Naturally, the first question would-be investors ask is "What do your financial projections look like?" The reason investors ask this question is simple: Companies are valued in relationship to their earnings. Hence the future value of the investment depends on how the company performs down the road. As a result, access to growth capital depends in large measure on the entrepreneur’s ability to paint a credible and compelling picture of his or her company’s financial prospects through a projected income statement.
But how to do so effectively? It’s naive to simply start with baseline sales and apply a formula that increases them by 20 percent per year. It’s probably even more naive to suggest that the market is a certain size and the penetration will increase a certain number of percentage points each year. The fact is there’s nothing formulaic about projecting future sales. It requires going through a spreadsheet cell by cell and thinking about each quarter.
When investors get close to doing a deal, they’ll want to examine every single detail of your projections. But at first pass, they’ll look at just five items: sales; cost of sales; gross margins; selling, general and administrative costs; and operating income. So what should each of these items include, and how should they be structured to avoid immediate rejection?
Sales: The most effective sales projections for pre-revenue-stage companies rely on original market research or test marketing conducted by the company’s founders. Neither of these activities needs to be exhaustive or expensive. But they are important because empirical data will move the projections out of the realm of fantasy and into the world of reality.
For instance, an entrepreneur offering pet-grooming services can test potential customer response through a direct-mail campaign even though he or she is not yet in business. Once the response rate is determined, projected sales are figured as a percentage of that response. This approach also begins to lend some credibility to the expense side of the equation since you now have hard facts to base your projections on.
Cost of goods sold: Compared to sales, the cost of goods sold is much easier to determine. After all, while projected sales require the entrepreneur to consider where, when, and how long it will take to open new stores, the cost of goods is a fait accompli because much of it relies on the calculations behind projected sales. When sales are known, the cost of goods sold is mostly just a case of plugging in the right figures.
But you can only plug in the right numbers if unit costs are known with some degree of certainty, which for many companies is the fly in the ointment. Pinpointing unit costs requires you to do some homework to determine the cost of materials and time that go into producing the unit or service, as well as any other expenses involved. These estimates are sometimes referred to as cost schedules.
If an entrepreneur is unwilling or unable to make detailed supporting schedules for the cost of products or services, it can be the kiss of death. After all, who would invest in a company where not even the founder is sure what it will cost to produce the product or provide the service?
Gross margins: Gross margin is defined as sales less cost of goods sold, and the investor usually looks at it as a percentage. So what must the gross margin say or not say?
First, the gross margin should not be too far out of kilter with the average for the industry. (For industry figures, contact a trade association.) For instance, according to statistics maintained by the National Restaurant Association in Washington, DC, gross margins for the full menu table service establishments are about 36 percent. If you’re opening a restaurant and your financial projections show a 25 percent gross margin, up goes the red flag. If your projections show a 45 percent gross margin, up it goes again.
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