Part Two of Three: The Five-Year Pro Forma[1]

Read Part One: Valuation here

Budgets are crucial — and usually provided to investors — for even the most nascent start-up. Even if no revenue is expected within the first year, money is still needed to run the business, so even the anti-planners (and I include myself in this category) have a one-year budget. Going beyond that, however, is often disregarded, ignored, or just simply not done. Why bother, the thinking goes, to work out something that is speculative at best and not trustworthy at worst?

That case can, of course, be made. Any planning too far out may indeed be untrustworthy, speculative, or circumspect. Planning for events beyond a year in the future with the precision to provide actionable data is difficult. Indeed, internal and external forces may dramatically alter the plan and make the labor meaningless. You do not know what you do not know, and that is always true as you go far in the future.

Worse than working on unclear presumptions, however, is setting up misleading expectations. If you lowball your plan and end up achieving far above it, the team may not realize that they have not reached their full potential. In this case, a conservative plan may lead to missed opportunities. More often, the pro forma will be overly rosy – and it will also be used as evidence of failure. A five-year pro forma is often Exhibit A in the post-mortem of a failed venture. “You told us you would be at $X gazillion dollars,” says the investor, “and you’ve only performed at 50%.” That discussion has happened many times in the past and will happen many more times in the future.

But these reasons do not excuse founders from multi-year projections. This exercise is important for numerous reasons:

  1. Capital takes more than a year of planning to raise. Regardless of the source of your financing, raising money takes time, so if you are going to need to make an investment into the business, you need to give yourself plenty of time. This is particularly true if you are raising from venture capital. As you start on this path, keep in mind the importance of your company’s narrative — and have the financial results to back it up. That takes planning far in advance. You cannot change the type of company you have in a capricious fashion. If you are a lifestyle business that reinvests its profits, you cannot suddenly become a venture capital rocket ship and vice versa. That is not to say that you always have to be one or the other: you can shift, and there are many things in between. But you cannot change financing strategies overnight. That takes years to build, and a multi-year pro forma helps your thinking in that regard.
  2. Team are built over multiple years. Talent is tough to find and nurture; people are not on-and-off switches. People typically do not move jobs on an annual basis. The emotional and financial stress is usually too steep, even if it has become more acceptable. You must look out further than a year to see how you are going to build your business and what the team needs to look like to get you there.
  3. A multi-year pro forma helps show the bigger picture. While some industries and investments allow for multiple years with little or no revenue, by and large, stakeholders need to see both progress and a bigger picture. They will need to see that over time they will have a stake in a larger vision, a bigger company, and a more dynamic organization, especially if the company’s stakeholders extend beyond you and your family. The beachhead model, which is a common and useful way to build a start-up, provides that you find a model that allows for an initial revenue source but then growth from adjacent revenue streams. A one-year projection can account and plan for capturing that first beachhead. But stakeholders know that a beachhead in and of itself is often not sustainable. You need to paint a bigger picture for them in your financial plan. While most investors are extremely — and appropriately — skeptical of hockey stick charts, many people nonetheless need to see them. You need to show how you can justify near-term losses. A bigger financial plan, found in a multi-year pro forma, is usually necessary.
  4. A multi-year pro forma can reveal the hidden issues in your unit economics. Figuring out the basic economic proposition is critical for success. Your initial success may not be sustainable, and as your work through a multi-year plan, you can sometimes find the flaws or at least discover some pitfalls. As you figure out the fixed and variable costs in your delivery of goods and services, you’ll also find that the costs and the revenue are not always neat lines running in parallel. More often than not, the costs resemble a staircase; rarely is input Y going to get a smooth output of X. You have to think through your plan and build a platform, and a multi-year pro forma helps you to do so.

How do you build a reasonably good pro forma for multiple years? When it comes to revenue forecasting, work forward, not backwards. Start with the number of people currently in your wheelhouse as customers and go forward from there. For example, a new service firm founder may know 100 people who could potentially hire him. If he calls 100, then X% will schedule a face-to-face meeting; then Y% will hire him to do a job that costs, on average, $Z. Build out and acknowledge potential impediments to the buyer’s journey. Start with the universe of people that you can reach with your planned advertising and walk through the reasons these people may choose to use your service or purchase your product – and the reasons they may not. When considering revenue models, remember that while recurring revenue has its obvious advantages, it isn’t the be-all, end-all. There are other valid revenue models out there. Make sure that you’re being realistic about all inputs necessary in cost structure, including fixed and variable costs. Finally, be brutally honest with yourself. Poke at everything. 

And what of the overly rosy pro forma? This speaks to the necessity of communication. At some point, as they move forward with business, an entrepreneur may realize their predictions were wrong. In most cases, you just need to come clean, be honest, and own up to it as soon as you know your predictions inaccurate. Explain why they did not materialize and, more importantly, present your plan for moving forward. More likely than not, your stakeholders will work with you, and if an investor did not provide for a contingency, then that failure is on them.

The multi-year plan is a necessary tool. Maybe the adage “think global, act local” is apt here. You want to act in the here and now: what are your short-term goals, and how do your daily actions drive you and your organization to meet those goals? But you want to be thinking on a larger scale: where are you ultimately driving? Thelma and Louise is a great movie, but a terrible way to grow a business.

[1] Valuation, the five-year pro forma, and competitive landscape charting: all of these activities provide non-actionable data — i.e., information that the entrepreneur cannot (or does not) necessarily need (or, rather, want) to act upon. They are often considered “busy work,” and, for a time-pressed founder, busy work is an anathema. However, each are absolutely key to the success of a start-up. In this series, we’ll discuss these overlooked but crucial activities. First, we tackle valuation.