The entrepreneur gushed “We just closed a $2.5 million Series A on an $8 million pre-money valuation.”
My response: “Great news – now that you’re a couple months past close, what’s the probability estimate of hitting the 1st year revenue target you set for the VC’s?”
The smile quickly vanished as the entrepreneur acknowledged it was far from being a lock to hit the target. Both the risks and attendant pressures were already starting to hit home.
Valuation optimism can be masked with insufficient data
Unfortunately, this is a much too common scenario as founder drive to minimize personal equity dilution by grabbing the fattest valuation possible seems to override their judgment on what happens post deal.
Typically the culprit is too little thought given to the underlying assumptions behind a detailed bottoms up financial model. Proper models take into account factors like average deal size, sales process steps and time to close, productive lead sources beyond executive team personal relationships and diminished close rates of non founder sales reps. [See my post: Leading Sales as a Startup CEO].
The worst offenders set their valuation target first and then back into a set of projections that align revenues with the valuation goal as they scurry about for data points supporting their wished for revenue trajectory.
While VC’s will certainly review assumptions behind revenue as part of their due diligence, entrepreneurs will get some leeway if the product offering is distinctly different with what’s already in the marketplace (thereby lacking trend comparison with similarly situated companies) and you’ve already racked up a few sales to your credit.
Overly optimistic projections come with consequences
The path to judgment day starts with board meetings in which the new institutional investor board members are now brought up to speed with the insider’s view of your progress against the expected revenue targets that were in the deal.
If you’re absolutely confident you’re right on path to meet or exceed the targets then you’re golden.
But if you’re starting to break out in a cold sweat soon after the deal closes, then you’ve got the hard choice of perpetuating expectations you may not have confidence in or going about the delicate process of resetting expectations.
Perpetuating the improbable is a gamble that ever optimistic entrepreneurs take, believing somehow, someway they will find a solution over time.
However, as projections don’t get fulfilled, that factor alone becomes the biggest reason entrepreneurs get pushed out of the CEO role in favor of someone who has a proven track record of “meeting the numbers.”
And that equity stake the founder was concerned about? When projections get missed and Series A funding dries up while there is still a substantial burn rate – you then have the classic down round scenario where in order to keep the company alive with a new financing, founder shares can get crammed down to a pitiful percentage of ownership compared to their post series A stake.
De-risk with detailed assumptions behind revenue components
You can mitigate risk by building a detailed model for how revenue projections are derived.
List assumptions behind each component of a revenue formula so there is complete transparency and no “black box” – even tilting assumptions towards most realistic, if not outright conservative achievement at critical components of the revenue formula.
The best entrepreneurs don’t settle on just a high level view of 2-3 revenue component steps to come up with a formula. Instead they tear apart every step in the customer acquisition process to find patterns which can be reasonably tracked (with a minimum of admin burden) that help point to predicting success at that particular step in the sales process, and in the aggregate – timing of future revenue flows.
Since early stage companies typically won’t have a large enough team for a professional CFO on staff to build such a model, they can fill the expertise gap with an “Interim CFO” who has the background and strategic perspective to dive in and gather input from multiple team members to guide a true bottoms up model with detailed, defined assumptions.
The best interim CFOs divide their time among a cadre of early stage companies and often have the pattern recognition of having been through this exercise across many similarly situated companies. This helps not just in developing the model but with an ongoing retainer relationship will help their client tweak the model as more data comes in and analytics for management and board are refined.
While it’s best to avoid optimistic projections pre-deal, the earlier that investor expectations get reset to the proper level the more likely you are to retain your credibility as a leader.
So don’t wait for your next round to beef up the visibility and accuracy of your forecast. When you’re depending on other people’s money – than your success, and that of your company, may end up riding on how well you can predict the future with a financial model that you actually deliver on.
[Related post: Embrace Public Company Readiness in Scaling a Private Company]