Financial Projection for Early Stage Startups
We’ve covered the overall market activities for ventures, but how do we know if thing’s gonna go well when we hit the road? This is when we need to take the financial projection pill.
Methods: Top-Down vs. Bottom-Up
The top-down method starts from above, then narrows it down to smaller sectors. You picture the Total Addressable Market (TAM) first, e.g. at the national / global scale, then find out the size of the market that suits your product and service, or the Service Addressable Market (SAM). And lastly , you estimate the amount your product and service may secure, or the Service Obtainable Market (SOM).
The bottom-up method takes the opposite approach by checking each component first, such as the unit cost / price, then estimates how many units you may deliver to the market, considering all variables. Like this, you get the whole picture and build things up from there.
If you’re running a software (ex. SaaS) business, then bottom-up method would really help in finding out how much things cost and how many users you may acquire in a specific timeframe.
On the other hand, the top-down method can pin-point your market entrance from above (along with other analytical tools such as SWOT):
How big is your target vertical?
What part of it should you take on?
How well can you penetrate in that area?
Each comes with its own pros & cons and specific uses, so it’s advisable to try both whenever possible.
Hardware vs. Software
One of the fatal mistakes a startup can make is under-estimating its costs (following the mistake of chasing weak market demands), especially for hardware startups and founders coming from the software side.
A software business delivers virtually most of the time and lives up its lifespan via version updates and customer services, hence the human hour cost would be the main source of expenses, a.k.a the “burn-rate”.
But for hardware startups, a small batch of test-run alone can cost you tens of thousands. You may run out of cash sooner than expected if you’re not really careful.
Use the Force, Luke! … I Mean Use Benchmarks
If you wish to make your projections look believable, you’ll have to gather data from your vertical / industry and do it as precisely as possible.
This can be tricky and frustrating for first-time founders and early stagers. Myself, I had a hard time figuring out my own projects from the perspective of market size, demand segment, production, logistics, marketing or the working capital needed — the whole process was like digging dinosaur bones for me, and I came in for business, not paleontology!
Thankfully, after some time of monkeying, I found one thing that really helped — the internet coverage of your vertical / industry.
Say you want to know the cost of some IoT chips, yet you only find quotes for development kits (way higher than the jobber price). Just Google your keywords with different price tags, e.g. “xxx”+“$1”, “$2”, “$3”, or in batch lots, e.g. “1000”+“pcs”, until you get there.
For things like market overview / projection, you may find your answer in publications from industrial associations, institutional studies, etc. Sometimes you even find reports and pitch decks from your peers on sites like Slideshare. (That’s an intellectual property issue, I suppose… they should have used sites like Docsend instead.)
Remember the story in which a boy from desert blew up a planetary battle station? Just be creative and don’t give up!
Integrity: The Only Metric That Matters
We usually value business with the key metrics such as revenue (gross margin), growth/churn rate (MoM, YoY), valuation (for funding), and so on, but before we actually head down the road, no one can be sure about the future.
This is where the real value of any financial statement chimes in: integrity.
Revenue-wise, your real-life sales and penetration can go way off either for good or bad, but the costs should remain close to original projections, sometimes even lower than expected.
That’s the last line of defense for your business, and a sanity check at the same time for your investors, and most importantly, yourself.
So be honest to your business, since the market never lies.