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It’s a new year and just as people are setting new year’s resolutions, entrepreneurs are also setting goals for the year ahead. A big part of every entrepreneur’s annual planning, whether they are on the market for funding or not, is creating financial projections. Even at the early stage when there is little historical data available to act as a basis for projections, the process of creating projections can help founders better understand the inner workings of their business, and how it scales.
While the structure of projections will vary greatly between startups, there are some common mistakes, over exaggerations, and omittances that entrepreneurs tend to make in their financial projections. These mistakes not only mislead less savvy investors, but they can also woo entrepreneurs into a false sense of security — showing the future as being more profitable or certain than it in fact is.
Adapted from the financial projections section from my book Funded, in this post I’ll lay out from an investor’s perspective the most common mistakes entrepreneurs make when preparing financial statements — and how you can avoid them.
1. List deferred revenue separate to other revenue
Deferred revenue is a liability that is created when monies are received by a company for goods and services not yet provided. Deferred revenue can help inflate a startup’s numbers early on. It is important that financial projections be clear about whether there is deferred revenue included in financial projections. If it’s not made clear, investors will likely ask.
2. List one-time revenue separate from other revenue
Sometimes startups make money through hosting events, doing services work, getting sponsorships, and other one-time activities in order to keep their company afloat. These one-time revenue sources can be very misleading if they are not separated out from monthly recurring revenue.
Let’s say a company made $40,000 in August. You may assume they will make that in September. But if $30,000 of that is from a one-time contract, their revenue may drop back down to $10,000 next month. Make sure financials clearly list where revenue is coming from.
3. List booked revenue separate to other revenue
Many companies will count revenue before it’s actually in the bank. This could be services that the company hasn’t been paid for yet, or the pre-sale of a product that hasn’t shipped yet. This type of revenue has some risk that it won’t be collected and should be listed separately to revenue that has actually been received.
4. Pay close attention to cash flow.
Make sure the financial projections include cash flow, not just the balance sheet or projections. In startups, cash is king.
5. Be conscious of over-spending
A lot of founders get caught up in the hype of what it means to run a startup. Beautiful offices, expensive perks, catered meals, team retreats – creating the Google experience.
While all of these things have their time and place, many companies introduce these perks when they simply can’t afford them. This type of spending can drastically increase a company’s burn rate — and should be avoided. Make sure the expenses listed in financials are reasonable for the geography and stage of the company.
6. Properly handle assumptions
Startup financial projections include assumptions — assumptions around growth rates, pricing, costs, and many other factors affecting the state of the company. Financials that do not openly list assumptions are red flags to investors.
The financials should include an extensive written explanation that explains the assumptions listed and how the entrepreneur arrived at those assumptions, including any evidence or supporting information.
Make bottom up assumptions
You should understand the company’s revenues and profits from the bottom up. The price of the product, the margin per unit, and the number of units sold should all match up to a revenue number.
How were the assumptions arrived at? Were they pulled out of thin air? Or is it based on past growth or industry averages? Was the bill of material cost a guess? Or did it come from actual quotes? Numbers that come from credible sources will make for much more accurate projections and signal a more sophisticated entrepreneur.
Include scenario analysis
The only thing we know is true about a startup’s projections is that they are wrong. It is a red flag if a startup doesn’t include multiple possible scenarios in their calculations. Anyone reading the projections should be able to plug different numbers into the startup’s assumptions, generally listed clearing in the top left of a spreadsheet, and see how different conditions might affect the company.
7. Understand the cost of goods sold
Almost all companies have a cost associated with the sale of their product. Cost of goods sold (or COGS) are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good, along with the direct labour costs used to produce the good. Any costs associated with delivering a product or service should be included as costs in your projections.
8. Address bad debt expenses
Most businesses, including software businesses, will experience customers not paying for a product that they have already received, leaving a bad debt. A great example is Uber. Have you ever taken Uber and been notified that your credit card payment failed to go through at the end of the trip? When this happens, Uber asks you to settle the debt before riding again. If you don’t, they are out of pocket for your ride. Bad debts can have a material impact on financials and should be addressed in financials.
9. Show loan payments
Has the company taken on any loan obligations in its previous funding? If so, are these loan repayments shown in the financials?
10. Include taxes and benefits
Many companies forget to include company taxes as a future expense (mostly because they are losing money and don’t need to pay taxes now). But taxes can be a huge expense, particularly for a profitable company. Depending on where you are located and your corporate structure, you might expect to pay 25 percent or more in taxes. This can drastically affect projected profits. Many companies similarly forget to factor in the fully loaded cost of employee salaries, once any benefit costs and employment insurance are factored in.
11. Include wiggle room
Ensure some margin for error is factored in for both revenues and expenses. Again, the only thing you know about projections is that they are wrong; in one direction or the other, be sure the company is prepared for that reality by either listing a margin for error in your expenses or slightly over estimating costs.
The ultimate goal of a company should be to…