Updated: Nov 2, 2020
“I feel like I’m pulling numbers out of thin air. It's still unclear to me how to ‘project’ and build believable financial assumptions.” — Liz
Good news: everyone feels this way and it's totally normal! Many entrepreneurs worry when it comes to their numbers. I almost drove my first company into the ground. That’s what it took for me to decide to learn enough startup finance to be successful.
Start by filling your brain with questions, not answers
The important thing is to start building your mental map. Don’t worry about getting the numbers exactly right, or even close. No one can accurately predict the future (ahem, Covid) so don’t worry about precision yet.
Here’s how powerful this is:
“I’ve worked through the Rocket Pro Forma hiring plan and realized how much $$ gets spent on salaries. Thus, I am focusing on key positions (salaried) in these early years, and using independent contractors in budgets for projects or consulting, hourly for fulfillment, and interns where needed (they can be wonderful help!).” — Liz again
What an incredible confidence boost in just a few days! Liz put together a first draft of her pro forma projections, realized she didn’t like it, and created a version she likes better. Best of all, she can now explain to anyone—including an investor—why she’s taking this approach.
Just get started and keep moving. The answers will come to you as you fill your brain with questions. You’ll learn in stages:
Pulling ideas out of thin air
Researching likely answers
Adjusting as you run your business
Mastery based on experience & data
You may only need to get to stage 2 to raise money, although many investors respond better at stage 3.
Stage 1: Pulling ideas out of thin air
Here’s what this sounds like:
“I have been gathering exact data for operating expenses, too, and made advances in product development which is a big part of COGS [cost of goods sold]. I still have to work out the revenue model. I am clear how it works conceptually but am unsure how to translate into the model and actual numbers.”
We can actually watch the learning happening here. Find a good pro forma template for startups and work your way through it.
Think of your startup’s pro forma financial projection as a living document that will evolve over time (exactly the same as your pitch deck, except that you’ll keep using—and improving—your pro forma projections even after you raise the money).
The goal of the first time through is to build the mental map of how money flows through your startup, so don’t worry about the quality of your answers yet. You’ll learn to find better answers later.
Stage 2: Researching likely answers
You’re not the first person to start a company, no matter how unique your idea is. There are standards and industry averages that investors expect to see in your startup’s financial projections. These aren’t mysteries, and they’re easy to find once you start looking for them. For example:
I recommend aiming for annual revenue per employee of $200k to $500k by year three of your pro forma financial projections. Anything less makes you look inefficient, and anything more starts to make you look unrealistic. Here's my deeper dive on revenue per employee.
Your conversion rate (CVR) is what percentage of visitors to your website purchase and/or take some other action like email registration. A good starting guess is 2%, meaning that for every 100 visitors to your site, 2 people will take the action. You may get better over time and converting visitors, so a good financial model template will let you adjust your numbers for each year.
The subscription lifetime is how many months your subscribers stick around before canceling your service. A good starting point is usually 18 to 24 months. Again, you may get better at retaining subscribers, so a good financial model template will let you adjust your numbers for each year.
You can do a little research on any metric—ask Google and/or the mentors you work with—to find a good starting point. I find it’s best to get several opinions and decide from there because no one has all of the answers, especially when it comes to your business.
Stage 3: Adjusting as you run your business
Magic happens when you find your first paying customer—and your second, your third, and beyond. You haven’t created a business unless you have both revenue and expenses (without revenue it’s just an expensive hobby—or an unofficial charity).
As you start spending and making money, you’ll be able to adjust the assumptions in your startup's financial projections based on actual results.
For example, founders often ask me what their conversion rate (CVR) and cost to acquire a customer (CAC) should be. There is no "should." There is only the individual answer for your startup—which no one else can answer.
Here’s how I started answering this question when I launched Rocket Pro Forma:
For CVR (conversion rate) I compare weekly unique visitors tracked in Google Analytics with the number of weekly purchases. My CVR hovers between 3.8% and 4.2% each week.
For CAC (cost to acquire a customer) I first need to know what it costs to get a complete stranger to look at the RocketProForma.com website. I ran a test on Facebook Ads that cost me $64.67 to learn that my cost per click averages around 60 cents:
Now I can calculate my CAC as ( CPC divided by CVR ).
In my case this is ( $0.60 / 4% ) so my CAC = $15 per customer. I can compare this to the $44 to $99 that my customer spend per purchase. So my revenue per customer is 3x to 7x my cost to acquire each customer. I should be able to build a healthy business off of these numbers.
And it cost me $64.67 to figure it out.
Stage 4: Mastery based on experience & data
Not only does your skill with financial projections improve over time, your data gets better as you run your company. You’ll also start adding to your management team as you grow, so you’ll have help. Possibly even from seasoned executives who have done this before.
You’ll never achieve perfection, but you’ll learn to come closer each time.
Here’s what I don’t recommend
One big benefit of using a pro forma template for your startup’s financial projections is that you get to see the complete map.
One company I spoke with decided to skip the template and build their own. They showed me what they created—but they had left out key items like the hiring plan, cost of goods sold, the cash flow statement, and the balance sheet.
This often leads to worse decision making and awkward conversations with investors. In fact, I made this mistake with my first business and nearly drove it into the ground.
I’ve been in meetings where the VC has asked:
“Can I see your cash flow statement?”
“Can I see your balance sheet?”
“What is your cost of goods sold?”
"Can you walk me through your hiring plan?"
Do you want your answer to be that you decided to skip those things? Was it because you didn't understand them, because you didn't think they were important, or because they seemed like too much work?
Look for a complete financial projections template and take the time to work through it. Answer all of the questions in order to start building the mental map. Your future self will thank you!
Think of it this way: you'd use a map to take a road trip—especially the first time. Once you've done the drive a few times you can start to look for shortcuts and create your own route.
Questions and answers
Here are some questions from entrepreneurs I’m working with.
How accurate do my assumptions have to be? Are we talking exact prices and COGS? What if there are changes?
Your first goal is to work through the model, answering all of the questions without worrying about whether they’re correct.
Think of your startup financial projections as a living document that you will definitely change, especially as you gather feedback from advisors and investors.
Which KPIs are critical for our business, and how do I identify and learn about them?
Let me demystify this for you. This is from an actual business plan:
The proposed innovation will contribute to our company’s overall revenue goals by significantly improving the product mix. Our estimated revenues for the next three years include $1.2m for 2020, $4.7m for 2021, and $10.4m for 2022. These projections are based on the assumptions of a 0.40 viral coefficient, a 5% increase in advertising monthly starting with buying 2,000 users at a $2.94 customer acquisition cost in November 2020, a 12-month lifetime, 12% conversion rate during freemium, $12 monthly subscription, and $0.14 monthly advertising revenue per user. These assumptions are all based on industry medians from the games and education industries, where needed.
Did that freak you out? Don’t worry, you’ll get there—just like you’ve learned everything else in your life. And you don’t actually have to become an expert.
The most important sentence is “These assumptions are all based on industry medians from the games and education industries, where needed.”
Most of what you just read are assumptions you would put into a financial model—meaning that these are things that you will figure out as you grow your business. The only outputs from the model are, “Our estimated revenues for the next three years include $5.3m for 2017, $7.7m for 2019, and $12.4m for 2020.”
The model doesn’t give you all the answers. Instead, your job is to get better at knowing what to put into the model in order to get the most accurate predictions back out.
How do I learn how to read the Income Statement, Cash Flow Statement, and Balance Sheet? I need a remedial course in understanding these three things.
Short story: I think that accountants make this more difficult than it needs to be. I feel so strongly about this that I’ve created a free pitch deck financials slide template that combines the income statement and cash flow statement—because it’s easier if we can see these two items together:
Long story: You don’t need to be an accountant in order to understand the three financial statements, but you do need to understand cash vs. accrual accounting (you'll use both).
Here are what the three financial statements do:
Income Statement (also called Profit & Loss Statement, or P&L)—Shows your company’s revenue, cost of goods sold, and operating expenses, along with items like interest, taxes, and depreciation. This is the document that your company submits to the IRS when paying taxes. The income statement uses the accrual basis and does not provide an accurate picture of the cash available to the company at any given time.
Cash Flow Statement—Exactly what it sounds like. Solves the problem that the income statement doesn’t accurately reflect cash. Calculated on the cash basis.
Balance Sheet—Shows the net worth of your company at any given time. The basic formula is (Assets minus Liabilities equals Shareholder Value). If you’re WeWork your shareholder value might be negative:
(It took me 2 minutes to grab this from WeWork’s public documents on the SEC’s website. I simply Googled “wework financial statements,” clicked into the first link, and then searched for “balance sheet.”)
If I am asking for $1.5M as a pre-seed, pre-valuation raise, is it showing how I invest those funds to generate X and get to the next round in 18-24 months?
Exactly! A good pro forma template should help you figure out:
How much money you need
How long that money will last (this is called your runway)
What you’ll be able to accomplish with that money
I recommend putting this into your Milestones Slide when you’re pitching investors.
Why/how even do projections past your first round? How can you even show profitability at any early stage?
We raised a $2 million Series A round for one of my startups, and I asked our VC how they decide which companies to invest in. He told me that they have to believe a startup can IPO. That means they want to see that you have a plan to grow exponentially larger as quickly as possible, which is likely to cost more money than you’re raising in the first round.
That being said, it’s certainly possible to raise money from angel investors who won’t be as obsessed with exponential growth.
If you're building the business with VC money, then growth is often the priority over profitability. Otherwise if you're building the business for yourself, you'll want to focus on profitability sooner.
First decide the business you want to build and the size you’re aiming for. Then go out and find the right investors to help make that happen.
Mike Lingle is obsessed with helping founders grow their businesses. He's a serial entrepreneur, mentor, and executive in residence at Babson College and Founder Institute. Check out Rocket Pro Forma if you want to quickly create your financial projections.