Many first-time founders wrestle with developing their startup financial projections. They don’t know if they should be doing three-year vs. five-year projections, what type of hockey stick to project and what expenses to break out. These details can be modeled by the excel wiz on your team or by hiring a finance expert. However, what the founders can’t outsource is ensuring the projections serve the purpose of addressing the questions an investor will never ask you directly.
Many early stage investors view an investment decision like a hand of poker, so what is important for a founder is to understand this mentality and use their startup's financial projections to help investors make a decision on whether to bet or fold.
Here are five questions every investor is asking themselves and how your startup financial projections can answer them.
1. How much can I win?
Investors are looking to make 10 times on their money within the lifetime of their fund. They know they are often betting ahead of the curve on a market and want to feel confident that if they are right there’ll be a big payoff. This is where having well-grounded metrics around the size of the opportunity are important. They want to see a large growing market for what you offer to be in the billions. This means that even if you don’t execute perfectly the market momentum may carry them to a successful exit.
This is also where the five-year startup projection is most relevant (if it doesn’t make sense in five years on paper, there’s no way it’ll happen within a 10-year fund lifetime in practice). The purpose of the five-year projection is to give a high-level view of what the key company financial metrics could look like ahead of a liquidity event so that an investor can assess what its potential value could be. If you're unsure what the key metrics are, look at the IPO filings and analyst commentary on relevant comparables.
2. Is this the right hand to play?
You’ve sold the investor on the opportunity. Now they are thinking whether you are the team to go with or to find another startup in the space (or even incubate their own). Here’s where you can really show you understand the industry by researching the key metrics and ratios that are important for your startup. If you’re in SaaS then that's what churn rates should you expect, if social media what ARPU are you targeting etc. Showing you understand the key drivers and key performance indicators (KPIs) of your business will give them a lot of confidence you are experts in the space.
3. What do I need to get a nut hand?
To be the next Google or Facebook your company will have a few KPIs where you expect to significantly outperform the industry. For example, customer acquisition cost if there is a viral component to your product, servicing cost if you have a superior operational platform, sales productivity if you have a more efficient way to source and screen leads. Make sure to identify what these are and how they line up with your product and operational milestones. The investor will need to get comfortable that you have a realistic "unfair advantage" that will translate to sustained superior financial performance across those indicators and that those are the main drivers for winning in this market.
4. What hands out there could I lose to?
This is the inverse of the exercise above. What are the key financial metrics that if they were to drop below industry average could kill your business. For example, inventory write-downs if perishable products don’t sell quickly enough. They want to understand what the main risks are and what financial impact they could have and then make their own assessment of how likely they are.
5. How much do I need to bet to see the next card?
This is where they are assessing how much they need to invest right now to get to the next set of milestones. This is where the more detailed one- to two-year operational projections showing use of cash from this round and key near-term goals is crucial. Where the five-year plan was laying out the vision for the ideal path to success this needs to be a credible near-term operational plan that they can assess progress against on a monthly or quarterly basis. This is where detailed expenses and cash burn or very important for showing that this round of funding will you get to the next set of milestones. If you don’t have a finance expert on your team then freelance sites can help you with this.
This may make the financial projections for a startup seem like purely investor marketing materials, but I encourage founders to use it as a useful expectation setting conversation. Ultimately, whatever plan you lay out is what you are also committing to delivering on. Similarly, use it as a way of screening out investors with whom you can’t discuss and reach consensus regarding key assumptions and logic behind your financial projections. Finally, treat the financials as an evolving document that you must constantly test and update as your company grows and the market develops.
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This article originally appeared on Entrepreneur.com. Minor edits have been done by the Entrepreneur.com.ph editors.