A client emailed the other day to ask for help in preparing his pro forma financial statements, the three to five year profit and loss statement and balance sheet that generally accompany business plans. He told me that he knew the cost to have his product manufactured and packaged and the that he had also settled on a selling price, but from there he was stumped. He wanted to know how to produce an attractive but credible forecast. This is not an easy question, of course, exactly how to forecast future financial performance always presents a challenge.
Perhaps the best place to start is to understand the problem a little better. The literal Latin meaning of pro forma is “as a matter of form” (or formality). Pro forma has come to have two popular meanings today, (1) in a perfunctory or cursory way, as in “a rather pro forma investigation for such a serious matter,” and (2) informal information or data presented in advance of having any actual data. For startups, the important point is that pro forma financial statements must be recognized to be both somewhat cursory and in advance of having any real data by their very nature. Startups also need to remember that investors fully understand this.
So, you may ask, why does it make sense even to attempt to estimate financial performance in advance? The threshold value is in illustrating that the entrepreneur has tackled the problem of producing a five-year forecast and wrestled it to the ground. Also worth noting is that running even back-of-the-envelope numbers will sometimes reveal flaws in a business model and help eliminate obvious non-starters. Perhaps most telling, smart investors will consider whether the entrepreneur has based the forecasts on well-grounded assumptions in order to narrow the error band. So, even taking into account the obvious limitations on accuracy that curtail their reliability and sensible application, pro forma financial statements can provide investors with important and actionable information.
Exactly how to proceed in a particular venture depends on that individual case. Investors generally accord rather little weight to the pro forma financial outcomes of startups with their “hockey stick” sales curves. Instead they will scrutinize carefully the underlying assumptions to evaluate how well management has thought through the challenge of preparing the statements, estimating major expenses such as cost of goods, marketing and sales, relating revenues (in time and magnitude) to marketing activities and so forth. In short, the question is not so much whether the numbers are believable as whether the thinking that produced them is credible, sensible and thoughtful.