Episode Transcript:

ADAM MCGOWAN [00:08]: Welcome to episode three of Ventures in Tech, brought to you by Firefield. This is Adam McGowan and on today's show we are going to discuss financial projections made by entrepreneurs for the purposes of raising capital. I'll again be joined by my colleague from Firefield, Henry Reohr, who will be guiding today's chat. And with that I'll let Henry take it away.

HENRY REOHR: [00:31]: Adam I have heard you tell a number of entrepreneurs that investors don't care about their financial projections. Since projections are standard in most pitch decks, that can't actually be true. Were you just being sarcastic?

ADAM [00:44]: Sarcastic? Not really. Mildly hyperbolic?… Okay, maybe that. But I would say that in some very specific cases my statement is totally true and I would stand behind it. I think the way I can stand behind it is to start by defining the scenarios I'm really talking about.

These would be early stage ventures that have not already raised a round of capital, particularly a professional round of capital from institutional investors or venture capitalists, that kind of a group. The second characteristic would be that the venture has very little, if any, early track record; so no data from which they can extrapolate future performance. And then the third is that their industry is not driven by really, really particular metrics.

For example – software as a service – there's a collection of metrics that are very standard in that space. And yes, projecting out those sorts of things will be pretty important. So anyway, I'm painting with a super broad brush, but yes, there are plenty of characteristics and opportunities where it is true that investors don't really have that much… they don't put that much emphasis on your projections.

HENRY [02:04]: So why do those different potential circumstances matter? Do investors look at projections differently in different cases?

ADAM [02:14]: I absolutely think that they do. I think that certainly when there's a track record it's got to be addressed. So if you're an existing company, you're looking to raise a follow up round of capital and maybe you didn't have outstanding numbers or you had numbers today that really didn't meet your prior expectations – they will want to know about that. You are going to need to give explanations for it. You need to project from that. So I think that definitely matters.

Also, when there are standardized metrics, like for example the cost to acquire a customer or the lifetime value of one of your customer, some pretty standard SAS based metrics, if you've got some track record around those, you're going to need to talk about those numbers. You are going to need to talk about how those numbers are going to grow, and even if it's your earliest round of funding, you're going to need to give some expectations of what those kind of numbers should look like.

I think those are two cases and I think really, if you wanted to generalize it, it's the case that whenever the possibility of there being more certainty exists (and this is from the point of view of the investor) then the reliance on projections goes up for them [the investors] as well.

HENRY [03:24]: Is the opposite of that true as well? As venture's uncertainty goes up, the value of the financial projections goes down?

ADAM [03:32]: Yeah, I think it's absolutely true in the other direction. Think about it this way: Let's assume you've got what I would say is a high uncertainty scenario. You've got an entrepreneur who's trying to break into a brand new market, maybe a brand new segment of an existing market. The point is that there's very little historic or comparable data.

And then an investor looks at their projections in a pitch deck and says, "Okay, they'll do 50 million dollars in revenue in year five." How reliable could that number possibly be? And so the argument I'm making is that in cases like that one, the ultimate projections really don't matter that much.

And I think… one thing to keep in mind is what I mean when I say "projections". I'm typically talking about the headline numbers: top line revenue or bottom line earnings numbers or… when you compare those things against expenses, how many months to break-even based on a certain amount of money raised. There are a handful of really-really big ticket items, if you will, big numbers that you could use as I said like a marquee or like a headline.

My concern, and the reason why I make the comment you suggested to lots of entrepreneurs, is that way too much emphasis gets put on that by them. And instead, what they really do is miss out on what I think matters the most which is the underlying assumptions that power those projections. That's what I think is really important and too frequently missed.

HENRY [04:57]: But aren't those underlying assumptions just as much of a crapshoot in a new or uncertain market? Aren't entrepreneurs just making wild guesses as well?

ADAM [05:10]: Absolutely they are. I mean, startups themselves are defined by the fact that they are unbelievably uncertain. If they weren't they'd be established businesses. If they weren't they would have already been created by existing businesses. So this nature of uncertainty is just a part of the game.

But I do think that these assumptions are really infinitely more valuable than those ultimate projections that effectively… they create, if you will. And I think that that's true for many, many reasons, but I think there are three clear ones to me that stand out:

The first one is the idea that projections are compounded. What I mean by that is that if you really think about a number like revenue or a number like earnings, think about how many assumptions have to go into the calculation of that ultimate value. And the reason why that matters is that if you're making value judgments or estimates on each of those assumptions, imagine if many of those in the chain are off or reality don't match up with what you had anticipated. All of a sudden it has a multiplicative or an exponential effect on the ultimate projection. So imagine a projection is almost like the end of the tail of a whip and the slightest movements at the beginning of that could be massively multiplied and expanded by the time it gets to the other end of the whip. So I think that's one thing, projections being compounded.

The second one is that the assumptions themselves can, in many cases and hopefully in most cases, actually be testable. Whereas I think projections can't. What I mean by that is that it's not always the case that entrepreneurs need to have answers now. I don't think investors look at your financials and say, "Okay, show me all the certainty with which you can answer all of these questions." Obviously you really won't be a startup if it was true that you had answers to everything.

But the issue really is the fact that what matters is how those entrepreneurs are going to go about getting answers to those question marks. That really comes down to: what are the assumptions?; what are the ones for which they think they have good answers?; what are the assumptions for which they don't really have really great answers and frankly, how are they going to go about finding those answers?

And it's much harder to say, "Oh, well we're targeting 50 million in revenue in five years." The next question isn't, "Well great; how do you test whether or not you can make 50 million in five years?" That's a very hard thing. You can't test something that big. You have to test things at a more molecular or incremental level and that's where assumptions come in.

And the third thing is that I really think that the process of creating and proposing your assumptions provides a window for the recipient of those assumptions, so in this case the investor, a window into the thought process of the founding team. You can look at the assumptions or a list of them and say, "Well, this is really interesting because these are the things that this founding team thought of. These are the things they thought were important."

Oftentimes it is more valuable to think about what they left out. If you're an investor who knows an industry very well and you realize that there are three or four or five key assumptions that really drive performance in this industry, and this founding team didn't mention them, or didn't talk about them, or didn't reference them, or didn't think about them – that could be a huge problem.

The third item here is "what do the founding team's testing and contingency plans say about their ability to lead and grow a company?". We know there's a lot of uncertainty in the space and we know that you frankly need to go out and turn those uncertainties hopefully into truths that are in the best interest of the business. So that's going to be a huge driver of, frankly, day to day activity as well as the performance and outcome of the founding team. So the means by which you turn unknowns into knowns is huge, and this gives a little bit of insight into what that process looks like.

And then lastly, it's a pretty simple question, but how honest are these founders being with themselves? So if they were to make assumptions and put wholly unvalidated and unrealistic assumptions around them, you could really ask the question, "well, when other tough circumstances arise in the future, is there going to be some sense of unfounded optimism that might result in you making bad choices?". I think this really just comes down to the fact that it really does provide, like I said, this opportunity for an investor to see more and learn more about the founding team than they might otherwise be able to gather from any other part of the pitch.

HENRY [10:02]: The economics of many of these funds is such that the investors can only really look at deals that have a potential for a really, really big exit. So if that's what's most important, how can they not put a lot of weight on these projections?

ADAM [10:19]: Let me clarify, And this goes back to me arguing that I was mildly hyperbolic in my claim that investors care about the projections. They do, They definitely do. It's just that they care about their projections, not yours as the entrepreneur. And what I mean by that is they ultimately need to make a judgment call as to whether or not this prospective investment they're going to make is going to turn into an exit that meets the requirements of their fund, of their investors, of their investment thesis..

And so the idea that there's no projection at all; that there is no assessment of how much this company could be worth or what the revenue might be; or whether they're profitable and by what time… they absolutely need to have projections on that. It's just that they in their diligence process are going to do that. They're not going to look at your financial statement and say, "Oh, look, the entrepreneur has told me the numbers and now I have a number. I can check the box." They aren't going to do that no matter what.

The real issue here is that they have to build their own expectations and they're going to be doing it pretty much I think in two key ways, through two key areas: The first one is "what is the potential exit value of the venture?". And then, "does that exit value meet our threshold?". Typically, no amount of engineering of your financial projections is going to change their view on that. They're going to dig until they get enough information to build that conclusion, and they can probably build it from their own knowledge of the market as well as what they hope to learn from you as a presenter.

But the second piece is a really huge one which I think sometimes founders lose sight of, which is, these investors are looking at the likelihood that this founding team is actually going to be able to achieve that outcome. If they think they've got a hundred million dollar venture on their hands, but they have a team who can't execute on it, then the deal is not going to get done.

So I think what's important is they need to understand both of those things and I think the means by which founders come up with their assumptions, the means by which they validate those assumptions, and the means by which they react when they get those conclusions to their assumptions, is really what's going to help investors determine the quality of the team and the likelihood that that team can execute to a level that maximizes the exit value of the venture. And I think in both cases, both those questions around what's the potential exit value and what's the likelihood of achieving it – they both come down assumptions.

HENRY [12:45]: To wrap things up for today, could you summarize the top three pieces of advice that you would give an entrepreneur who's preparing the financial component of their investor presentation or pitch?

ADAM [12:56]: Well I think the first piece of advice I would give would be to not reverse engineer when it comes to financials. And what I mean by that is if you've got some number in mind, for example a revenue number that you think you've got to hit to be able to get investment from a particular investor, I've often times seen people rework all the numbers leading up to it to ultimately reach that number and a lot of times it's not based in reality. So I think what's important there is to say to yourself either A: "maybe that investor isn't the right fit for us" or B: "maybe we have to go back to the drawing board", Make the numbers authentic from the ground up, and don't work your way backwards.

The second piece of advice I would give would be to do everything you can to identify what I call your highest leverage assumptions. So there's going to be tons of assumptions that go into this process, but think about the ones and really understand the ones whose result, or changes in the magnitude of the result, has the largest impact on the overall likelihood of success of the business. This ultimately gives you an ability to rank order the assumptions on their importance, and frankly, bring the most important ones to the top, know your answers cold, understand how you're going to get the answers if you don't have them… And those should be the ones you really spend your time on as far as prep because those are going to be the ones the investors will focus on.

And then the third will be this notion of embracing what you don't know. As founders I think all of us tend to have a hard time suggesting that there's a gap in our knowledge. You feel like it's a sign of weakness. You think it's going to blow up the deal or not going to get you funded. But the reality is it's the people who embrace what they don't know which lends the greatest opportunity to be very clear about your assumptions, understanding which ones need the most validation, and frankly I think, have the greatest likelihood of resulting in more successful businesses. So that level of self-awareness and humility is huge, particularly when it comes to assumptions, validating them, and translating them into success in your business.

HENRY [15:02]: That's all we've got for today. I'm Henry Reohr from Firefield and you've been listening to another episode of Ventures in Tech.