This article was written by XSeed Capital Partner, Jeff Thermond.
Almost half of the initial pitches we view at XSeed do not contain a Five Year Projected Financials slide. Another quarter have a forecast, but it only goes out two years. So, three quarters of the entrepreneurs we meet start out with a pitch deck missing an indispensable element of the investment evaluation process.
This absence will create several unnecessary friction points to raising capital as I will point out in just a minute. However, what is most important for the entrepreneur is how disadvantaged they will be because they have not taken this essential step.
The five-year plan is where the founding team states a series of hypotheses about the business they are trying to create. It forces them to be specific about how much they will sell, at what price and at what costs to their target market. It forces them to balance the resources given to each department to achieve that plan. And it forecasts how much capital it will take to start and at what times that initial capital will need to be increased.
Such a plan is not a one-time exercise, but rather iterative. It strives to get closer and closer to an expected and defensible set of null hypotheses about the business. And it forces team members to think through all aspects of the business.
This is highly beneficial to the team and it is almost impossible to do too early. My partners and I can tell immediately if a team we have just met has gone through this exercise or not. The differences between those who have thought this out and those who have not are very striking.
So, we recommend that entrepreneurs do this early and often just for themselves. But do not overlook the fact that the absence of a plan will cause needless friction points on the road to securing a first financing,
But, if planning early is such a good idea, why do so few teams we see have this in place? We hear several rationales as to why they have not.
The most common is that the entrepreneur has not figured out how big a business this might become and over what time-frame. Another frequent comment is that the task is complex, and often someone will say it is not worth the time because the “numbers will be wrong anyway.” And almost everyone who shows us their two-year models says the reason they do not have the subsequent three years is because they have not figured out that part yet.
There is a germ of truth in these comments. It may be too early to project the maximum size of the business with confidence. The task can be hard. And it is probably true that the end result will vary from the model in significant respects.
However, venture capital, like the music and book publishing business is a business of a few mega-hits making up for many investments which do not live up to the promise and hope the investors and entrepreneurs saw. Investment returns which would thrill individual investors (e.g., 200%+ return in two to three years) will disappoint Limited Partners who invest in venture capital. So, the promise that an investment has to show to be worthy of initial investment is incredibly high in order to raise both the first and also future rounds of venture capital. In order for a partner to sponsor an investment with all of his or her other partners, she or he has to have a thesis about how big the potential business can become.
In order to be believable, that thesis has to be developed by the team which is going to execute on it. Even firms like XSeed, who offer a great amount of support, time, and advice to young teams in building these plans, know that at best they are coaches and not players. When is the last time you saw a coach make the winning score in a game?
This means that a financial plan and forecast is an absolute requirement to get funded (unless you have already been wildly successful for that investor) and that it must come from the management team. And the team must own the plan and drive the key spending decisions from it. So how can an entrepreneurial team make doing this easier on themselves?
First of all, see the model as a tool to build and refine the business, and not as some arbitrary and bureaucratic venture capital process obstacle. Venture capitalists (I am excluding those who practice the Spray and Pray investment model) like to see entrepreneurs who already realize that the tool is essential.
Two, start early because building a good model is iterative and is hard. Very few hard things worth accomplishing can be done quickly. Kicking the can down the road will result at best in a delay in funding and more likely a decision to pass by an investor.
Also, stop using terms like “right” or “wrong” about the numbers in your forecast and substitute terms like “fairly close” or “wildly off.” Entrepreneurs are not creating auditable and accurate financial statements about events which have not happened yet. What entrepreneurs should be trying to do is to produce a serviceable model which aids in considerations like pricing a product, figuring out a go to market model, and deciding when enough progress has been made to raise a next round of venture capital.
In a serviceable model, being “fairly close” on things like the price the market will bear, the cost of expanding sales resources, and the number of potential customers provides immense value to the entrepreneur. In this case, there is very high value in being ‘fairly close’ even though almost by definition you will not be precisely accurate.
Finally, get help from a financial professional who has worked with startups raising money before because often they know what is essential and what is window dressing. People who have done this before know what key line items need to be shown broken out and which ones should be rolled up into categories. They know to round to the nearest thousandth dollar for many items because the model aims to be a close approximation of future results. They know to do the first two years as either monthly or quarterly forecasts and that the back three years can be shown as annual numbers. And they know the rough hurdles each round of financing must surmount to earn the next round of venture investment.
If your team engages early on this key issue and sees the tool as an essential resource to be developed early and not a meaningless exercise to be deferred as long as you can, it will make your team stand out, and it will remove an important source of friction in investor-entrepreneur dialog and interaction.