Friday, September 8, 2006

Ask Brian: 5-Year Pro Forma Projections?

DEAR BRIAN: I am founder and CEO of a startup and we are preparing our investor presentation for raising a Series A round now. All is going well with the pitch so far, but I'm confused about what to put for the 5-year revenue projections. I've never raised money from a VC before and I'm trying to strike a balance between showing the phenomenal upside potential of the company while not setting the wrong expectations - five years is a lot of time and a lot of things can change along the way. If I show the optimistic numbers, which get really big really fast, I'm worried that it will look unbelievable. If I show the pessimistic numbers, I would certainly exceed expectations downstream, but I'm not sure I can get funded because it doesn't look like a big business. What really worries me is whether the VC will use this document against me when raising Series B or Series C if the company's performance does not match the slide. -- PERPLEXED PRO FORMA PERSON, San Francisco, CA

DEAR PERPLEXED PRO FORMA PERSON: Seeking venture investment money is certainly an exciting time in your company's history. Congratulations for making it this far!

The bottom line for most of my advice is to first and foremost be true to yourself.

Don't create an investor pitch that is full of things that you think the VC wants to hear or see. That's not fair to yourself or to your investors. It is true that VCs want to invest in something that can build to be a big business, but they are really making an investment in you first and the business second. They know that 5 years is a long way away, but the pro forma income projections slide shows them a bit about both you and the business in a single slide. It is an important slide and you are right to give it its due consideration.

VCs are very good with numbers. An investor pitch is filled with numbers. When you get your chance to present to the entire partnership of a VC firm, you will find that someone in the room knows something about every one of the numbers in your slides. One partner will ask about your market sizing (TAM and SAM), one will ask about your pricing structure, one will ask about the revenue split with your partners, one will ask an extremely detailed question about your technology, manufacturing process, wireless range of your device, milliamps consumed, yields, or the guage of the wire you're using. These guys are numbers guys. They ask you these questions to understand, very quickly, how much you know about your business and how you respond is what's key. They know bullshit when they hear it.

So, on the pro forma income projections, just put where you, personally, want to take the company and what you, personally, based on your experience, fully expect to deliver over the coarse of the next 5 years. Put down your goals for the company, not what you think their goals are. If there is no match, much better to know that now instead of later (when you are being fired). If you stick to being true to yourself and your investors, always, things will go much better.

The VCs get that there are caveats and risks associated with every single number in your slide deck. What's important is that you can talk authoritatively about the numbers, backed by actual experience of yours or through case study references of others. They will want to hear you reason through the numbers. How you got there, assumptions you made, what made you think the assumptions were reasonable, other companies that had similar revenue ramps, why you grew sales faster than engineering in year 3, etc.

So, to your question on whether this document will come back to bite you in later rounds of funding. My experience with good VCs says that it will not. You will be having monthly Board meetings. You will be communicating openly and honestly with your investors before, during, and after the Board meetings. You will be keeping them informed always. You will be transparent with them. You will enlist them to help you work through the new risks and challenges and competitive threats that arise along the way. If you do these things, you will be creating a new set of 5-year pro forma income projections for Series B. Be transparent, open, and honest and the rest will work itself out. Manage your Board and your Investors appropriately and the business will thank you for it (as will your spouse).

This post is part of The "Ask Brian" Series and is held to the same legal considerations as described therein.

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  1. Dear Brian

    I am trying to raise some funding for a startup. I have been advised that my paper must necessary contain exit options for the investors. These exit options must be built on the basis of possible valuation (as per the plan) of the company in the 5th year. I don't have a clue on how to construct / determine the valuation ! Can you please advise ? I have also been advised that most VCs would look for 10X at the time of exit (or for proposition to be attractive) - what does this mean ? Best Regards AG

  2. AG: A trustworthy VC would never ask for you to construct a valuation model for exit. They care most about your revenue growth, market domination, and profitability. Show those things to be strong, and you've got a business with excellent exit potential.

    Sure, VCs want to get 10X out of each investment. Wouldn't that be great. That's not how the real world works, though. The VCs like to see that they have a credible path to a significant exit, though. If you use the 10X number as a guideline, you might find the math pretty interesting. For example, if you close a round of funding with a $6M post-money valuation (say, wth a $3M investment), you will need to sell your company for $60M for your investors to get something like 10X out. In today's depressed valuation and tepid exit environments, that's a pretty hard thing to do on a single $3M round of funding.

    Determining your future valuation is something of an art. You can look at comparable M&A transactions in your industry -- similar companies that have been acquired. Figure out what the multiple was between the company's revenues and valuation at the time of purchase. 5-10X is often a reasonable range. So, if you need to hit that $60M valuation at exit, you may need to find a way to build a $12M/year revenue business.

    There's a lot more to it than this, but this gives you a start.

    Best of luck!



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