Many founders are reactive when business doesn’t go as planned. They may make knee-jerk reactions like: “If I lose 10% of revenue then I’ll just lay off five people.”
The problem with such approaches is that they don’t always solve the underlying business problem.
Take Peloton as an example: At the beginning of the pandemic, the at-home fitness company was riding high and nearly doubled its annual sales. The spike — largely driven by people turning to home fitness as gyms suddenly became untenable — would also be its downfall, unleashing a series of miscalculations that sent its stock diving.
What really happened with Peloton was that the unanticipated demand led to financial and planning mistakes. Peloton had banked on consumers changing their behavior and preferring to exercise at home. They were wrong.
What could Peloton have done to prepare for both the sudden upswing and downswing? They didn’t have a crystal ball, but luckily, we have something that comes close. It’s called a “Three-Case Model.”
Case scenarios are only effective when time, effort and thinking is invested in them.
What is a three-case model?
With case models, companies can proactively mitigate risk and forecast financial trajectories. The business climate, consumer preferences and competition can all send into motion sequences of events that nobody can predict with certainty. Thankfully, founders can still prepare for them.
Case models are a part of scenario analysis, which helps you visualize the mostly likely outcomes for a business. Through case models, founders can understand how shifts in the business climate could impact sales, cash flow, profits and more. They can also visualize the ramification of strategic decisions, such as what would happen if they make an acquisition, build a factory, raise prices or go after a new market.
In every scenario analysis, there are three key scenarios that must be identified: the best-case scenario (home workouts are a permanent trend), the down-case scenario (people will go back to the gym) and the base-case scenario (equilibrium will return).
Typically, the base-case scenario falls between the extremes. For example, in financial modeling, you might say that Peloton experienced both its “best case” and “down case” scenarios within a year.
How to build a three-case model
Building case scenarios starts by taking financial inventory. Founders must ensure all books and records are up to date across every stakeholder, including sales, operations and tech/development (typically the three main components of an early tech company). Those with a very good historical setup can project scenarios more accurately.
Once records are in place, key stakeholders should share what they believe is the most likely scenario for the coming year. Have each responsible party put together a case for what they believe to be the most likely outcome. This is difficult, but the more they are asked to do it, the better they will become at analysis and projection.
After meeting as a team — and challenging assumptions — the information can be used to prepare a “base-case” scenario. This should be a 12-month projection from the current timeframe that forecasts results for the coming year and the most likely outcome for the business.
The next step in the exercise is to ask the same question, but with the slant of the worst possible outcome. It’s difficult here to be realistic. For example, I know the worst case for sales could be “sales drops to zero,” but unless that is a scenario that may actually happen, it doesn’t make sense to forecast.
For development, it could be, “We’ll need to beef up resources just to get to milestone X,” so you could see increased spending or delays in delivery. For operations, it could be “We need to renegotiate the XYZ contract, and it could come in much higher than anticipated.”
Review all areas where the footing is weak on what you will spend or what you will generate. Use this information to forecast your “down case” scenario.
If there is a scenario where you believe you can outperform your base-case scenario, plan for that, too. This exercise is similar to what we used to arrive at the down-case scenario, but with a more positive, opportunistic slant.
Case scenarios are only effective when time, effort and thinking is invested in them. One pitfall is not spending the requisite time or effort to put forth your best effort to forecast appropriately. If you say, “Let’s plan for a 20% decline,” you should ask yourself what that 20% number is based on. Why is it 20% and not 40%? Should you plan to match that with a 20% decline in headcount?
Make decisions based on your planning
Once you build your best-, base- and down-case scenarios, you should play with the model, posit decisions, and then try to understand how they impact everything else. Rarely does a decision in one area not affect others. Think it through, understand what happens when you make changes and measure the result.
Founders must be accountable and make decisions based on their plans. For example, if the down-case scenario has a startup running out of money in a matter of months, set firm dates to implement the decisions you know are necessary based on your scenario planning. For example, if you don’t get to X by Y, you should be going into your first measure of cost containment.
It’s also important to have people who can be trusted when it comes to these decisions. One of the key duties of the board, advisers and mentors is to help management make the best decisions possible. Founders should let investors in on their plans and communicate that they are thinking of preserving the company. Let them help you with advice.
Often when we ask for money, we get advice, and when we ask for advice, we get money. If your plan to survive can’t realistically happen without an equity infusion, create a milestone plan and share it with your investors. Circulate the plan and make it work. Earn their trust.