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If you’re an entrepreneur who’s looking for investment, you already know that you need more than a good business idea — you need a strong pitch that includes solid financial forecasts.
This is vitally important when seeking out the right investor as it shows them that you understand the fundamentals of your business. It also helps investors understand other key points, such as the attractiveness of your business model; the amount of capital required to meet milestones; and the valuation of the company to be applied to the current financing round.
But figuring out what to include in these forecasts can be tricky. At MaRS IAF, we see hundreds of pitches every year. This is what we want founders to know.
Include the right numbers
The most important thing in a financial forecast is an income statement that spells out your revenue, cost of goods sold and expenses. Cash flow projections are also key: Most startups are not profitable at first, so it’s important for investors to understand what kind of runway the companies are forecasting and whether they have the funding to continue operating until they achieve their goals. Include quarterly, and if necessary, monthly projections for various scenarios, as well as your plan if things go awry.
Many founders present what’s called the base case, which tends to look at the most plausible scenario when it comes to their cash flow. But we’ll often ask, what is your worst case in terms of what could go wrong? For example, what would happen if your revenue gets delayed by six months or a year? When would you run out of cash? That’s not just important information to have, it’s also a good reference point for us to see how founders evaluate and plan for risk. Often the difference between success and failure is in the execution, so we want to know how they’ll handle it when things don’t go to plan.
Learn the economics of your industry sector — and don’t give overblown projections
Different types of industries have different margins and cost profiles, which founders must be aware of if they’re going to generate accurate and reasonable financial projections. For example, software and SAAS companies could have gross margins of up to 90% because their cost of goods sold is very low. On the hardware side, it’s closer to 50% because of manufacturing costs. The traditional automotive industry has typical net income profit margins between 3% and 5%.
To fund all their R&D and other expenses, they need huge revenue volumes and the associated economies of scale. If a founder is projecting profit that doesn’t mirror the reality of their industry, it will ruin their credibility because it’ll indicate they haven’t done their homework or don’t understand their business, which can make an investor wonder whether they can trust any of the company’s projections.
Have a plan — but be adaptable, too
Founders come up with scenarios based on any number of assumptions that differ from their base case — including the timing of revenue, margins and expenses — so we don’t expect them to have a scenario for every single parameter. But be prepared, because potential investors may ask for more financial analysis.
It’s also a good idea to include your contingency plans in your financial projections. So, if things go in a negative direction, what changes will you make to ensure your survival? That could look like hiring people on a contract basis rather than bringing them on full-time or planning to cut core staff. But many entrepreneurs will save this as a last resort because cutting too deep can lead to a vicious circle where you cannot deliver on promises that you’ve made to customers. Oftentimes, part-time employees have other sources of income and it’s less painful to disengage with those than with full-time employees. It may also make sense to hire a part-time or fractional CFO instead of bringing on a high-priced full-timer right away.
Use a model that makes sense for the stage of your business
In the first and second years of operations, companies have a reasonably good idea of what they need to do to meet their milestones and what resources they need to get there. For example, if they need to develop a new feature, they can likely estimate how many engineers and how much time to dedicate to the project.
Similarly, it should be fairly easy to calculate how much that would cost and how much revenue they need to generate in order to fund that. That’s how you build an income statement using “bottom-up” projections. But any further out, it becomes difficult to estimate exactly how many engineers the company will have and how much revenue it’ll generate. At that point, it’s time to switch to “top-down” models, which use typical industry margins, cost structure and revenue per employee to generate a projected income statement.
How to choose the right investor
Not every startup gets to choose their investors — sometimes, it’s whoever will give you money. But, ideally, founders should look for investors who have some important characteristics, and domain expertise is a big one. That’s their track record of investing in that industry, which means they will more easily understand the business case and the value proposition.
It’s also wise to seek out a firm that can add value after the investment. Look for firms that can provide the resources, skills and networks to validate their ideas and bring products and services to market. I like to call this the “virtuous circle” of venture capital. If a venture capital firm has a good reputation, chances are the companies it invests in will attract better opportunities and therefore see better outcomes. Contacts in the industry are also important because that means your investor can support you in the long run by helping open doors with potential customers and partners, which will help the startup become more successful.
Founders should also do their research to find out what companies the VC may have already invested in. If they’ve already begun a relationship with a direct competitor, that can present another challenge.
The bottom line
There are a lot of details to line up and work through, so make sure you are fully prepared to talk confidently — and honestly — about your business plan. If you want to attract an investor who is committed to your company’s growth, you need to first invest the time to ensure your numbers add up.