Welcome to this week's module in entrepreneurship, preparing for launch. In our last module, we talked about revenue models and pricing strategies. In this model, I'm going to focus on building your financial model or projections. There's an awful lot going on in our word cloud for this lesson. It's about estimating sales, revenue costs, and cash flow, as well as some of the mistakes that entrepreneurs commonly make when they build their financial models. Entrepreneurs often say that they think the whole process of preparing financial projections is a waste of time. After all, nobody can really predict the future. Most start up companies don't do as well as the founders thought they would. A few do much better than anyone could have expected. There are so many variables and so much uncertainty. The only thing you can 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 have immense value, both for you and for anyone who is considering investing in your business. First, they demonstrate your aspirations for the business. What are you really trying to build? A fast growth market dominating company, or a stable and profitable lifestyle business, or something in between? What will you as the founder of the company considered to be a success? They also show the extent to which you've identified and understand what the key drivers of growth and profitability will be. Are you able to identify the parts of the model that you should invest in to maximize sales, reduce your costs or accelerate your growth. They also show the extent to which you understand how your investors can get the return on investment they're looking for. They'll be trusting you with their capital. They need to be confident that you have a plan to maximize their returns. And they help investors determine whether or not the business fits their profile, so they can decide whether or not they want to learn more about you and your opportunity. Maybe this should have been the first thing on my list even before you start your business, the work that you do to prepare financial projections can force you to take an objective look at the opportunity, so that you can make an intelligent decision about whether or not to proceed. That's the go or no-go decision. And it may be the most important decision that you ever make about the business. There are good business plans and there are bad business plans. And in my opinion, how you build your financial model will have a lot to do with which group you're in. Your financial projections should be tied to and consistent with your business model. Revenue projections should be consistent with your value proposition and your go to market strategy. The revenue model and the pricing strategy must work for both your customers and your business. Unfortunately, a lot of entrepreneurs fail to do this. Too many financial projections are based on a top down approach. Top down is perfectly fine for estimating the size of your market, but it's not a good way to actually forecast your sales revenue. By top down, I mean, the financial projection is based on an assumed market share. Essentially, the entrepreneur is saying there's a really big market out there. We're just going to assume that will get a 1% market share, that will result millions of dollars in sales revenue per year. Believe me, when I say that this is a pretty big turn off for most investors. Here's another approach that I sometimes see. This is a forecast that's based entirely on the number of sales people the business can hire. This type of projection is essentially saying that each of our sales people will close X number of sales per month, and will grow the company by adding more and more salespeople every year. The problem with both of these approaches is that, they completely lose sight of the customer and the value proposition that the businesses offering. The best way to build a financial projection is from the bottom up. You do this by developing a pipeline of customer prospects made up of potential early adopters at first, and then expanding into the broader market. Your business plan should explain the strategy that you plan to follow to convert these prospects into customers. The projections can then be based on the assumptions you make about the sales conversion rates, customer acquisition costs, and so on. Essentially, a bottom up projection says we expect to acquire a certain number of customers in our first month, quarter, or year by implementing our go to market strategy, and that will result in why dollars of sales revenue. If you can do that, 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. They should be based on the answers to these questions. What's your revenue model? What's your pricing strategy? How many customer prospects can you reach in your first month, quarter, or year? How many of these prospects can you convert into paying customers? As you learn more about your customers, you should be able to grow your sales both by reaching more prospects, and by improving your sales conversion rate. How fast do you think that you can grow your revenues on a month to month, quarter to quarter, or year to year basis? With the answers to these questions, you can start making revenue estimates. In any given month, your revenue will be equal to the number of customers that purchased from you times the average price per transaction, times the average number of repeat purchases per customer. So 100 customers in month one, paying $100 per transaction times two purchases per month should be equal to $20,000 in revenue in month one. You'd use the same approach if you're looking at a quarter or a year. But of course, most of the predictions that you make about the future will turn out to be wrong. Most financial projections are overly optimistic. So where do entrepreneurs usually gets wrong about their revenue? In my opinion, the biggest errors that entrepreneurs make about customer adoption rates and the sales cycle. Your customers are busy, and it will probably be harder than you think to get their attention. The status quo can be a pretty formidable competitor. Then, 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 other 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 for a long time. You should make sure that you have a solid understanding of typical sales cycles in your industry. The government hospitals and universities in particular are all notorious for having very long sales cycles. You also have to estimate the expenses. You'll have to pay to deliver your product or service, acquire customers, and operate the business. Cost of goods sold or colleagues is what it costs you to produce and deliver the products and services you sell in any given time period. This is the first expense for most businesses, and it's frequently the largest. Your gross profit is the difference between your revenue and your cost of goods sold. Selling and marketing expenses, as I discussed in our last lesson, are what you pay primarily to acquire customers. These are going to be tied very closely to your go to market strategy because there what you need to pay to build awareness, generate leads, and close sales. And then there are the cost you'll incur to operate the business itself, separate from producing your product, and acquiring customers. These are general and administrative expenses or corporate overhead. They're mostly fixed expenses and they include things like rent, administrative salaries, insurance, legal, and accounting costs, and so on. You should be able to get a pretty good handle on some of these expenses. You can make accurate estimates of what you'll need to pay for office rent, equipment, software, and so on. You can probably estimate the number of people you'll need to hire, and the salaries you'll need to pay to retain them. You can get quotes from suppliers of raw materials or finished inventory. You can talk to vendors to learn what you'll need to pay for a website for marketing, and advertising commissions to resellers, and so on for other expenses. You may have very little information to work with. Fortunately, there are places you can go for guidance. For example, you can look at financial statements for public companies that are comparable to your business. In some way, they're in the same industry. They have a similar business model. They have similar customers, etc. SEC filings and financial ratios are available on both paid databases like capital like you 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 examples, publishes annual statement studies which include dozens of financial ratios for over 500 lines of business. These are taken from tax returns and they include both public companies and small and midsize businesses. There are also paid databases available through companies like Bizminer.com. So where do entrepreneurs usually go wrong when they estimate their expenses? In my opinion, the two biggest areas are general and administrative and selling expenses. You may think you've identified everything you need to operate the business, but things happen and you need to be prepared. Legal, accounting, travel, employee health care, these can all add up quickly. You may also find that you need more people than you thought, or you need to spend money to replace employees that didn't work out. Entrepreneurs often underestimate the cost of building and maintaining a direct sales force in particular. Some sales people will be more effective than others. And it can sometimes take months before a new salesperson is truly up to speed and meeting his or her goals. If they are defective, you'll need to replace them and that starts 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 flow forecast out of your revenue and expense projections? Here are some of the things you need to consider. If you offer credit terms to your customer, you'll have to estimate how long it will take them to pay their invoices. This is your average collection period. Remember that this is something that's outside of your control. You can't write the check for them. Another name for the average collection period is days receivable. It's the average number of days it takes to collect your accounts receivable from your customers. How much inventory will you need to carry, and how much will it cost? It's not revenue until you sell it. Inventory turnover is a measure of the number of times you turn over your inventory in a given year. The faster you sell your inventory, the less cash you'll need to have tied up in it. Will your vendors offer credit terms to you? They may not when your business is new, and you don't have a credit history. If you're able to get credit terms, you should be able to use them to improve your cash flow. Days payable is the average number of days that your accounts payable are outstanding. The length of time that you're able to take between purchasing and paying for your inventory. These short term assets and liabilities, accounts receivable, inventory, and accounts payable, will be the primary drivers of working capital in your business. Yeah. Moving beyond working capital, you need to estimate what you'll have to invest in fixed assets or capital expenditures. This includes land and buildings, including any improvements you have to make to leased property, machinery, office equipment, vehicles, and so on. And finally, do you need to invest in intangible assets like patents or copyrights. Cash is king, and entrepreneurs often gets wrong about how their revenue and profits will translate into cash. They underestimate the amount of time that will elapse between when they purchase inventory and when they collect cash from the customers who bought that inventory. This is the company's cash to cash or operating cycle. It can be reduced somewhat if your vendors also give you time to pay for your purchases. A lengthy operating cycle means that the company will have to have a lot of cash tied up in working capital, which is mostly inventory and accounts receivable. And sometimes entrepreneurs forget that there need to invest in working capital, which ties up cash will increase directly with their sales. It's important to make sure that you have enough cash available to pay your bills as your company grows. Ideally, your financial model can be built using a set of linked worksheets in Microsoft, Excel, or some other spreadsheet software. You'll probably need at least three years worth of projected income statements, including revenue, expenses, operating profits, and net income. You also have to have projected balance sheets listing your assets, liabilities, and net worth, dated as of the end of those same three years. You should also have projected cash flow statements, especially if you have significant needs for working capital or capital expenditures. All of these should be prepared in a format that's consistent with generally accepted accounting principles. I also think you should have a 12-month forecast of cash inflows and outflows. This is called a cash budget. It's what you use to determine your cash runway, and the amount and timing of any cash you're going to need from investors or lenders in order to avoid running out of money. 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 key assumptions, keeping everything else the same, and see what the bottom line impact will be. 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 and cash flow. Some of you probably consider yourself to be pretty good at building spreadsheets. Fortunately for the rest of us, you don't have to build all of this from scratch. There are start up and small business financial projection templates available for free from score, or you can purchase templates from profit vendors like Foresight. Foresight also provides information on best practices for building financial models even if you don't buy their templates. In our next lesson, I'll address ways to present your financial projections to potential investors.
