# The Importance of Financial Projections for Startups
Written on
Chapter 1: Understanding Investor Expectations
Many startup financial projections resemble fiction, yet investors still seek them for valid reasons.
One entrepreneur I had been collaborating with recently expressed his frustration after a meeting with a venture capitalist. He plopped down in the chair across from me and sighed heavily. "I just don’t understand," he said. "The VC wanted my funding projections for the next five years. It's absurd! How can I predict my revenue five years from now? I’m not a fortune teller. I don't even know if we'll still be here next year."
I chuckled, having been in his shoes before. I distinctly recall my own feelings of disbelief when investors requested revenue forecasts. I would spend countless hours crafting figures simply because I was told it was necessary to secure funding. How could anyone accurately forecast the future of a startup? It felt like an enormous waste of effort.
"I completely understand," I reassured him. "I felt the same way when I was starting out."
"But what about now?" he inquired.
"Now," I replied, "I still find it a bit frustrating, but I see why investors request financial projections. It’s not about predicting the future."
Section 1.1: The Real Purpose Behind Projections
Investors are not naive. They’ve encountered enough startups to recognize that the entrepreneurial path is highly unpredictable, particularly in the initial stages. When they ask for financial projections, they know the numbers are largely hypothetical.
So, what’s the rationale behind this request?
In reality, financial projections serve as a quick gauge of an entrepreneur’s level of sophistication. Investors are not merely interested in the potential return on investment; they use projections to evaluate the entrepreneur. They seek to uncover insights such as:
- How well do you grasp the complexities of your own business?
- What level of thought have you put into your growth strategy?
- Are you aware of the costs and obstacles that lie ahead?
- Do you understand the financial norms of a venture-backed company?
- What real-world experience do you have in running a business?
The details you include in your projections can reveal a lot about your preparedness to manage a company.
Less experienced entrepreneurs, like I was two decades ago, often approach projections as a mere exercise in guesswork. In contrast, seasoned entrepreneurs recognize that these projections reflect their business insights and their capacity for critical thinking about future challenges.
Subsection 1.1.1: How Projections Reflect Entrepreneurial Acumen
Inexperienced entrepreneurs frequently misjudge customer acquisition costs (CAC). They often become overly optimistic about their customer growth over five years. Lacking real experience in customer acquisition, they envision explosive growth akin to success stories they’ve heard about—doubling or tripling their customer base—without considering the marketing expenses, sales teams, or partnerships necessary to achieve such growth.
Conversely, more experienced entrepreneurs possess a clearer understanding of CAC. They recognize that acquiring customers can be costly in the early stages and incorporate these costs into their forecasts. They factor in elements such as diminishing returns on marketing efforts as businesses expand and the competitive landscape's impact on acquisition expenses. Their revenue growth projections are linked to specific marketing strategies, sales channels, and customer retention initiatives.
Another area where experience enhances financial projections is in estimating operational costs. Unsophisticated entrepreneurs typically focus on salaries, office rent, and fixed product costs, leading them to underestimate expenses such as legal fees, insurance, HR needs, and even software tools that accumulate over time.
In contrast, seasoned entrepreneurs, often those who have faced these challenges before, are acutely aware of the hidden costs associated with running a business. They understand that scaling operations requires more than just hiring additional staff; it also involves investing in the infrastructure necessary to support that staff. They account for increased payroll taxes, employee benefits, compliance costs, and cybersecurity measures.
Section 1.2: Why Financial Projections are Crucial
Are you beginning to see the significance of financial projections? They are not merely an exercise in filling out a spreadsheet to appease investors. The process of creating projections compels entrepreneurs to deeply contemplate the intricacies of their business. It urges them to think about the challenges they will face, the resources they will require, and the steps necessary to reach their goals. In essence, crafting financial projections encourages you to adopt the mindset of a sophisticated entrepreneur.
During my early days as a founder, I failed to grasp this concept. I viewed projections as a tedious requirement imposed by investors. However, now, as someone who collaborates with numerous startups and entrepreneurs annually, I recognize that projections are invaluable tools for assessing how much thought founders have invested in their ventures. This is precisely why investors request them.
The next time an investor asks for your five-year projections, resist the temptation to roll your eyes and dismiss the task. Instead, embrace the opportunity. Even if the projections themselves are not accurate predictors of the future, they provide a valuable assessment of the entrepreneur you are today. This is a chance to demonstrate to investors that you are more than just an individual with a compelling idea; you are someone with a sound understanding of what it takes to build and manage a thriving business.
Chapter 2: Learning More About Startups
In this video, "Startup Income Statement Projection - Start with a Monthly Plan, not Hockey-Stick Growth," we explore effective strategies for projecting income statements in a realistic manner.
This video, "How to Create 5 Year Projections AND Business Valuation," guides you through the process of creating five-year projections and understanding business valuation intricacies.