Why financial projections are important for pre-revenue companies
Let’s be honest, accurately predicting the future is impossible. Anyone who has ever cursed the weatherman for being caught in the rain without an umbrella knows this. And yet, when building a new business, it is expected that founders provide investors with a financial representation of what their business may look like 12 months or even five years from now. You haven’t made a single dollar and are being asked to envision the numerous financial aspects of your company half a decade in the future. Compounding the absurdity of this practice is the fact that many early-stage investors outright ignore financial models for pre-revenue stage businesses.
So, why then, should you even prepare pre-revenue financials? The answer is simple. It provides the opportunity for a critical look at all aspects of your business – the surrounding market, your customers, operations, overhead, etc. – and forces you to describe them in unequivocal quantitative terms.
Showing your work is more important than getting the correct answer
Your numbers are going to be wrong and everyone knows it. There, now you can relax! Remember, predicting the future is impossible, however, demonstrating the data and logic used to generate your prediction is invaluable. An early stage pro forma allows investors the opportunity for a quantitative understanding of how you see your business plan and company being successful.
Data is everything. You MUST conduct extensive research on your market, customers, and business model before attempting to generate financial predictions. You will have to make certain assumptions and your assumptions MUST be backed by data. This data can come from any source. Interviews, surveys, market reports, or media articles are all acceptable. The important point is that your assumptions must have tangible support. It is extremely uncomfortable to not have an answer when you are asked how you arrived at a given conclusion. Remember, having data validating your assumptions not only helps answer investor questions but allows you a better understanding of your business and the market you are entering.
Be honest when you know your numbers need work. Not all answers are out there but you must have a plan for capturing essential data points in the future when you are (more) operational.
Educate yourself, use a template, and get help
As a founder, more often than not, your expertise is not finance. That’s okay, but you must know enough to prove that you can responsibly run a business. You can demonstrate this in two major ways: speaking the language and having a great team.
If you do not know the difference between an operating expense and a capital expense, then you must educate yourself. There are numerous books and courses on entrepreneurship, finance, and startups that serve this purpose. A great place to start is an online platform like Coursera or Udemy. Many of the courses are free or less than a fancy cup of coffee from your favorite cafe. Resources are plentiful on the internet. There are many websites offering free financial templates such as the ones found here. Use one!
You do not have to be a one-person show. It is to your benefit in the eyes of an investor (and to anyone, really) to admit a weakness and seek out expert support in that area. This is especially true with your financials. Find a friend with a business degree and/or an understanding of finance and ask for their help. Put them on your team and recognize them when you are pitching. When the time comes, there are virtual/remote CFO services that you can utilize as an interim step before hiring someone full-time.
Describe the breadth of possibilities
The U.S. Navy Seals have a saying when it comes to preparedness, “two is one and one is none.” In the case of early-stage financial models the saying is, “three is correct, and anything less is garbage.“ You need three models: a best case, an expected case, and a worst case. Run a full set of numbers for each scenario.
Also keep in mind that you are biased. You think your baby is the cutest of all time, therefore, you are naturally inclined to overestimate your revenue and underestimate your costs. Prepare all three case scenarios with this bias in mind.
The important question that investors are asking is, “where will the company be after the money I invest is spent?” What milestones will be accomplished? Demonstrating what must occur for target milestones to be accomplished in the best, expected, and worst case scenarios shows not only that you have identified potential pitfalls but have also formulated plans for addressing issues in the future and predicted the accompanying financial implications.
Well-conceived financial models are an invaluable decision-making tool
The preparation of pre-revenue financials is more for you as a founder than it is for investors. As your business grows and generates revenue you will discover what trajectory you are on – the best case, the expected case, or the worst case. Having thought through each scenario and the accompanying ramifications makes execution simple and straightforward.
Your financials are not something you prepare once a quarter and forget about. Don’t let them gather dust. Update and refer to them often. You will notice patterns and be able to make data-driven decisions. Prepare for success and know that you will likely require additional capital as you build revenue and start to scale. Continuously updating and utilizing financial models is infinitely more pleasant than hastily preparing projections immediately before the next time you raise funds.