Securing angel investment or venture capital for your business is not easy even if you do everything right. Many entrepreneurs further hinder their chances of securing funding by making one of the following common mistakes with their pro forma financial statements.
1. Creating Top Down Assumptions. One of the worst mistakes you can make when developing financial projections is to start from the top and work your way down. An example would look like this:
The average Starbucks has $3.5 million in sales each year, I believe our new coffee shop can do at least half as much as Starbucks, so I am projecting $1.75 million in sales for the first year.
Another common top down approach is to say that the total market is a billion dollars and you think you can get 1% of the market.
Your assumptions must be built from the bottom up, not the top down. An example of bottom up assumptions looks like this:
- We will have 2 full time salespeople
- Each salesperson will make 20 phone calls per day to potential customers
- 2 of those calls will turn into meetings
- 1 of those meetings will turn into a sale
- The average sale will be $500
- This means that monthly sales will start out at 2 people x 1 sale per day x $500 average sale x 20 business days per month = $20,000 sales per month
See the difference? Which option is more realistic?
2. Incorrect Cost of Goods Sold. Your next challenge as you create your financial projections is to accurately forecast your cost of goods sold (COGS). The most common mistake here is to incorrectly categorize expenses. The question is really what exactly is cost of goods sold for a product business and what is cost of sales for a service business. Cost of goods sold can be defined as follows:
All the costs incurred to purchase the raw materials, to produce the final product, and to ship the product to a point where it can be sold.
This definition holds for a product business, but what about a services business? Cost of goods sold for a services business is a bit different. Since you don’t actually have a product to sell, you won’t have costs for raw materials or labor to produce the product.
Instead, you may have labor costs to provide a service. For example, let’s say that you own a painting business. You don’t actually have any employees, instead you subcontract out the work to a group of guys who will do the painting whenever you have a job. These 3 guys will charge you $15 an hour each. So your cost of goods sold for this service will be $45 an hour to have all 3 guys working for you. On the other hand if these 3 guys were salaried employees, their wages would not be considered part of COGS because you would have to pay them whether you had a job or not.
As a basic rule of thumb you should simply ask yourself “Would I incur this expense if I did not make a sale today?” if the answer is “yes, you would still have the expense even without an additional sale”, then it is not a COGS expense.
3. Stating, “These Projections are Conservative”. This is by far the most common mistake that entrepreneurs make with their projected financial statements. There is no other statement that will send investors the other way faster than by calling your projections conservative. Everyone thinks their pro forma financial statements are conservative and yet according to the Bureau of Labor Statistics of new businesses that started in 1994 or after only between 50 and 55% of those businesses are still in business after 5 years.
So here is my question, do you think that any of the 45% of businesses that failed within the first 5 years had financial projections that showed that they would close their doors within 5 years? Of course not! Every single one took the risk to start the business because they thought it had a good chance of being successful. They all probably thought their projections were conservative and yet half of them failed completely. The point is, don’t claim that your statements are conservative even if they are. Investors know that startups are risky, very risky.
4. No Apparent Way for Investor to Earn 10x Return. Investors are much different than bankers. The banking model works when you have a portfolio of 100 companies and 99 of them pay you back the full loan amount plus interest while 1 company may default on the loan and go bankrupt.
The venture capital investor model is different. Out of 100 investments 50 will probably fail and you will lose everything. 30 will just return the initial investment. 10 will double your money. And 10 will win and return 10x the investment back to the investor. That is just the way the investment model typically works for early stage companies. So that means you need to be able to prove that your company has the potential to return 10 times the initial investment to the investors.
If your financial projections demonstrate that the best case scenario is for the investor to double their money, the investors are going to look elsewhere. Investing in your company is a huge risk, and it is not worth investing in if the best case scenario is only to double your money. Unless you can demonstrate a realistic path toward 10x returns, investors are going to look for higher potential investments.
As you work on creating your pro forma financial statements, keep these 4 common, but deadly mistakes in mind, avoid them, and you just might have a chance at landing a major investment in your company. Good luck!
About the Author: Adam Hoeksema is the Co-Founder of ProjectionHub which is a web application that helps entrepreneurs create financial projections without the need to have a PhD in spreadsheet modeling.