If Growth Forecasting Were Easy, There Would Be Only One VC fund: Nostradamus Partners

Growth Forecasting is Difficult By Nature And Impossible In The Long Term

When we think about company valuation, we have to forecast its future result: is the technology going to work? Is the product experience disruptive enough to be adopted by users who need to cover the switching costs? How much will the company grow? Is the company attractive enough to seduce an acquirer or public investors during the IPO? Is the company able to generate sufficient cashflow in the future?

So forecasting what a company will look like 10 years ahead is impossible by nature and yet VCs can’t do otherwise. So how to maximize your growth forecasting when you have to make predictions which cannot be done?

[Declarations] of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.
Thinking Fast and Slow — Daniel Kahneman

In Search Of a Good Heuristic

First of all, you need to focus on the value creation (for the user). Revenue is only a consequence.
Let’s focus on the models that seems to be the simplest to predict: transactional products such as SaaS.

Founders will have the beginning of a chart with their traction, which should be defined as quantitative evidence of market demand. It is very often related to the actual usage of the product. For SaaS, it may be revenue (such as Monthly Recurring Revenue) or usage (Monthly Active Users or Daily Active Users).

Growth forecasting in most pitch decks from early-stage startups look like the picture below:

The temptation to claim exponential growth is especially strong for early stage startups when month on month growth (m/m % growth) can be very high in the first months.

Sadly, it’s not possible to know whether the beginning of a strong growth will last and if it is a linear growth or an exponential growth. Statistically growth is going to decline during the first two years before reaching a more stable m/m percentage. Sometimes, the magic happens and growth is exponential. It is the very exception.

Look at the incredible growth of Slack: once it’s done, everyone knows it is an exponential growth, but if we had stop anywhere we could have made a linear growth forecasting.

Also, growth of one Key Performance Indicator (KPI) is never enough per se.

As Andy Grove, the former CEO of INTEL, said in his wonderful book High Output Management:

Indicators tend to direct your attention toward what they are monitoring. It is like riding a bicycle: you will probably steer it where you are looking. If, for example, you start measuring your inventory levels carefully, you are likely to take action to drive your inventory levels down, which is good up to a point. But your inventories could become so lean that you can’t react to changes in demand without creating shortages. So because indicators direct one’s activities, you should guard against overreacting. This you can do by pairing indicators, so that together both effect and counter-effect are measured. Thus, in the inventory example, you need to monitor both inventory levels and the incidence of shortages. A rise in the latter will obviously lead you to do things to keep inventories from becoming too low.

So even if growth of usage is the lead indicator, you need to pair it with another one which can react inversely in case of abuse.
An example of good pairing for a restaurant would be daily sales & customer satisfaction. In a startup, you can pair metrics such as MRR and Net Promoter Scores.

Embracing Complexity But Keeping It Simple

For a SaaS product, new users is not enough, you need to pair new users with churn.
In fact, it would be even better to distinguish a bit more and to measure on a MoM basis: (a) new users, (b) churned users and (c) resurrected users, to be MECE (mutually exclusive and collectively exhaustive).
In your dashboard, it is more useful to monitor retention rate than its contrary, churned rate (1- churn rate= retention rate).

Note:
[users last period + new + resurrected — churn] = [users new period]
churn = [user last period + new + resurrected] — [users new period]

Retained users = [users last period] — [churn new period]
retained users = [users new period] — new — resurrected

Pairing is important because as a CEO you need to focus on the most relevant metrics and because you can’t have too many metrics in mind all the time. So selecting the rights ones (that should be not correlated if something goes wrong) matters. Another way of pairing is looking at ratios (like new+res./churned), to be sure you are still growing, on a active user basis.

That’s being said, even good pairing and / or good ratios don’t resolve the issue: predicting the future for a business is really hard (it’s a complex open system), almost impossible. The product is evolving, the users are evolving (especially when you cross the chasm), the competitive environment is evolving, the technology is evolving, the… (you got the point I guess ;))

Bottom line: We’ve seen that growth is key, yet growth forecasting is very hard. We’ve seen the importance of choosing the right KPIs for growth, even if it does not make it more predictable.
Yet, investing is not a sheer game of luck. Everything is about assessing one’s potential and hoping for exogenous forces to evolve in your favour (trends are a good indicator too).

And to assess one’s potential*, despite the tradeoff between growth and profitability, we need to consider fundamental economic units, such has COGS & revenue. After having invested tons of money in uncertain future regardless of the financials of the companies, VCs tend to refocus on gross margin. Let’s deep more into that in Part 4.

* I won’t speak that much about market, product & team considerations, which are key elements for a VC, but focus solely on the business traction itself

Want to know more about startup funding? Read our articles:

Part 1 — Startup Funding: Growth Is The Only Way
Part 2 — The Jedi Trick: You Have to Choose Between Growth And Profits
Part 3 — If Growth Was Easy To Forecast, There Would Be Only One VC fund: Nostradamus Partners
Part 4 — You Need to Lose Money, But Some Loss Are A Really Bad Idea
Part 5 — How To Have Growth AND Profits? (Part1: Transactional models)
Part 6 — How To Have Growth AND Profits? (Part2: Non-Transactional Models)
Part 7 — What About Valuation For Late Stage Startups?
Part 8 — Fail Often, Fail Fast. Investors Do Half of That
Part 9 — What daphni will not invest in
Reminder: daphni investment thesis