Scenario Planning: Be Prepared to Be Proven Wrong
Part 4 of 5 in the “Financial Modelling for Startups” Series
When looking at startups to invest in, it is a common saying that most investors tend to discount 50% from every forecast they receive. Even if the exact percentage of deviation will never be known, it tends to be true that investors will not treat your original forecast and unit economics as the sole analytical basis for evaluating the deal.
This is because startup lifecycles are never linear. Success in building and scaling up startup companies instead comes down to the ability to quickly and decisively adjust plans and react to new information or sudden changes in relevant variables while not losing sight of the big picture.
Even in the rare cases in which a startup experiences a seemingly flawless growth story from seed directly to IPO in a couple of years, you can be sure that the founders have adjusted and changed their financial and strategic plan so many times they would probably not recognize the financial model they used for seed fundraising.
Thus, your projections and plans prepared in the model are not meant to be set in stone but act as guidelines for your day-to-day decisions that will regularly be iterated and refined. In fundraising, conveying an image of a founder who has this flexibility in his thinking is essential.
Even with absolute bullet-proof reasoning underlying your projections, somehow, and to some extent, you will be wrong anyway. Implementing a scenario planning section in your model can help you to show investors that you are an entrepreneur that can strike a balance between believing in a plan while having an open mind for adjustments, being aggressive in your goals but rational in your approach, pursuing the best while being prepared for the worst.
Step 1: Examine your base case projections
A deep dive into the unit economics and key metrics, (e.g., by observing the steps in the previous article), can deliver deeper insights into the business’s fundamental relationships.
After you have your projections following the current micro-level dynamics in sales generation, costs, and the generation of cash flows, it is time to pay attention to the resulting big picture and consider how alternative scenarios could impact your business’s outlook.
Scenario planning always starts with a close-up examination of the base case scenario, which contains the narrative that, in your opinion, has the highest likelihood of occurring.
In your financial model, this case should be the initial setup. You can either integrate other scenarios in the same model (link on how to do that in the appendix) or copy the file and adjust variables in a new file. Integrating scenarios in one primary model is preferred since comparing the cases and basic assumptions is straightforward.
However, as this requires a little more knowledge in spreadsheet modelling, it should only be done with the priority of avoiding errors and unnecessary complexity.
Before thinking in detail about adjusting assumptions and the implications for outlook or appropriate strategies, founders should make sure that the big picture of the base case as a foundation for further considerations follows a few general principles.
First, the base case should include a “safety margin” for misestimations in key growth variables and expenses, in the form of sufficient runway. Base case projections that are considered robust should have at least 12–18 months of runway. Some investors might even expect to see a similar runway without any revenue taken into account.
With the closely related burn rate, meaning the business’s monthly net cash outflow, runway projection is something you should have displayed in your model and ready to discuss with investors.
The best entrepreneurs are outstanding and creative when managing burn and runway depending on the business’s development. Managing burn comes down to thoroughly understanding your cost structure and being aware of the short-term flexibility you have when shortening the runway to accelerate growth or extend the runway by reducing costs.
Even if these considerations are not directly displayed in your model, it is recommendable to think about concrete actions with which you would either shorten or lengthen the runway before going into discussions with investors.
Second, make sure that potential investors can identify meaningful milestones in your base case scenario that summarize the overall plan in practical and concrete terms. While the ambitions of a long-term plan can be hard to grasp quickly by looking at a P&L statement, milestones provide investors the core strategic and financial benchmarks that you are aiming for when growing the company.
Some investors even like to connect parts of their total investment to specific achievement milestones, which stipulate conditions in which the investor is not required to invest his remaining commitment if the business underperforms its projections.
Considering this perspective when examining the big picture of your base case scenario should make an even stronger argument for a rational assessment of KPIs and against simple top-down projections.
Even if you somehow succeed in fundraising with an overly optimistic, top-down plan not taking trends in KPIs into account, having overpromised and then underperforming self-set benchmarks will reduce your chances for follow-up investments and might create unnecessary tension in the partnership with your investor.
The last aspect you should double-check when looking at the big picture of your base case will sound trivial but is also often overlooked by founders. That is that how your projections are presented should make it easy and intuitive to summarize the case in “investor form”.
In most investment committees where a potential investment case is presented, the introduction of the case could look something like this:
“This company is a [business model type] selling [product] to [market definition and size]. Currently, they have [core KPIs strategic/financial as discussed in Part 3 of the series] and are raising a total of [capital need] with an expected closing in [capital timing] on a Pre-Money Valuation of [Valuation].
With the new financing, the management team aims to reach [expected growth in terms of core KPIs strategic/financial] within [referring to milestones either strategic or financial]. Assuming current projections, they will have a [burn rate] giving them [runway].”
Except for the variables valuation, which will be discussed in the last part of this series, and market, founders should make sure that all the gaps can be easily filled by looking at the financial model.
Step 2: Prepare a hypergrowth scenario in your model
When you have read the earlier parts of this series, from defining the case’s outer boundaries over selecting and forecasting KPIs up until examining the base case big picture, you have noticed that the suggestions for each distinct conceptual part of the model serve various functions.
Illustrate that the founder has a rational understanding of the business, arouse some fantasy about the case through storytelling, and ensure that the founder’s way of thinking fits the typical challenges of managing and scaling a venture company.
Within the scenario planning step of building the model, preparing a hypergrowth case is a further opportunity to arouse the investor’s fantasy about how your business could develop in a perfect world.
The purpose of preparing such a scenario is not to mindlessly exaggerate drivers and trends upwards to indicate that your company could potentially go from early-stage to unicorn in a year.
Instead, as with nearly every part of the model, the takeaways for investors lie less in the total numbers forecasted as in the thinking that is communicated by such a scenario regarding creating and managing extreme growth.
As for the practical application in your file, it is highly recommended not to alter the structure that was used to illustrate the base case, this way you ensure that the scenarios are comparable. Therefore, only adjust the variables and do not add new ones for the hypergrowth case.
Guiding your forecast should be the consideration of showing significant scaling effects and expansion opportunities after achieving product-market fit and some traction in your core target market. Startup investors are interested in exits that could potentially bring them multiples of 100x and beyond. Reaching such an exit value implies that the company must experience exponential growth at some point in its lifecycle.
Depending on the business model type, there are common leverage variables for digital products for achieving hypergrowth that you should stress in this scenario.
The most common scaling lever which is responsible for hypergrowth scenarios in business models is the network effect. Network effects occur when a company’s product or service becomes more valuable as the usage increases.
Utilizing network effects is one of the few remaining ways in the digital age to make a business genuinely defensible, if not immune against the competition.
Seeing these effects in scaling, amongst other things, makes a business case way more interesting for investors since these effects fuel exponential growth that can quickly turn startup companies into global enterprises and thereby bring startup investors very attractive returns rapidly.
Network effects can be seen across various categories, and formulating and executing strategies for achieving them is another interesting topic worth exploring in more depth in a separate article.
As for implementing network effects in your projections, there are a variety of ways to do this and I will briefly discuss two examples.
B2C companies working with a direct business model, in which the product user and customer are the same people, can experience hypergrowth, for example, through virality or multiplier effects in distribution channels. Virality means your product is rapidly popularized by people communicating directly with each other.
Multiplier effects in distribution channels can mean finding a cooperation partner with a big audience or platform that brings you access to a new group of target customers.
When modelling hypergrowth, you can adjust variables upwards that belong to your sales funnel assumptions. For example, with virality effects, you can assume that you can attract more customers organically, conversion rates increase rapidly, and customer acquisition costs decrease over time.
For multi-sided business models, where the user of the product and customer are different persons (such as in social networks) and marketplaces, network effects make up an even larger part of the potential value for investors.
The essential scaling levers for platforms and marketplace are engagement (i.e., creation of derivative assets such as attention or data) and liquidity (i.e., match rate between buyer and seller). For example, as a platform business, modelling hypergrowth could mean forecasting an increase in customer engagement. Engagement on platforms drives the value for new customers and creates data that can be monetized by offering supplementary services or selling targeted advertisements.
The previous article mentioned a few standard metrics for customer engagement, such as daily or monthly active users. That said, which metric you use is not important, as the primary point should be to show how you plan to monetize the engagement on the platform.
In most cases, network effects in different categories appear simultaneously or cause other network effects, and thus there is no one-size-fits-all way of approaching them.
The important takeaway, however, from this section is that scaling effects, in whatever form, should find their way into your projections and should be made visible in the hypergrowth case.
The distinction I made in this section between the base case and hypergrowth case scenario does not mean that these dynamics should only be visible in the latter case. Base case scenarios, the most likely development of your business, should include scaling effects for it to be an attractive case for investors.
However, with the distinction between both cases, you have the opportunity in the hypergrowth case to deviate a little bit more from the rational foundation of historical KPIs and exaggerate drivers in a way that would, in most cases, be considered an unreasonable way of business planning. Showing simply the base case in your spreadsheet could be viewed as a weak point for the overall impression of your case. Therefore, implementing a hypergrowth case is a tool for both demonstrating strategic foresight for expanding the business and plays into the big vision story you are telling.
Step 3: Prepare a downside scenario in your head
It is, of course, very satisfying to go through potential hypergrowth scenarios and model exponential growth. However, the downside view is equally important and can yield much more valuable insights than upside projections.
Startups operate with usually limited funding in attractive, and therefore highly competitive markets. Within these circumstances, hesitating to adjust can mean losing critical ground either financially or strategically.
Within scenario planning, the base case scenario reflects the structural, rational approach to business planning and the hypergrowth scenario has the purpose of stimulating your investor’s fantasy.
Formulating a downside scenario, in contrast, is mainly a thinking exercise to avoid hesitation in critical situations either while having discussions with investors or in real-life scenarios.
As a thinking exercise, similar to sensitivities in KPIs, you should not display the downside scenario in the financial model you show to investors. Founder sometimes add a downside case due to the misconception that investors will recognize this as humble or cautious. However, even though offering the bet represented by an investment case must only be done while avoiding serious overpromising and acting with integrity, it is simply not the founder’s job to direct the investor to all of the business plan’s risks.
Instead, going through the suggestions that follow only serves the function of getting yourself ready to discuss your business’s riskiest parts in discussions and negotiations in the fundraising process.
The starting point for thinking through a downside scenario in your head is hypothetically imagining the failure of the whole plan or parts of it and then logically working backward to potential reasons that determined that failure.
The technique is sometimes called inversion or pre-mortem analysis and is an excellent tool for founders to rehearse potential risks in the business that an investor will notice and want to discuss.
This thinking exercise fits perfectly into the series on financial modelling and fundraising because a financial model explicitly outlines the assumptions on which your plan relies and makes it easy and intuitive to systematically apply inversion to them.
The practical application for your plan means going through each block of assumptions previously identified for the case, namely sales generation assumptions, cost assumptions, and cash-flow assumptions in the base case scenario.
Hypothetically, assume as a first step that your base case estimates and the plan fails, then ask yourself what exactly could have been determining drivers.
At a high-level, these rehearsed difficulties are typical for venture companies and do not necessarily bring much informational value: adoption and conversion rates are lower than expected due to missing product-market fit, or costs are higher than expected due to prior misestimations in attracting talent or building and maintaining customer relationships.
On a deeper level, though, formulating potential causal drivers of these developments can yield fascinating insights that can be used not only for management decision-making but also to overlap with other key business areas such as product management.
Even if the underlying causes are highly specific to every venture, an example could be finding potential root causes for the fact that a newly launched premium feature fails to bring the expected extra revenues through upselling or does not adequately increase customer engagement.
When investors address these potential risks in discussions and raise doubts on your plan’s corresponding assumptions, it is, of course, not enough to mention that you have also identified that risk.
Instead, you want to address those doubts by elaborating on two separate points: first, what would you see as an indication that this hypothetical problem manifests itself in real life. And second, how you would approach solving it.
While having confidence in achieving the business plan laid out in the model and actively expressing that belief in conversations with investors is essential, considering downside cases before going into discussions can be a valuable exercise for addressing doubts and questions investors will have concerning your business plan.
Scenario Planning: Key Takeaways
The integration of different scenarios in your financial model is not a must and should be seen as a nice extension that can help you argue for your case.
However, even if you decide only to display your base case scenario, thinking through hypergrowth and downside cases might generate interesting insights that you can use in discussions in fundraising with investors or your long-term business planning.
The main takeaway from this section should be that founders have to find a way, even if it is not through integrating scenario planning in the model, to give investors confidence in the following hypothesis:
The founder not only has a clear perspective on the micro-level business dynamics but is also equipped with the necessary flexibility and foresight in his thinking to manage and react quickly to sudden changes that will either positively or negatively affect the business.
Integrating scenario planning in the model can help you to display that image by giving you a clear summary of your base case scenario (runway, milestones, investor summary), arousing fantasy and similarly indicating that you can manage growth (hypergrowth scenario) and foreshadowing potential problems and their solutions (thinking through downside scenarios).
Step 1: Examine your base projections
- Check if your runway is in a reasonable range of 12–18 months
- Integrate meaningful strategic and financial milestones
- Make sure the presentation of the projections makes it easy to fill in the gaps of the typical investor summary
Step 2: Prepare a hypergrowth scenario in your model
- Add a hypergrowth scenario either as an extra file or in the same model with the same structure
- Identify relevant scaling/network effects for your business and display them through an upward shift in relevant variables
Step 3: Prepare a downside scenario in your head
- Use inversion to figure out where the riskiest parts for your business case and projections are
- Rehearse potential solutions for upcoming problems in your head to be able to address them in discussions with potential investors
In every part of this series, I have referred back to the initial analogy of fundraising for a venture case as selling a bet that ultimately depends on the confidence that investors have in the underlying hypotheses.
After the last parts have hopefully helped you to present a business case that supports these hypotheses convincingly, the last part will conclude with some further suggestions on how to combine these parts into a compelling big picture and avoid common mistakes.
>> If you are a founder looking for an investment, I hope you find this article series helpful for your preparation.
Find the additional parts here:
- Part 1: Purpose and Organization
- Part 2: Market Sizing
- Part 3: Unit Economics and KPIs
- Part 4: Scenario Planning
- Part 5: Storytelling
Especially if you are working in the fields of FinTech, Blockchain or AI, I would love to hear about your company so feel free to connect with me on LinkedIn.
Similarly, if you are a VC Investor and have some feedback or additional notes on this topic, I would love to learn more about your views.<<