[guest post] By Frederick J. Beste, III
There is a dichotomy in the world of entrepreneurship which is almost beyond belief:
- Every start-up entrepreneur believes that he is going to exceed his projections, yet
- None of them even reach them.
I know, I know, one should be very careful in using absolutes like “every” and “none,” but in over 40 years of start-up stage venture capital investing, I have seen only one exception to these statements. Take a hundred entrepreneurs selected at random, hook them up to lie detectors, have them place their left hands over pictures of their moms and their right hands over books of worship of their choice, and ask them “in your heart of hearts, do you really believe that your projections are, to use your word, ‘conservative?'” You will not only get one hundred yeses, but not a single needle will quiver. Yet if you came back to them five years later, you would likely find that not a single one of them hit their numbers.
How can this be?! To be sure, in any group of 100 entrepreneurs selected at random, there will be dozens of fools – people who are literally kidding themselves about their prospects. But there will also be dozens of solid citizens – bright, hard-working, relevantly experienced men and women who have devoted serious research and thought to their prospects.
The answer is two-fold in nature, the first part of which is known to just about everyone, and the second part of which I have never heard anyone else voice. The first part of the answer is that entrepreneurs are, almost by definition, optimists. Their glasses are almost always at least half full. They believe in themselves, their team and their opportunity. They expect and project good things to happen.
The second, and far more important part of the answer is that, while entrepreneurs sincerely believe that their projections are conservative, they are in fact Utopian.
As the easiest proof of this fact, grill a start-up entrepreneur on his projected expenses. Ask him questions like the following. What provision has been made in your projections for:
- Uncollectible receivables?
- Management team member turnover and/or failure including management team member vacancies of months on end, and ultimately paying headhunter fees?
- Aggressive price reductions from competitors?
- Competitors ultimately leapfrogging your leading edge technology?
- Employee theft?
- National and/or industry recession?
- Products recalls due to component failures in the field?
- Litigation costs?
You will likely get a blank stare in return, because all of the above falls into the category of “stuff that goes wrong,” and there has been no thought given in the preparation of the projections to anything going wrong. It’s not in the nature of the entrepreneurial beast to even acknowledge such things.
Why is this so important? Cash flow. Cash is literal life. A friend of mine once described a start-up as a race against insolvency, and he was right. One which badly misses its numbers will either become insolvent or require a whole lot more money to stay afloat than originally anticipated.
So how can you, as an entrepreneur, address this strange and frightening dichotomy? Again, because it is easier, let me first address the below-the-top-line part of the profit and loss projections.
Start by doing some research on your industry’s metrics. Secure some annual and quarterly reports for companies in your industry. Get a copy of Robert Morris Associates’ Annual Statement Studies, which not only includes model balance sheets, income statements and financial ratios by business type, but also does it by business size. Place a call to your industry’s trade association and find out what information they have that can guide you. Fashion your projected expenses accordingly.
Next, take a look at your industry’s gross margins. If the industry leaders are around 55% and your projection is for a shade under 70%, you are in all likelihood headed for a fall. Your competitors have economies of scale which you do not. They have momentum, they have name and brand recognition, and rock-solid balance sheets. They have all manner of advantages over you. They are not only industry survivors, they may well be industry leaders. Stated another way, counting on a gross margin superior to the industry standard is not only likely foolish, but asking for a future cash flow crisis. For at least the first two or three years, and even if you intend to push the state-of-the-art, assume that you will experience gross margins at least a little below the industry standard.
Now let’s address the much more daunting task of creating sales projections for a start-up. Surely there is no more difficult challenge in all of business. Here you are, at the very beginning of a business odyssey, trying to divine out of thin air what your sales will be in your first few years of business. You have no history to look at. Your company has no customers, no momentum, no reputation, no market awareness.
The only intelligent way I know of to bridge this chasm is to identify your company’s top dozen or so prospects – those companies where you probably have personal relationships, and which you believe would have a keen interest in buying your product after it’s developed. Then call up the buyers at those companies and request an audience to share your plans and get their reaction. Sit down with them and tell them what you’re up to. Share your product specifications and prospective pricing. Tell them what you think your product will do for them. And then ask them: What do you think? How interested or excited are you about what we’re up to? Would you have an interest in being a beta site? How much of this product category do you buy each year? Who do you buy from now? How does our prospective product compare to their’s? Do you have a policy of second sourcing? If so, how does that work here? How would you go about evaluating our product? Over how long a period of time? If we introduced our product to spec at the price I mentioned, how much of it do you think you would buy in the next few years? While there will likely be buyers who will not divulge all of this information, you will be amazed by how many will, and particularly if you have a personal relationship with them beforehand.
Then, take what you learned and pessimize the numbers. If the twelve buyers, in aggregate, estimated that they would buy one, three and four million dollars of your product in years one, two and three, assume that they will do half that. Or maybe two-thirds. When in doubt, go with the more conservative choice. After the first two years, assume that you will sell to some other customers beyond these first ones. Additionally, if your product category features resellers or sales reps, getting their feedback can be a useful sanity check on the above.
If you’re in a service business, check in with the executive director of your industry’s trade association for some guidance or references. Then speak to as many leaders of similar companies as you can, to learn of their start-up experience. You may have to focus on those in distant geographies so as to avoid concerns of competitiveness.
A word of caution – one popular method of start-up sales projecting which is not likely to be on the mark is to assume an arbitrary, seemingly low percentage market share multiplied by the size of the market (the market we are addressing is $800 million. How could we fail to penetrate one percent of it after three years? There can be a very good answer to that question if there are 300 established companies already serving it.)
There is one final cash flow driver in a start-up, and that is the timing of initial sales; in other words, how long a period of time your product will be in development. If, after protracted consideration by your engineers, they tell you that it should be ready for sale in nine months, assume twelve or thirteen. If they’re right, the surprise will be a pleasant one. If you’re right, you’ll have anticipated the need for the additional three or four months of funding.
You may be saying to yourself as you read my advice, “Boy, there are cushions for the cushions in this approach.” And there are. But I’ll bet you that even if you take my approach, you’ll still end up needing more capital to get to positive cash flow than your projections indicate. The difference, though, will be one heckuva lot less than if you had done it your way.
Fred Beste has been active in the venture capital community for over 40 years. He remains the CEO of the General Partners of Mid-Atlantic Venture Funds. In addition, he currently holds the title of Partner Emeritus with Originate Ventures.