The late, legendary Silicon Valley attorney Craig Johnson used to say, “The leading cause of failure of start-ups is death, and death happens when you run out of money.”
And the leading cause of running out of money in a start-up is poor financial forecasting.
At the core of unrealistic forecasts is the undying optimism of most entrepreneurs. Their “what could possibly go wrong?” attitude leads to many forecasting disasters. My father used to say that when he looked at investing in an entrepreneurial venture he would always double the start-up costs and triple the time it takes to get to break even.
My rule of thumb is a bit different. I believe that being overly optimistic leads to entrepreneurs making fatal mistakes in estimating revenues, which is at the heart of most forecasting errors. So, my approach when reviewing a business is plan is to cut revenue forecasts in half.
Here are the four most common revenue foresting mistakes I see:
- Assuming an “instant on” button for a new business. Most business plans I read show significant revenues from the beginning of the business, sometimes even for the very first month that they open their doors. The reality is that it takes time to build a customer base for any business. That is why an entrepreneur should have at least six months personal living expenses available to make it through the startup in addition to the money the new business needs.
- The magic of the hockey stick. A common pattern in business plans is to show a relatively slow initial start to revenues, and then assume some that unexplained breakthrough will occur that leads to a sudden and dramatic increase in sales. When you graph this type of revenue forecast it looks just like a hockey stick. The reality is that such sudden growth is just not that common and usually results from specific actions.
- Assuming enough sales to make the business model look successful. In this mistake entrepreneurs forecast their expenses and then they plug in enough revenues to make the business become profitable. When I press these entrepreneurs, their explanation of revenues is “well, these are the revenues I need to make the business work.” The truth is that the market will not give you the sales you need, it will only give you the sales you earn through a well-executed business model.
- The marketing plan tells a different story than revenue forecasts. The marketing plan should specifically explain what you are going to do to achieve the revenues you forecast. Why will customers want what you are selling? Who are these customers? How are you going to communicate to them about your business? The marketing plan should explain in words the numbers shown in the revenue forecast. Most plans just do not make this connection.
To avoid running out of cash before your business model has time to work requires an accurate assessment of how much money you will really need to get the business off the ground. While knowing your costs is important, accurately forecasting your revenues is critical.
It is so sad to see a business model that has real potential fail simply because the entrepreneur was unrealistic about how much money it would take to get to the point of success.