The Underlying Assumptions of a Financial Plan.
As a venture capitalist you review hundreds of business plans a year. Often we find at the end of the business plan a financial section, including financial projections. Part of my responsibility is to assess these projections.
Why do we assess financial projections? First of all, because 95% of financial projections presented to us look more or less like a ‘hockey stick’ as depicted in Figure 1 below. Secondly, the financial projections might have an impact on topics like management ambition, funding requirements, ROI, and valuation. Thirdly, by closely looking at the financial plan you can better understand the company’s business model, learn about the growth strategy, identify strenghts and weaknesses, and start better understanding management. Last but not least, we only want to invest in the best companies out there in order to create maximum value for our investors.
It begs the question ‘how’ we assess a financial plan? Basically we focus on validating the underlying assumptions of the financial model. Every model has several key value drivers (or input) that drive future growth. Some that I often come across include customer acquisition costs, churn, average sales price, sales productivity, and conversion rates. Strong, reliable entrepreneurs (try to) use historic data and other relevant public data (sources) to obtain the estimates of these important model parameters. Put differently, they have valid reasons and/or proof points to justify them. By requesting information such as cohort analysis (logo and revenues), breakdown of the monthly P&L 2014–2015YTD, number of customers won per quarter, KPI dashoboards and sales pipeline we attempt to confirm management’s statements. On top of that, there is such thing as ‘belief’ that can make these input improve, accelerate, increase or grow in the future. Yes, I am fully aware of the fact that this is venture capital; not private equity, rocket science or set in stone!
Continuing, as we are validating the financial projections we might realize that some of the underlying assumptions are (i) too aggressive / optimistic, (ii) unrealistic, or (iii) pessimistic (hey, here lies opportunity!). To give a couple of examples: gaining a 25% market share in a very competitive market might be overly optimistic, opening offices in 15 countries in six months unrealistic and increasing upsell by only 2% pessimistic. Therefore, we often decide to develop financial projections for internal purposes after our meetings with management (and financial advisors) based on our findings. As a result management’s base case scenario (Figure 1) could transform into Figure 2, or what I shall be calling the ‘Investor Case’. In this scenario Company X would not grow the business to €102m in revenues in year 5, but ‘only’ to €63m. This might still be a very interesting business case to us, yet at the same time in our view the company requires €19m instead of €14m to get to profitability. Now I will repeat myself: In the Investor Case scenario the company might still be very interesting from an investment perspective. However, the company is just a little bit less ‘great’ in our opinion. Simplified, one of the three following scenarios will arise:
· The investor walks away;
· The investor is still intersted, but considers (changing) certain deal terms; and
· The investor continues to champion the deal (remember, there is a bigger picture here!).
In order to avoid the first scenario, my advice to entrepreneurs is to be as transparent and honest as possible. If you intend to raise millions of investment, you should expect investors to do a bit of number crunching. Actually, I believe you should be wary of investors who don’t. Yes, we love to see ambitious growth plans, but they should be realistic. Admit when you misinterpreted financials, do not withheld or manipulate data, and for sure do not lie. I have been told several times that investors challenge financials with one sole objective: to negotiate better deal terms. I can promise you that’s not the case. We look at many more areas than financials before we decide to invest or not. This is just part of our due diligence. Finally, please realize that we also have investors on board. What do you think they will do if something goes wrong with one of our portfolio companies? Yes, start asking dozens of questions.