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I'm Tom Parkinson, welcome to Entrepreneurship II, Practices and

Approaches.

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In this lesson, I'm going to talk about financial projections.

Once you've decided on an appropriate revenue model and pricing strategy to

bring your idea to market, it's time to start making assumptions about sales,

income and expenses and cash flow.

It's time to start building your financial model and your projections.

I frequently hear startup entrepreneurs complain that they think the whole process

of preparing financial presentations is a waste of time.

Afterall, nobody can predict the future.

Most startup companies don't do nearly as well as they predicted.

A few do much better than anyone could of expected.

There's so many variables involved, and there's so much uncertainty.

The only thing you really know for

certain is that your financial projections will turn out to be wrong.

But that's not the point.

Nobody expects you to be able to accurately predict the future.

Financial projections and the process of preparing them can be very valuable.

Even before you start, the work that you do to prepare financial projections

can force you to take an objective look at the opportunity,

which will help you make an intelligent decision about whether or not to proceed.

That's the go or no-go decision.

For other stakeholders including your investors, your key employees,

strategic partners, folks that you want to bring in to your business,

your financial projections will tell them a lot.

They demonstrate your aspirations for the business,

what are you really trying to build?

A fast growth market dominating company?

A stable and profitable lifestyle business or something in between.

What will you, as the founder of the company consider to be a success?

Your financial projections also demonstrate the extent to which you have

thought through and understand what the key drivers of growth and

profitability for the business will be.

Are you able to identify the areas in which you need to invest in order to

maximize the potential of the business, sales, operations, technology,

channel development, customer support.

Similarly, they demonstrate the extent to which you understand the key drivers

of return on investment for investors in the company.

They'll be trusting you with their capital.

They need to be confident that you have a plan to maximize their returns.

And finally, they help a potential investor quickly determine whether or

not the business fits their profile so that they can quickly decide whether or

not they want to learn more about you and your opportunity.

Here's some quick advice before you start.

While it's perfectly acceptable for you to use top down thinking when you're

estimating your market size, it's not appropriate to build your financial

projections that way even though that's what a lot of entrepreneurs do.

This is one of the differences between a good business plan and

a bad business plan.

By top down, I mean a financial projection that's based on an assumed market share.

There's a really big market out there,

and we're assuming that we're going to get a 1% market share, and

that will result in millions of dollars in sales revenue per year.

That's a pretty big turnoff for most investors.

A similar approach is to say that you're just going to

throw salespeople at the market.

Each of our sales people will close x number of sales per month and

will grow the companies simply by adding more and more sales people every year.

The problem with these approaches is that they completely lose side of the customer

and the value proposition that you're offering.

The best way that build a financial projections is to develop a customer

pipeline, made up of potential early adopters at first and

then expanding into the broader market.

Your business plan has to explain this strategy that you developed to convert

these prospects into customers, and why you think your assumptions about sales

conversion rates and customer acquisition cost are reasonable.

If you can do that and

base your financial projections on those assumptions about customer prospects and

sales conversion rate, then you'll have a solid financial projection.

As I said before, this is one of the differences

between good business plans and bad business plans.

So let's get started.

The first thing you need to do is build your revenue projections.

What's your revenue model?

What's your pricing strategy?

How many customer prospects can you reach in your first month, or quarter, or year?

What percentage of those prospects do you think you can convert into

paying customers?

As your business gains traction and you learn more about your customers

you should be able to grow your sales both by reaching more prospects and

by improving you conversion rate.

How fast do you think you can grow your revenues on a month to month,

quarter to quarter, or year to year basis?

That's where you start with your revenue projections.

As we've already discussed,

most of your predictions about the future will turn out to be wrong.

Most projections are too optimistic, so

where do entrepreneurs usually guess wrong about their revenue?

Well in my opinion, the biggest error that entrepreneurs make are about customer

adoption rates, and the sale cycle.

Your customers are busy, and it'll be hard to get both their time and

their attention.

The status quo can be your most formidable competition.

Even when you do have their interest,

it can take a long time to move a customer prospect through your sales pipeline.

Especially when you're making a business to business sale.

Your end customer may not be the final decision maker, and

they may have to get a lot of additional people involved before they can purchase.

Even when you think the purchase decision has been made,

your contracts may be tied up in legal review or somewhere else for a long time.

You should make sure that you have a solid understanding of your typical sale cycle,

or the typical sale cycles in your industry.

The government, hospitals, academia, for example,

all of these are notorious for having very long sale cycles.

As you're building your revenue projections,

you also have to be estimating the expenses that you'll be committed to.

How much will it cost you to make and deliver your product,

acquire customers and maintain your business infrastructure?

These are your cost of goods, your sales and marketing expenses and

your general and administrative expenses, or corporate overhead, respectively.

You should be able to get a pretty good handle on some of these expenses.

You can find out what you'll need to pay for office rent, equipment, software, etc.

You can estimate how many people you'll need and

what salaries you'll need to pay to recruit and retain them in your market.

You can get quotes from suppliers of raw materials or finished inventory.

You can research what you'll need to pay for a website, online and offline

marketing, advertising, commissions that you pay to resellers or dealers, etc.

For other expenses, you may have very little information to work with.

Fortunately, there are places you can go for guidance.

You can look at financial statements for

public companies that are comparable to your business in some way.

In the same industry, with a similar business model, or

maybe they have similar customer targets.

SCC filings are available on both paid databases, like,

CapIQ, and free websites like, Yahoo or Google Finance.

You can also look at published industry averages, which you can find in most

business libraries or by working with your local Small Business Development Center.

Risk management associates, for example, publishes annual statement studies that

contain dozens of financial ratios for over 500 different lines of business.

These are taken from tax returns, and they include both pubic companies and

small and mid size businesses.

So where do entrepreneurs usually go wrong when they estimate their expenses?

In my opinion, the two biggest areas general and administrative and

selling expenses.

You may think you've identified everything you need to operate your business but

things happen and you'll need to be prepared.

Legal, accounting, travel, employee healthcare, these can all add up quickly.

You may also find that you need more people than you thought, or

you may need to spend money to replace employees that are not working out.

Entrepreneurs often underestimate the cost of building and

maintaining a direct sales force in particular.

Some sales people are going to be more effective than others.

And it can sometimes take months before a new sales person is truly up to speed and

meeting his or her goals.

If they aren't effective, you'll need to replace them and

that's start the whole process over.

Profits are nice, but ultimately you and your investors care about cash.

So how do you go about building a cash forecast out of your revenue and

expands projections?

Here are some of the things that you need to forecast.

Your average collection period, if you're going to offer credit terms to your

customers you're going to have to estimate how long it will take to pay you.

Remember that this is something that is outside of your control.

You can write the cheque further.

How much inventory will you need to carry and how much will it cost?

It's not revenue until you sell it.

Will your vendors give you time to pay for that inventory?

How much will you have to invest in fixed assets?

This is real estate including improvements that you make to lease property.

Machinery, office equipment, vehicles, etc.

Are you going to need to invest in intangible assets?

Do you need to invest in patents or copyrights?

Do you have to spend money on research and development?

For many of these you can look to comparable companies and

industry averages for guidance.

Cash is king and entrepreneurs often guess wrong about how their revenue and

profits will translate to cash.

They underestimate the amount of time that will elapse from the time they purchase

inventory to the day that they collect cash from their customers.

The customers that bought that inventory.

This is the company's cast-to-cash or operating cycle and

it's an important metric to understand.

A lengthy operating cycle means that the company will have to have a lot of cash

tied up in the inventory and accounts receivable.

So what will you ultimately have to have in your financial projections package?

Ideally, they can all be developed with a set of linked worksheets in

Microsoft Excel, or some other spreadsheet software.

Keep it as simple as possible, you want them to be easy for both you, and

others to review and understand.

You'll need at least three years worth of projected income statements,

projecting revenues, expenses, operating profits and net income.

You'll also need to have projected balance sheets, listing assets,

liabilities and net worth dated as of the end of each of those same three years.

You should also have projected cash flow statements for three years,

all of these the income statements, the balance sheets,

and the cash flow statement should be prepared in a format that is consistent

with generally accepted accounting principles.

It's also a good idea to have a monthly forecast of cash inflows and

outflows for the first year, that's also called a cash budget.

This is what you use to determine your cash runway and

the amount of cash that you need to raise from investors or

lenders in order to avoid running out of money during the year.

Finally, you should have a separate list of the key assumptions that are driving

the most significant numbers in your projections, sales,

sales growth, profitability, cash flow, etc.

If you prepare all of these projections with linked worksheets,

you should be able to quickly do a sensitivity analysis.

That's where you change a couple of the key assumptions keeping everything else

the same and you can see what the bottom line impact would be of those changes.

A sensitivity analysis is a good tool for

helping you understand which assumptions matter the most and

where you should focus if you want to maximize profits or cash flow.

Fortunately, you don't have to build all of this from scratch.

You can download a free financial projections template from SCORE.

Or you can buy a set of templates from vendors like Foresight.

Foresight also provides some great information on best practices for

financial projections, even if you don't buy their templates.

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Projections: Financial Projections

Entrepreneurship II: Practices and Approaches

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