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A Global Source for Entrepreneurs Seeking Venture Capital

PROFORMA FINANCIALS THAT WORK

Probably one of the most vexing challenges facing entrepreneurs is the creation of pro-forma financial projections. Entrepreneurs wonder how fast they should plan to grow their companies; what venture capitalists want to see; and what financial projections would be considered realistic.

Let's face facts. Many pro-forma financial projections follow roughly the same revenue trajectory: $500,000 in year one, $5 to $8 million in year two, $25 to $30 million in year three, $40 to $50 million in year four and $75 to $100 million in year five. The issue is not what the top line numbers say -- those numbers are pulled from thin air anyway. The real issue is the support mechanism you offer for your top line numbers. Investors need to know you have a full and complete grasp of your industry, your product and your sales process.

Listed below are five key items you will need to consider when putting together your pro-forma financial projections. Follow these steps, and you should be well on your way to creating comprehensive, realistic projections that will show investors you have a complete understanding of your company and its financial potential.

1. Build from the Ground Up

A compressive assumptions page should support your top line revenue figures. For example, if you are stating you will have $50 million in revenue in year three, it would be good to show:

• Your gross margin in comparison to the competition's gross margin.
• The number of sales people you will need to reach that milestone.
• The amount of sales each person will need to make per period of time.
• Your sales cycle, whether it conforms with the industry standard and if not, why.
• The number of IT, marketing, finance and administrative people you will need to support your sales people.
• The amount of marketing dollars you must spend in order to achieve that sales figure.
• Your ratio of marketing dollar spent to revenue dollar booked.
• The amount of office space will you need.
• Your fixed and variable expenses.
• The variable expenses that will grow on a one-for-one basis with sales.
• The variable expenses that will provide economies of scale as your company grows.
• The amount of an average sale per employee.
• The time it will take to hire and train new employees.
• Your employee turnover rate.
• Your allowance for uncollectable accounts.

2. Have a Full Set of Financials

Most projections include a pro-forma income statement. Few offer a pro-forma balance sheet, and fewer still offer a pro-forma cash flow statement. The most impressive plans will include all three, and of these three, the cash flow statement will be stressed as the most important. Without delving into the minutia of accounting, the cash flow statement ties together the income statement and balance sheet and follows the flow of money in three key areas:

• Financing - money obtained/used from selling or buying stock or debt.
• Investing - money used/obtained from buying or selling equipment, facilities, etc.
• Operations - money obtained/lost from selling a good or service.

3. Focus on EBITDA, Not Taxable Income

Who wants to pay taxes? A truer measure of your company's operating performance is its earnings before interest, taxes, depreciation and amortization (EBITDA). The EBITDA figure strips away all the ancillary financial factors and shows an earnings number based on the internal performance of your company. In other words, are you doing what you are supposed to do? Are you selling the product your investors think you are supposed to be selling?

4. Be Wary of "Hockey Stick" Revenue Projections

Gary Knaus: "Very rare are those businesses that go from zero to ten -- or even hundreds -- of millions of dollars in revenue in one to three years. Of course, some businesses have an inherently greater financial upside than others, but revenue step functions are very infrequent. Take a look at the Inc. 100 or other similar lists for a reality check. For every hyper growth company, there are thousands of slow growth companies. There have to be very strong and sound business arguments to lend credibility to spectacular revenue growth projections."

5. The First Step

The first step from pro-forma business plan to reality is often too big to take. This is usually the result of creating pro-forma sales figures that look good, but are not rooted in sound assumptions. Even if you can reasonably expect each new employee to produce a certain amount of revenue, can you really staff up and support all of those people within the time constraints of your plan? It takes time to hire and train people; it takes time to buy and install software; and it takes time to hook up networks and phone lines. Even if you have the money to hire and buy to your heart's content, do you have enough time to adequately set everything up?

Finally, after you have perfected your assumptions page, and created pro-forma financial projections based on achievable milestones, understand that nothing you created will come to fruition. What's that old saying? "There are lies. There are damned lies. And there are business plans." You are going through this arduous task for a simple reason: Investors want you to demonstrate that you understand every detail of your business. Therefore, it is crucial that entrepreneurs do their homework and know every the nuance of their business. Those who fail to do so will find it very difficult to gain the capital they need to make a good idea into a successful venture.

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