New entrepreneurs often wonder, “Are my numbers in the ballpark?” How can anyone reasonably project the revenue and expense figures to complete the set of 3- to 5-year financial projections that accompany nearly every business plan? Scientists, inventors, engineers and Internet innovators who have just become entrepreneurs often have little business experience and perhaps none in preparing financial statements; they just don’t know what numbers are reasonable. Though every business is unique, there are some general guidelines for arriving at credible revenue and expense projections.
Entrepreneurs fret most over their revenue projections and often with good reason. Many suppose that prospective investors want to see “hockey stick” sales growth that takes off sharply from near zero and then rockets into the stratosphere. Get real folks! Investors know that any spreadsheet application can convert unrealistic projections, even total fantasies, into “black and white. You need a sound forecast that projects sales that walk the line between growth that is sufficiently attractive to merit capital investment and reasonable enough to maintain credibility with investors. Never use “Chinese math” that could ruin your credibility. Bear in mind that smart managers and investors know that growing too fast can lead to operational chaos and failure.
One sensible path to realistic sales forecasts is to base them on headcount growth. It is reasonable to assume that most well-run companies can achieve around $250,000 in gross revenue per employee. Sure, a handful of historically notable Internet ventures have hugely exceeded these norms for productivity, but modeling your growth after eBay strains credulity. If you have reliable industry data from a trade association or competitive intelligence that says otherwise, you may consider building a forecast on those figures. The point is that no matter what level of productivity you project, growth in revenue is nearly always proportional to growth in headcount. It is obvious that operating problems will result if you hire people too fast. You need to train them adequately in technical processes, policies and procedures and inculcate them with important company values. Further, you may find that certain operations do not scale well and instead start blowing fuses above a certain transaction volume. These concerns and others underlie the need to “control growth” and tailor it to the operating realities of a particular business.
Once you have arrived at a credible growth rate you can apply reasonable and familiar financial ratios to work out the other three sections of the profit and loss statement; cost of goods sold, operating expenses and net income. By following typical P&L ratios you can build credible projections and reasonable goals, adjusting them as you gather experience and learn sound reasons to vary from familiar norms.
Cost of Goods Sold
For most manufacturing operations, the cost of goods sold (COGS) runs between 25% and 40%. Products with strong intellectual property protection such as patented drugs will command premium prices and so achieve lower COGS, of course, but most manufactured products will fall within this range. Software COGS typically runs around 15%. Treating a social networking site as though it was a software company probably makes sense, at least initially. The direct costs associated with services comprise salaries, materials and expenses that may vary broadly. Window washing obviously costs a good deal less than engaging a Bain consultant for an hour’s work. So no COGS ratio applies to service businesses generally; some competitive intelligence gathering may be needed to estimate COGS.
Some operating expenses may also vary considerably by industry though some typical ratios are useful for start-ups. Setting general and administrative (G&A) expenses at 10% and research and development (R&D) at 15% are reasonable for most businesses. Typical sales and marketing (S&M) expenses run somewhere around 25% for products and 40% for software.
To estimate salaries, allocate departmental headcount according to these categorical expense projections. These rough estimates work because overall productivity is calculated as a company-wide average. Next, look at on-line job boards for a reality check on competitive salaries for administrative assistants, sales people, managers, scientists, road warriors and other positions your company will need to fill as it grows, and don’t forget to load them for benefits, taxes and insurance. Add travel expenses equal to the salaries of road warriors and sales staff that travel nationally. Headcount also drives rent; allocate 200sq.ft/person and multiply the cost of office space in your start-up location.
You have probably already noticed that these typical ratios don’t leave room for huge profit margins. The lesson is simple; most businesses have rather modest margins. The few exceptions with larger margins include professional services firms and product manufacturers with intellectual property that creates monopoly power.
Top Down Estimating vs. Bottom Up Calculating
There is an old business adage that says “Everything costs more and takes longer than you think.” It’s still around because it is true and it applies with special force to new ventures. Forecasting the four major income statement categories from the top down, without trying to fill in all the low-level detail avoids common projection errors. Building estimates from the bottom up is a trap for novices because it will necessarily underestimate some expenses and leave out others entirely. It must fail because only trivial costs are subject to accurate prediction while many of the most crucial expense details are simply not knowable at start-up. Office supplies, telephone expenses, rent and utilities may be predictable, but these pale in relevance compared to COGS and S&M expenses.
Using rough, typical ratios tends to work because it reflects reality. Managements control their expenses by choosing between various ways of solving problems based on actual operating priorities. For example, initial performance may convince managers to hire additional sales staff and stop going to as many trade shows. Trying to predict that level of detail before the business operates is futile and investors know it. Sure, you can and should adjust the ratios where you have a reliable basis that makes sense for a particular business model, but generally don’t waste time on hypothetical spreadsheet details that you cannot possibly get right.
Instead, start with reasonable productivity, divide up revenue according to typical ratios for the rest of the P&L sections, calculate overall and departmental headcount and fully loaded salaries. Be sure that you have a sound, ration basis for COGS and S&M estimates. Those ratios often vary and are generally the largest budgets. Some trial and error will help make your specific numbers look most reasonable in year five; after operations run routinely.
It is not necessary or even desirable to paint unrealistically optimistic pictures of revenue growth. Work backwards from a complete year five projection to your present financial situation. Note that growth is generally slow in the early years and does not usually accelerate logarithmically. Smooth the curve to show modest and increasing growth rates, i.e., forecast manageable growth. Only after you believe that your forecast reflects achievable revenue performance based on reasonable and express assumptions should you show it to investors.
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