Many entrepreneurs and VCs alike are hesitant to produce a proforma for more than two years out into the future. They claim that it’s impossible to know what will happen and that the third year and beyond are “just numbers.” While I would agree that nobody expects a startup to perform according to its projections, I am heartily in disagreement with the claim that a five year proforma doesn’t tell us anything.
First of all, let me say that it’s totally ridiculous to think that even a two year proforma has some degree of accuracy. The earliest launch dates are typically missed and the first two years are highly variable – perhaps even more variable than years three and beyond. So, if you’re going to say that you can’t predict years three through five, I will counter that you might as well abandon the effort all together since nobody has a crystal ball that extends to two years, much less five.
Why do I want a proforma out to five years (or more)?
1) I am focused on the EXIT. I want to know clearly how you plan to get from Point A (where you are today) to Point B (your exit strategy). I want to see how you think and how big you expect to grow. If you’re only planning on growing to five million in sales, and that’s your best case scenario, then maybe I’m not interested in investing. I want to know what you’re shooting for.
2) I want to know if you can SCALE. I see a lot of entrepreneurs who are good at running companies with up to twelve employees. But there are relatively few who know how to grow a big company, develop partnerships, put systems and metrics into place and scale up BIG. Your numbers will show me that you know what it takes to scale and the resources required to do it. I recently reviewed a proforma for a company that projected $35 million in sales with three employees. Even with outsourcing their manufacturing, it didn’t make sense.
3) I want to know how you THINK. Are you detail oriented and able to develop your numbers from the bottom up, or are you just taking a percent of your total projected sales? Do you understand the factors that will impact your growth and the costs that will accelerate or decelerate growth? Do you show a straight line growth curve or does it vary wildly from year to year? Do you understand the common ratios for support staff, sales and management at each level of growth? Even if you’ve got a disruptive strategy that operates more efficiently, I want to see that you know what the norms are and how your new methods will be more efficient.
4) I want to know how you came up with your VALUATION. I use five different valuation models when assessing investment in companies and three of them are based on your exit strategy and the exit value is typically going to be some multiple of sales or EBITDA. I will adjust your sales figures to what I believe are realistic, but I also want to see how your valuation relates to your projected sales. Are you picking a valuation out of the air or are you doing the work to research and find ratios that make sense?
5) I want to know how long it will be before I get my MONEY BACK. Are you planning on an early exit within two or three years, or does your strategy take five to seven, or is it eight or longer? These numbers will be critical to my investment decision since I don’t want to be in deals that take longer than seven years to liquidity. If you think it will take eight years, then it will probably take ten and I’m not going to be hitting my investment objectives. I calculate my returns based on Internal Rate of Return which is a ratio of total return of capital over time, so the longer my capital is out, the lower my IRR.
So, if you’re pitching to a VC, it can be in your best interest to show all years projections between now and your exit – and most VCs are realistic in knowing that if you actually hit your numbers that it will be a miracle.