Adam J. Davis’ Blog

Number cruncher.  Bean Counter.  Captain Spreadsheet.

I freely plead guilty to being all of the above - for part of the day at least.  Being a ‘dyed in the cloth finance man’ as one of my former Indian colleagues labeled me, I cannot help but pass comment on one of the things that routinely trips up my fellow entrepreneurs and investors nearly right out of the gate - disillusion financial projections.

Trust me.  I have learned this lesson the hard way more than a few times over.  Your humble author would have gladly forked over a few more grand in college tuition than have forked over several times that in money lost in business.

In spite of the general contempt I felt toward “the man” when I was a crunching numbers in a cubicle, one of the most valuable lessons I learned while working in corporate finance was the art (and I use the word ‘art’ quite offensively to any true artists out there) of thoroughly evaluating financial numbers of businesses and operating units.

Many venture capitalists have grown quite long in the tooth preaching that it isn’t a good idea to plan in fantasy land, i.e.: “the market size is ‘X’, if we can capture just one percent of ‘X’, our company will make a killing,” or something along these lines.

Now, I know that many entrepreneurs are not finance people by nature, so they may be inclined to hire a CPA or consultant to assist with putting together their financial projections. Inevitably, most of these proformas are no good, still focused on obtaining some level of sales and working down to a bottom line number from there, often engineering a result that an SBA loan approval committee or venture capital investor wants to see.

Based on some experience, the best way to prepare financial projections, in my view, is to work from the bottom up, build in a healthy margin of safety and remove illusions of grandeur and 3 year IPO ‘liquidity events’.

1. Work from Bottom UP

Start with the basics:  what will it cost you to get a customer? what do you need to cover fixed costs?  Working from here will help you learn what it will really take to achieve the minimum profitability necessary to make your business start-up or acquistion a worthwhile endeavor.

2. Margin of Safety

Make sure to establish revenue projections that give you pricing flexibility.  Market forces could put pressure on your prices right away, even if you are a premium provider.  If you are going for a cost leadership-type position, someone else could have a similar idea or a new innovation could spark margin pressure for you.  Also, give yourself multiple marketing options and customer acquisiton options.  When companies limit themselves (and base financial forecasting upon) strategies that are too focused, bad things like ‘red-ink’ quickly follow.

3. No grandeur

Aim to build a profitable and sustaining enterprise.  Be happy if you have to keep your business forever.  If you can’t be happy with owning your business for a long period of time, then you are starting it (or buying it) for the wrong reasons.  Even though CNBC glorifies the leveraged private equity buyouts and raiding takeovers that aim to take quick profits and fip companies around like pancakes, very few of these stories ever end well (but it sure makes for good TV).  Don’t start with the 3 year exit in mind, it will only further delude you into thinking you are superman and batman combined.

Accomplishing these things in financial forecasting for entrepreneurs is going to be difficult, but not impossible.  If you need assistance, feel free to hire a consultant to help you. Of course, as many of you know, you can tap a global community of service providers that can aid you in this endeavor, and give you a good perspective from their viewpoint.

As an investor, the golden rule is to run far, far away and very fast from rosy financial projections.

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