If Financial Projections Are Never Accurate, Why Prepare Them?
According to the results of a recently published study by a highly credible research organization, 0.00% of financial projections issued by startup companies end up being accurate one year after they are issued. Okay, while the research organization and the study may be fictitious, I have no reason to doubt the veracity of the conclusion. In my experience, financial projections issued by startups not only end up being inaccurate, but the actual and projected figures often bear no resemblance to each other whatsoever.
So why do we, and most venture capital investors, require them from startups seeking investment? Just as the eyes are the window to the soul, financial projections are the window to a company’s soul. Financial projections give investors deep insights into how the company’s principals think about their business.
When you break it down, what are financial projections? They are a set of assumptions based (often loosely) on historical company and industry results. Investors understand that the projections will never be accurate, but we can assess how realistic we believe the assumptions are and we can try to understand the thinking that went into preparing them as a means for understanding the path the company intends to take.
If financial projections are prepared thoroughly and thoughtfully, investors who review them will learn the answers to some key questions about a company:
What will drive future growth? What will the product and revenue channel mix be? Which marketing channels will the company utilize? How much will it charge for its products? How many employees will the company need, in which roles, and how much will they be compensated? How much will the company pay to acquire customers, at what rate will customers churn and what will be their lifetime value? How much money is the company planning to raise, how much will it burn each month and how much runway will that result in?
After gaining this insight, investors will reflect on whether or not the assumptions used to build the model are realistic and achievable. This assessment is naturally based on two pillars: the company’s performance to date and investors’ experience with other similarly situated companies or use of average industry metrics. Questioning the assumptions and understanding the rationale behind them is an important next step.
After the process of analysis, reflection and questioning is complete, investors have a comprehensive perspective about a company, its principals, and whether the investment is a good fit for them. The value and importance of financial projections to an investor cannot be overstated.
A final word to founders: Don’t prepare financial projections for the sole purpose of securing financing. The process of preparing them can be a particularly enlightening and meaningful exercise. It can help align the principals’ varying goals and visions for the company as well as help to clarify roles and responsibilities (or identify areas of misalignment that cannot be mended — better to know this early on). There is, of course, a fine line between financial projections that are thorough and those that are overly complex. Be sure your projections can be understood by an investor and that the impacts of changes made to assumptions can be easily tracked.
Developing and maintaining financial projections will not only serve as an indispensable planning tool, but it can aid in self-reflection about the company’s growth drivers, assumptions, and capital needs. In this way, the time and effort you invest in carefully thinking about and preparing thorough financial projections could quite literally mean the difference between your company’s success and failure.