, “So, uhh, we are running out of money – can we have some more?”  As you may guess, your reception would not be great.  Would you give more money to someone who so grossly underestimated their financials and operation?

How much runway do you need?  There is no one right number.  In the absence of any other data, six months to a year would be a good starting point, since you can’t reasonably expect to be up to speed in just a few months.

To determine your runway number more thoughtfully, think through how long it will take to deploy 2 iterations of your business model.  In other words, how long will it take you to really know if the way you are going to market is working?  Then double that number to allow yourself to fail once, learn from your failure, and deploy a second business model successfully.  Triple it if you can.  Then look at the expenses you’ll occur during that time period.  As you can surmise, finding ways to test the market more quickly pay off.

Good luck with your venture!

May your financial statement proformas be realistic, relevant to your market, and may you have the runway to get your venture up to speed!

 

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Bootstrapping Tips #1

Posted by on November 13, 2011

Bootstrapping is essential for any start-up.  Actually, the concept behind bootstrapping should be essential to any business.  What organization would say saving money and minimizing expenses was not a strategic concern?  But typically, as organizations grow in size, concern for little expenses tends to go away.  The threshold for evaluating every expense continues to decrease proportionate to the size of the organization.  As your organization continues to grow, try to always keep the concept of bootstrapping always at the forefront.  Sound financial practices and common sense go a long way in business.

While sound practices may seem like common sense, I have seen multiple start-ups that do not spend the time analyzing and thinking through these decisions.  To get you thinking, here are a few bootstrapping tips:

  • Always shop any quote.  Never take the first option, even if it is exactly what you are looking for.  Always at least have three bids on every project.  If a project is absolutely critical to the success of the organization, bump up the amount of review to at least five.  Compare, contrast, and be open and honest with those providing the quotes.  Many times, you can drive down costs just by simply letting everyone know there are 5 active quote and you plan on going with the best rate.  You will receive better deals.
  • There is very little need to purchase overly expensive marketing, PR type services in your start up years.  Research online; you will find much better opportunities.  In particular, you can find great deals on printing and print material.  One example is Vistaprint.  For $10, you can purchase 500 business cards.  The quality of online options has increased dramatically.  And it will be difficult to find cheaper options locally.
  • Find a free lance graphic designer to help create your logo.  There are many freelancers you can find through research or your professional networks.  Instead of spending hundreds or even thousands of dollars on a logo design and branding campaign, spend a fraction of the cost with someone willing to do the same quality work.  Freelance graphic designers can charge as little as $25/hour.  Just use your network to make sure you find someone good.  There is a major difference between a good designer and a great designer.
  • Use coaching services and free resources available.  There are resources through the SBDC, SCORE, economic development agencies, and local business incubators.  Many of the individuals working in these organizations have been there developing their own organization at one point or another.  They also know that entrepreneurs are the life blood of the economy, and your success is a direct measure of their success.  Take advantage of these free resources for planning, research, and connections.

Remember, the fundamentals behind bootstrapping are simply common sense and sound financial principles.  Find the best deal, negotiate, and take advantage of free resources.  It sounds simple enough.  So do a little research and save yourself some money by making good decisions.  It’s serves as a great foundation for your start-up.

 

 

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Yes, a Blog is Coming

Posted by on November 12, 2011

Stay tuned for valuable information about starting or growing your venture!

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