When I was an early-stage founder, I bristled at the idea of making a five- or even three-year financial projection of my business. I can promise you one thing: It will be dramatically wrong. But as part of your fundraising, you need to make them anyway, and there are a couple of great reasons for that.
VCs understand as well as you do that you can’t predict the future. Hell, that isn’t just true for companies at the pre-seed stage; if founders could predict the future, there wouldn’t be so much nervousness around IPOs.
But it’s worth keeping in mind that your investors aren’t asking you to predict to the nearest penny how your company is going to perform in 2030. They are looking for two very specific things: Whether you understand how the financial dynamics in your business work and whether you are venture-scale.
Being venture-scale
To be venture-investable, you need to be “venture-scale.” That means that if an investor puts $1 million into your business, you need to have a very firm grasp of how you’re going to turn that $1 million investment into a $10 million return. Now, not every business is going to do that, of course, and it’s not easy to guess which businesses are going to successfully give investors a 10x return.
I can guarantee you one thing, though: If the financial projections show steady 10% year-on-year growth for the next decade, it may be a good lifestyle business, but it’s never going to give a 10x investment return.
In other words: Yes, your financial projections need to be “realistic,” in the sense that they show that there’s a logical progression from where you are to where you want to be. But you also need to show, in spreadsheets and numbers, that you at least have a fighting chance at being venture-scale. If your most optimistic, most aggressive growth trajectory falls short of this, you’re not going to have a good time as a VC-backed startup founder: It shows that you have fundamentally misunderstood why investors invest.
Understanding the financial mechanics
When you are raising money, you need to show your investors that you have clear plans for why you are raising money. In other words: What are you going to do with the money?
That is measured in milestones (delivering a number of customers, product features, market expansions, etc.) rather than time. Saying that you’re raising $2.5 million because that gets you 18 months of runway is pretty useless; yes, you keep the lights on, but that doesn’t say anything about what progress you are planning to make in that period. The short-term part of your financial forecast is called an operating plan, and you’re probably going to spend a fair amount of time talking about it with your would-be investors and reporting on how you’re doing to your board.
However, the three- or five-year plan does something else: As I mentioned, it isn’t expected that this will be perfectly accurate. As we discussed, you can’t see the future. What is expected, though, is that you show how your business evolves over time.
For example, you’d expect your blended customer acquisition cost (blended CAC) to go down over time as you learn more about the market and as you explore how your various marketing spends scale as you gain brand recognition and experience with marketing to your customers.
As you hire more and more experienced engineers, you’d expect that your cost goes up but also that the pace of developing new features goes up.
Similarly, if you hire more marketing staff and start allocating more resources to advertising, PR, marketing and other outbound efforts, you’d expect the pace of your customer acquisition to go up.
The key is that the results (ARR, customers, revenue, product quality, R&D speed) should go up at roughly the same pace as you’re resourcing the company. In a good set of financial projections, all of these things are linked, and a good CEO should be able to verbalize what the financial projections are showing.
That might look a little bit like:
Well, if we want to go from spending $50,000 to spending $150,000 per month on advertising, I need an additional senior and a junior marketing staff member, an external ad-buying agency and an upgraded marketing plan. Upstaffing and finding the agency will take three months, but in return, that will result in a 3x increase in the number of new customers, a 10% increase in efficacy of our marketing spend, and it means we will burn through our funds four months faster, but we’ll be ready to raise our next round of funding six months earlier. It will increase our monthly recurring revenue by $75,000 per month, but because our customer lifetime value is so high, we should recoup those costs in nine to 11 months.
Of course, none of the numbers in the above example will be 100% accurate, but they don’t have to be. A financially literate CEO shows that they understand how the financial levers in the business impact each other. Ultimately, your investors are in it for the financial side of things, and it’ll be very reassuring to see an internally consistent and externally plausible set of financial projections.