New accounting interview series asks Tim DeBone for advice on financial modeling before lining up people to fund your business.
By Brooks Malone, @Brooks_Malone_
New capital-raising tools are popping up everywhere, giving entrepreneurs access to new types of investors and new deal structures.
Monday, May 16th, the Securities and Exchange Commission's Regulation Crowdfunding went into effect, giving entrepreneurs the ability to raise $1 million each year from people they have never met. The new rules can be found here. And the North Carolina legislature wants our state to offer its own crowdfunding option too. Our legislators will likely vote to double the federal limit to $2 million each year.
As I discussed in my last article on Crowdfunding GPS, the first step to developing your map to the money (and to take advantage of any new law) is to be able to forecast how much money you need and how long is your runway before it runs out.
I am an accountant. And like most accountants, I audit the financial statements that tell investors what happened to a business during the prior year. Investors are different. They care more about the future than the past. It's nice to know how we got an inch of rain yesterday, but most of us look at weather reports to find out whether it will rain later today or tomorrow.
They make big bucks by making predictions. They make even bigger bucks if those predictions are right.
I want to understand more about this world and help more people understand what sort of investment strategy is right for them. And so it's my personal quest to interview the best and brightest people who help their businesses forecast their financial futures.
I will start by focusing on the Software as a Service ("SaaS") industry. And what better place to begin than at Windsor Circle, a fast-growing, venture-backed marketing automation company located at American Underground.
Here are some forecasting best practices from Tim DeBone, the company's director of finance and operations and a UNC-Chapel Hill grad who previously worked for NetSuite and Intel in California.
What mistakes or war stories can you share related to forecasting?
The forecast will always contain mistakes, but the key is to review the output and know your business well enough to identify what happened. Do you have sales volume up 125% next year, but revenue growing 300%? Do your employee expenses vary wildly month to month or does your cost per employee fluctuate versus last year? Can you prove out that a dollar of salary flows from expense to cash in your forecast?
I have been fortunate enough to work in organizations that strive for and force an open discussion of the forecast and test the assumptions that drive results. If you don't compare your forecast to the results, you will never know what you are doing right or wrong. A very public example of a forecasting mistake costing a company was Zirtual, which terminated 400 employees overnight because of forecasting errors. In the end, they forecasted payroll incorrectly and nobody caught the error before it was too late.
What are the benefits to developing a realistic bottoms-up forecast model versus a big picture simplified top-down forecast?
We do both a bottoms-up and top-down forecast. The top-down forecast may provide quick insight into your business and is simpler to assemble, but the bottoms-up forecast forces you to better understand the underlying assumptions that drive your business; such as headcount drivers on the expense side or per-unit forecasting on the revenue side. No forecast is 100% accurate, and you need the detailed, bottoms-up forecast to understand why something did or did not happen.
What are the risks of not having a realistic forecast model?
The biggest risk of not having a bottoms-up forecast is making incorrect assumptions when comparing the forecast to the actual results and then making the wrong business decision. The detailed forecast model allows you to compare not just the results, but the why in the results. You can then adjust your next iteration of the forecast to make it more realistic.
When in a company's life cycle should its leaders develop a realistic forecast model?
There is not an early enough stage to have a bottoms-up forecast. If you are fundraising, you need to project what you are going to accomplish. On the sales side, you need to project how much you are going to sell and when, how much market penetration, etc. Forecasting the expense side is also important since funding is not unlimited and you need to understand your outflows and when the next funding event will be required. The bottoms-up forecast allows you to more accurately project your anticipated inflows and outflows and develop your company's long-term plan.
How often should a forecast be updated, and what are the best practices when reporting your actual results during the year versus your forecasted plan?
It depends on how frequently the business changes. I recommend the forecast be updated at least quarterly. At Windsor Circle, we update it every month including reviewing sales growth and trends, the hiring plan and discretionary spending. We do a bottoms-up, detailed forecast for the next 12 months and a higher level forecast for the next three years. We compare our actual results against our Board-approved budget that is completed each Q4, but we also compare our results against our updated forecast for the next 12 and 36 months so we always understand how the company is performing versus our projections.
What are your lessons learned over the years for developing a realistic forecast?
No forecast is perfect. It is important to understand the underlying business drivers and don't be afraid to incorporate new information into your forecast. You also need to understand what the key variables are in the financial success of your business. If you finish at 80% of every key assumption, do you hit 80% of your forecast or do you finish at 20% because they compound? If they compound, determine the key driver and focus relentlessly to ensure you hit that goal.
What industry specific forecast issues are there?
For SaaS companies, the biggest issue is the timing of revenue recognition. Because we deliver our service over an annual contract, we must recognize revenue over that time frame. In SaaS, revenue isn't the guide to how the business is doing, but a reflection of the past. Our investors and management team understand this concept so we spend time also reviewing sales by looking at Annual Contract Value instead of just revenue. We also use industry standard metrics like LVT (Lifetime Value) over CAC (Customer Acquisition Cost) to ensure we are setting up the business for long-term success.
What advice would you share with new entrepreneurs that plan to raise capital?
Your forecast is never right the first time. Iterate over time as you better understand your core business. Start simple and add complexity over time. Build in a cushion, such as downside protection, to not rely on 100% perfection of your assumptions. This will help make the forecast more realistic. Most importantly, understand your plan with the raised capital and when you may need to raise more.
Tim DeBone's practical advice demonstrates the importance of fully understanding your business and the due diligence it takes to develop a realistic forecast. With this forecast and a deeper understanding of your business and financial state, you are now better equipped to take the next step in your fundraising journey.
Next up is Dave Neal, who's a co-founder of The Startup Factory with significant experience as an advisor, investor and Chief Financial Officer.
Note: Raising investor capital requires strict adherence to all federal and state securities laws, and consulting a qualified securities attorney is strongly recommended.
About the Author
Brooks Malone is a CPA and partner with Hughes Pittman & Gupton LLP. He has 27 years of experience and leads the Technology practice group at HPG that serves bootstrapped and investor-backed technology companies. Brooks currently serves on board of directors of the Council for Entrepreneurial Development ("CED"). He is also a listed contributor to the National FastTrac Tech Curriculum that was funded by the Kauffman Foundation.