Important Elements of Financial Forecasts for Startups

by Leung Kwok

Great news! You found angel investors who show interest in learning more about your business. One of the first things they will ask to see is your Financial Forecast. Are you ready?

This is a brief overview of what I try to find out when looking at a company’s numbers. To make communications easier, I’ve adapted some of the language & acronyms commonly used in Silicon Valley. I also try to go beyond the definitions with examples and describe some of the common pitfalls. I apologize ahead of time if you already know all this. You’re ahead of the game. This also assumes your product built and is in the market. So this does not apply if you are in prototype.

Contents:

• Unit Economics

• Life Time Value

• Customer Acquisition Cost

• Working Capital

• Fixed vs. Variable Costs

• Financial Statements

• Cash vs. GAAP

• Financial Forecasts

Unit Economics

Unit economics is the profitability from selling one unit of your product or service, including all costs associated with making the product or providing the service (from here on just “product”). Most startups make a gross profit on each unit, but have to reach sufficient volume to cover fixed costs & to be profitable so they have losses. This is okay and is expected.

It’s likely the investors most interested are those who are familiar with your industry. So it’s important that your unit economics are in line with the commonly-known economics of an industry. For example, if you need to provide integration services or customer training for your business to succeed, build those costs in.

Unit economics are important because it is the bases for building your business. When you have the units right, then you can work on growing your business or growing the “Units”. Growth, without attractive unit economics, is pointless. Investors want to see growth, but only if the underlying business is profitable, or the unit economics are attractive. Don’t be the old joke of Losing money on each sale, but making it up in volume.

Common Pitfalls:

• Giving away the product or selling at a small gross profit (or gross margin when measured in %) so the number of units need to cover fixed costs is very high & takes a long time. Investors won’t see this as a real business.

• Some companies move their variable costs associated with producing a product “below the line” to hide it in fixed costs to make the gross profits look better. Don’t. You’ll get caught, lose credibility and the investor.

LTV - Life-Time Value (of a customer)

After you find a customer to pay you, what is the “life-time value” of this customer. That is, the total profits you will get from a customer, as he/she buys your product over and over until he/she stops and leaves you. Individually, it is the total gross profit of a customer. In aggregate, it is function of the number of units a group of customers buys from you per time period, your gross margins and how many customers in the group leaves you in each time period (or churn) until they are all gone. Knowing this informs you of how much you can spend on the next item – CAC

Common Pitfalls:

• A customer only buys from you once. To get this customer to buy from you again requires a great deal of effort again.

• Having a product that has high churn or assuming too low a churn in your numbers

CAC - Customer Acquisitions Cost

CAC is the cost of getting a customer to pay for your product. After Unit Economics, it should be the 1st thing you need to good at in your business because it is what drives growth and is often one of the first questions an investor will want to know. Depending on the business, you will need to know and show all the elements that roll into the CAC. For example; in an enterprise sales business, the number of leads generated, the cost per lead, the close rate, and the length of the expected sales cycle. Some types of businesses have up to a year of sales cycle time, with the need to make many expensive face-to-face visits to those customers over that sales cycle. In contrast to a consumer business where feedback loop is short & you know if the CAC you spent is working or not in a very short time. There are usually multiple sales channels each with their own CAC. Know and show each.

Common Pitfalls:

• Expensive CAC or not knowing your real CAC to a specific LTV – we love business with low & effective CAC. It tells us this founder has some special insight others have not found yet.

• Diminishing returns – If you find a good customer acquisition channel (i.e. low CAC & fast sales), every additional dollar of CAC you spend acquires fewer customers – move on if this channel has run dry.

• Timing – As in the enterprise sales example above, your CAC may be spent well ahead of a sale. In the meantime, you have to make payroll.

• Related to Unit economics – If your CAC is higher than the Unit Economics of your 1st sale, you’d better hope the customer comes back to buy another unit without you spending more CAC. LTV / CAC next.

LTV (Life Time Value) / CAC

LTV / CAC is in effect the payback multiple, a variation of payback period. How many dollars back (LTV) do you get when you spend a dollar (CAC). It’s both a good way to think about your business and a way to communicate to investors who have gotten used to thinking about startups this way. It is a useful metric to include in your internal reporting and as an assumption (or output as a result of your assumptions) in your forecasts for yourself and to investors. A reality is the more a founder is on top of a key metrics like this for his or her business, the more comfortable the investor will be.

Working Capital

Working capital is about timing. Some businesses get paid up front (online retailer gets a credit card payment with an order) before paying expenses (then goes & buys the product to ship) while in other businesses (most manufacturers) have to pay for raw materials & labor first and then collect from customers a few months after the product is delivered. It’s important you understand the timing & plan your growth and working capital cash needs accordingly. Examples of working capital items that use cash are inventory (you buy materials before getting paid) and accounts receivable (you’ve delivered the product and the customer has accepted it so revenue has been “earned” on your P/L – but the customer has not paid you yet) Examples of working capital items that provide cash are accounts payables (you’re bought material to build your product but have not paid for it yet) and deferred revenues (customer deposit or the entire payment and the product have not been delivered) As an example, you may have a great product. But you can be in a situation where strong demand for your product is constrained by high working capital need.

Fixed versus Variable Costs

In the long term, all costs are variable. However, in the short term, say month-to-month, you will have to pay some costs with or without revenue. These are fixed costs. Rent, for example, is usually a fixed cost. Other costs are variable and occur only when you make the product such as materials and labor. There are discretionary costs, money you spend because you think it will help your business, but without assurance that it will, such as market research, R&D, advertising, etc. which I will not go into here. If your Unit Economics are strong, have enough revenue and your LTV/CAC makes sense, you just have to grow to a point where you can cover fixed costs & the rest, as they say is gravy. Investors know this.

Common pitfalls:

• Categorizing costs in the wrong place

• Don’t see a way in a reasonable time to cover fixed costs

Financial Statements

A starting point to understanding your business and communicating with the outside is your financial statements -- Profit & Loss statement, Balance Sheet, and Cash Flow statement. External financial statements are usually built based on General Accepted Accounting Principles, or GAAP, a set of rules developed over many years by the accounting industry and that most investors and lenders understand. It is a common language if you will. They need to be done correctly but for a startup there is usually no need for them to be audited because an audit can be expensive and may not add much value. Some investors, however, might ask to see your bank statements to confirm your cash, or may tour to see your inventory and equipment listed on your statement.

Common Pitfalls:

• The P/L, Cash Flow and Balance Sheet don’t balance. Use an accounting software package, especially if you have many transactions. Unless you are a trained accountant, don’t try to wing it on a spread sheet. The numbers need to be right and a typo will blow it.

• Reflecting “earned” revenue (Revenue where you’ve delivered the product and the customer has accepted irrespective of you actually having received payment or not) vs. Cash – money you have in the bank – next.

Cash vs. GAAP

There is a timing difference between financial statements reported in GAAP vs. Cash. Cash reflects what you have in the bank & what you use to pay expenses. GAAP reflects what you have “earned” whether you have the cash or not. A business lives and die by the cash-on-hand so it is good to build internal reports and financial models based on cash in addition to GAAP which you will need for investors to understand your business. In addition to timing on the P/L, working capital (above) on you balance sheet also impacts cash & you need to be on top of it.

Financial Forecast

Based on the historical financial statements, investors will want to see your forecast (with assumptions) monthly for the next 12 months and yearly for the next 3-5 years. The assumptions you used to build your financial forecast should be based on the items above; Unit Economics, Life Time Value, Customer Acquisition Cost, Working Capital, Fixed and Variable Costs, etc. Don’t worry about absolute accuracy. But they need to be based on reality; for example; actual unit economics you have experienced or quotes for costs from actual counter parties. Not guesses. These forecasts are not for telling the future, but to understand what would happen based on your assumptions and changes to the assumptions. So, it is vital to be explicit about your assumptions, as well as building a forecast model that supports what-if analysis as assumptions change. For example, what if your CAC is higher or lower? What if your unit economics crashes because of competition? How much price pressure can you take? What if your LTV is higher or lower?

Make sure you align the strategies in your business with the assumptions in your model. For example, if your go-to-market is via distributors, make sure you reflect your assumptions about the number of distributors you enlist, their reach to end customers, and their margins. In short, it helps investors understand how you think.

I also prefer to see actual historical monthly financial statements side by side with your monthly forecast financial statements, rather than month 1, month 2, etc. You may have to assume what date you will have your funding to be able to identify actual months. It will help you to see if your forecasts are reasonable and make it easier for investors – in other words a faster decision.

Common Pitfalls:

• Assumptions not explicit

• Assumptions for the forecast do not match history

• Assumptions do not match your business model

Leung Kwok has been in financial services for 30 years, most of it with General Electric Capital Corp. 25 of those years were in Asia covering Korea, Taiwan, Thailand, Malaysia, Indonesia, Japan and about half the time in China. During this time, he deployed about $3bn and recovered about $5bn. The products were Private Equity, High Yield Lending, Project Finance and Distressed Debt. Over the years, he has examined thousands of companies and projects in need of capital and provided capital to a hundred or so.