Want to raise a Seed or Series A? Here’s a tip: Don’t have impossible financial projections.
Venture capital firms see a surprising number of pitch decks with completely impossible financial projections. When a VC sees a financial forecast that no business in the history of humankind has been able to achieve, the entrepreneur and company instantly lose credibility. And VCs see so many financial projections they can spot an unreasonable forecast in five seconds or less.
What do I mean by “impossible financial projections”? I mean projections that aren’t based on rational or well-thought-out assumptions. VCs expect you to be optimistic about your business, but they also want to know you understand the economics of your business. Your model contains extremely aggressive growth? No problem — just make sure you have reasonable assumptions and the cost structure to support it!
Many entrepreneurs are familiar with Battery Ventures’ Neeraj Agrawal’s great post “Helping Entrepreneurs ‘Triple, Triple, Double, Double Double’ to a Billion Dollar Company” and think that’s the magic revenue formula to building financial projections that are attractive to investors. They get the revenue growth math right but neglect to get all of the underlying math and assumptions, which actually enables that growth, right. Again, I don’t mind seeing aggressive revenue projections based on Neeraj’s post. The problem comes when cost growth is disconnected from revenue growth.
The problem comes when cost growth is disconnected from revenue growth.
In episode 663 of This Week In Startups with Jason Calacanis, Jason Lemkin of SaaStr says he doesn’t expect early-stage companies to have accurate financials but “what I’ve learned is that if they’re ridiculously stupid, there’s something wrong in how you’re thinking about the business.” He goes on to say “if it’s really wrong…. Numbers that aren’t even remotely sane, show the founders don’t understand how business works. That’s scary as an investor.”
For me, impossible financial projections are scary for two reasons. First, as described above, it demonstrates a lack of basic financial understanding. If an entrepreneur doesn’t care enough to understand those parts of his or her business, why would an investor feel comfortable giving him/her money? Second, a well-thought-out financial model drives invaluable strategic discussions. Understanding sensitivities in your financial model and the trade-offs between investment opportunities will allow you to make the best, most-informed decisions for your business.
Here are a few examples of red flags frequently seen in pitch decks or financial models that scare investors:
Sales reps generating more than $1MM in ARR per year .
Most early-stage companies are still figuring out their go-to-market. They don’t have a pipeline, they don’t have sales operations or systems to help reps operate more efficiently. One major impact of that reduced efficiency is lower sales productivity. If your company’s average contract size is $20K, that means a rep would need to close 50 deals in a year to reach $1MM — nearly one per week. That’s incredible sales success for an early-stage company when the rep has to do almost everything him or herself. Two other factors that reduce rep productivity are attrition (spoiler alert — not all of your reps will work out) and ramp time (another spoiler alert — they won’t be at full productivity the first week on the job).
Costs don’t scale appropriately with revenue.
Your SaaS business may be amazing, but it’s probably not going to generate $100MM in ARR with 15 employees. A helpful exercise is to consider staffing ratios. For example, how many customers can each customer success team member support? If you have 200 customers and each can support 50, you need 4 people. How many customer success team members can you hire before you need to hire a manager? Eight is usually the magic number for span of control. How many business development reps do you need per sales rep? All of these ratios depend on your specific business, but building that logic into your model will make you look like a superstar when walking a potential investor through your assumptions.
Hyper-growth businesses kicking off lots of cash.
When I see a forecast for a SaaS business that shows the business growing from $36MM to $72MM and generating $20MM in cash, I know something is missing. SaaS businesses growing at that rate are investing in current and future growth — hiring tons of sales reps, customer success resources, and making all of the other investments that will allow the business to grow well past $100MM. This is usually a byproduct of costs not scaling appropriately with revenue but is worthy to call out.
Gross margins higher than 90%.
If your gross margins are this high for a SaaS company, you’re missing some costs that should be included in cost of goods sold (COGS). Hosting costs, customer support costs, implementation, and other professional services costs all should be counted as COGS. One challenge for early-stage companies is that frequently a few employees are doing activities that could fall both in COGS and operating expense (OpEx). An example is the first few customer success team members who may handle COGS work (e.g. implementations and support tickets) as well as OpEx activity (e.g. upsells and renewals). Also, engineering teams in early-stage companies frequently act as tier 2 or tier 3 support, and those costs should be captured in COGS. If you can allocate a portion of your customer success and engineering costs to COGS or include a footnote explaining that OpEx includes costs normally included in COGS, that’s sufficient to demonstrate your understanding of gross margins.
Use your financial projections to gain credibility with potential investors, not lose credibility with them.
Embrace digging into the details of your financial model because if your assumptions are thoughtful and you can explain the logic behind them, you’ll check a big box that many investors consider before making an investment in an early-stage company.
P.S. Did you read this whole post without knowing what a financial model is? Read this from Techstars.