10 Mistakes to avoid in financial projections

I have made and seen thousands of financial projections. Some great ones that gave a better understanding of the company. Other financial projections contained serious errors, were too complex for the users or even a few that told the wrong story and put investors off. Having made many mistakes myself, here are my top 10 mistakes to look out for. I did not include some of the simpler mistakes, like running at a negative cash balance for an extended period without access to lending facilities or discount rates that were not aligned with the riskiness of the asset class.

My top 10

1. Using projections that you don't understand. There is nothing worse than when an investor asks you a question about your model, and you can't answer it because an advisor built something you don't understand. If you don't understand your model, use a simpler model, spend time understanding every bit of the model or get someone with financial expertise on your board who can support you.
   

2. Treat a financial model as the prediction of the future. It is extremely unlikely that the 5-year growth path of a pre-revenue Startup is anything close to what was predicted. So don't try to predict your telephone costs in year 5, but do think about what your Gross Margin might look like when at scale. Use the financial model as a storytelling tool that gives insight into things such as your competitive moat, the competitive landscape, the size of the market and the ability to generate a risk-adjusted return. The financial model should give the founders, investors and other stakeholders a greater understanding of the company. It highlights the strengths and addresses the potential weaknesses/unknowns that might make an investor less likely to invest.
   

3. Not tailoring your projections to the investor. Every investor is different. Some VCs look for companies that can scale fast in large markets where negative cash flow is not an issue, while other investors look for businesses that can become cash flow positive with minimal additional investment. You can not use the same financial model for every investor. You need to understand what an investor finds important and use the right format. You are selling your shares and want to do so at the best price possible. Don't assume that an investor will spend hours understanding your model. Make it easy to find reasons for them to invest.
   

4. Stop at Net Income and ignore Free Cash Flow. Too many financial projections follow the format of annual accounts, where the projections stop at the net income level. This can give an inaccurate picture of the investment potential, especially for companies that need significant capital expenditures to grow or have a working capital (e.g., cash)/sales ratio that is different from 0. Free Cash Flow is the driver of value; net profit is a poor proxy, and to quote Buffet & Munger EBITDA are BS earnings. If you don't show these calculations, an investor might make the wrong assumptions that your proposal is Capex or Working capital heavy while you actually have a smart way of dealing with this, creating a competitive advantage.
   

5. Not using a peer group. Creating a peer group of similar companies helps in understanding your company and what your margins and ratios should look like. What is the average gross margin of the competitors? How much do they spend on Sales, Marketing, Research and Development? How much are they worth, and could they buy your company? A good peer group help you answer these questions and points an investor in the right direction. The various databases with financial data that investors are not always accurate/complete. An investor might reach the wrong conclusion if a few relevant deals are not in the Database.
   

6. You predict to become very profitable, but your margins and ratios do not make sense. If your gross margin is significantly higher than the competition's, it might be because your product is significantly better than theirs, but more likely it is that you underestimated your costs and/or overestimated your selling power. If you rely on your brand name to sell your product, but only spend 10% on Sales and Marketing, your projections show you make a lot of money, but to an investor, it shows you don't really understand your market.
   

7. Use 3 to 5-year detailed projections with fixed costs. Unfortunately, this is a problem caused by many grant, debt, and equity providers, who ask for these long-term, detailed projections. Founders then create a model where the income increases linearly or even exponentially, but the costs mostly stay fixed, leading to excess cash from year 3 onward. If you do this, the first question of an investor will always be, "Why are you looking for an investment?" Just get a personal loan and repay it in year 3. Therefore, make sure that your overhead costs are variable and scale with the revenue. You can use the Peer group ratios to sanity check your Selling, Marketing, and General (SM&G) and Research & Development (R&D) costs. My preference is to have detailed 12-24 month projections to monitor the cash runway and less detailed longer term projections focusing on margins and ratios instead of detailed costs, but see point 3.
   

8. Have a subscription model without deferred income/cost, churn rate, Customer Acquisition Cost, etc. If you sell a product or service on a subscription basis, the gross margin is not easy to calculate, as income and costs fall in different periods. To correct for this, the company needs to use deferred Income and costs to give a more accurate picture of the gross margin. The same goes for direct costs like Customer Acquisition Cost, which are hiding in the overhead costs. To determine if and how profitable a company can grow, these kinds of ratios need to be understood.
   

9. Use a top-down approach for market size. Market size is a part of the financial projections, but not in the way I see it done in many pitch decks, where the founders do a Google search and find a quote from a consultant with a top-down number that is several billion with little to no granularity.

   A good bottom-up market size calculation will help investors understand your market size, providing an opportunity to discuss the marketing plan/product pricing, and ultimately the attractiveness of the proposal. You create a granular breakdown of your possible customers with their assumed spending, and once you add this up, you have your bottom-up market size. The more tangible the possible customer, the easier it is for the investor to check your assumptions for everything from Gross Margin to Customer Acquisition Cost.
   

10. You priced a Startup but did not check the valuation. In my last blog post, I wrote about the difference between pricing and valuing a startup. Most start-ups are priced, but when you provide financial projections, you also give an implicit valuation. Normally, you expect the founder to price their company below the value, but I do see many founders pricing their company above the value, which is not a very strong sales argument.

A good financial model is not the 5-year projected Profit & Loss, Cash Flow and Balance Statement in a format used for the yearly accounts.

A good financial model is the quantification of the information shared in the pitch deck and includes, among others, competitors, market size, the moat, free cash flow and valuation/pricing methods. It points investors in the right direction. It should be internally consistent and tell the financial story of the company to make it more likely that investors want to buy the shares. It should be easy to read at a quick glance, but it is like an onion with many layers if an investor wants to know more.