Tag Archives: profitability

Your Profits Are Way Too High!

Angel investment, , ,

The most common mistake in startup business plans is having the profits way too high. There’s no sense whatsoever to priding oneself in projected profits, as in profits you predict your business will have in the future. That’s like having replicas of future Olympic gold medals made and putting them into a trophy case. And in most business settings, it just lowers your credibility. I read 100 or so startup business plans every year, and I’ve getting tired of it. I’ve discovered a new 50-50 rule of profitability in business plans, as in, 50% of the plans I’m looking at project 50% or higher profits on sales.

Pick one: high growth or high startup profits

projected-profitsIn real business, there is inherent conflict between high growth and high profits. That is the collective result of lots of small decisions owners make as they choose to spend marketing money or not. Every dollar you keep in profits is a dollar you didn’t spend to generate growth.

It’s not just coincidence that the history of high-growth online business successes started with losses. Facebook founder Mark Zuckerberg resisted charging membership fees in the early years, when Facebook was losing money but staying free to users. Sure, later, through advertising, Facebook found a way to make money – but first it had to grow its user base to gain the critical mass that made advertising a practical source of revenue. And Facebook is still free to users. Twitter is still free, struggling to figure out how to make more money, but not even for a second considering charging a fee for participation. LinkedIn is still free, and was free and losing money for years. Revenues came later, after the user base was established.

And even with more traditional businesses on main street, startups are rarely profitable. There are always expenses before launch, and those cut into profits. And few businesses manage to generate revenue to cover costs from the very beginning. Most have a deficit phase as they gain traction and grow.

And as they do establish themselves, they still have to decide, dollar for dollar, whether they spend available money on marketing, or save it and keep it as profits.

Find realistic levels of startup profits

Real businesses make five or 10 percent profits on sales, at best. The NYU business school keeps an updated web page that lists profitability by industry, with an overall average of 6.4%

Occasionally a very successful startup will come up with something so new that it can, for a while, chalk up very high profit margins. That’s extremely rare. Out here in the real world, though, nobody really makes much more than 5-8-10% or so profits on sales. The real startups might make 15% or even 20%.

Projecting 40%, 50%, and even 60% profitability on sales doesn’t tell me you have a great business; it tells me you haven’t done all of your homework. You’re underestimating cost of sales, expenses, or both.

I find this particularly galling in business plans with some social implications, related to health care, or education. I’ve seen many startups planning to sell something offering huge medical benefits to people suffering from serious medical problems, projecting profits of 100 percent or more. Do you agree with me that this is wrong? Nobody chooses to buy these things. Can’t they charge a fair price, that allows a fair profit?

What would I like to see instead? First, find out average profitability for the industry you’re in. Put that number into your plan. Then explain why your company’s projected profitability is higher. Proprietary technology, specialty niche market, new processes? Okay, I can take that; just be aware of what the normal is, so you know what you’re up against. Please.

Standard financials are available from several vendors, for less than $100 per industry (and here I can’t resist adding that they’re bundled with LivePlan, my company’s software product. Sorry. I’m an entrepreneur. I can’t help it.) You can also get those from Oxxford Information Technology, or the Risk Management Association (RMA). And some summary profit by industry data is available for free, from sources such as the NYU page above.

 

What ‘Accurate’ Means in a Business Plan

Business Plan Contest, Business Planning, Venture Contests, ,

Questions_iStock_000011860969_modified (1)I just answered this questionon Quora. I think it’s an interesting question, one that comes up often enough, and one whose answer is worth considering.

How can I write a very accurate business plan. I’m hoping to win a grant in a business plan competition?

The rest of this post is my answer on Quora, reposted here with Quora’s (implied) permission:

This is an important question, but also a big one, hard to answer in a few hundred words. And I’m going to stick with the subset of business plans that apply to business plan competitions. These are more traditional and formal business plans, written to communicate with outsiders, and therefore significantly bigger than the lean plan (see below) you need to just run a business.

What Accuracy Means in a Business Plan

It starts with this: in your summary and descriptions of the business model, company formation, market, business offering, and management team, your readers take accuracy for granted and so should you. Tell the truth about your business and what you plan to do. Period. Accuracy isn’t a variable.

I have to guess that you bring up accuracy in the context of projections, specifically your market forecast, sales forecast, projected profit and loss, projected balance sheet, and projected cash flow.

Accuracy in market information

With market information, make sure you distinguish between the statistics, demographics, and descriptions you present as facts – external available information, with sources cites – and estimates and projections.

Approach this with the understanding that there are no facts about the future, just guesses; and there is no guarantee that the information you’d like to have will be publicly available. So therefore you have to develop reasonable estimates, based on assumptions, for which accuracy is mainly a matter of making your assumptions logical, and transparent.

Here’s a real example from a plan I was involved in recently for a social media consulting firm (Have Presence):

  1. The target market is small business owners who want social media presence, don’t want to do it themselves (or don’t have time), and have the budget to pay for a service.
  2. To develop an estimate for the U.S. portion of the market, I start with known statistics on small businesses in the U.S. and cite the source (in this case, the U.S. Small Business Administration), to arrive at some number, say 5.5 million (I’m not taking the time, while answering, to go check the actual number; but it’s a real number, publicly available, with a reliable source).
  3. From there I have to make an estimate of how many of those 5.5 million business owners meet the criteria of wanting presence, not doing it themselves, and having budget. There is no way to get the actual number with any accuracy. I have to estimate. And whether I end up saying it’s 2%, 5%, 10% or 20%, the quality of accuracy in this specific case is a combination of going from known statistics to estimates, and keeping the estimates clarified.
  4. If I really cared – perhaps because I was entering a business plan contest with my plan – I could probably figure out how to educate my guess in point #3 by looking at Facebook statistics, Twitter statistics, businesses by number of employees, and so forth – that would still leave me with estimates, but better estimates. In fact, I’m fine with what I did in point #3 because that tells me there is enough market to go for … whether it’s half a million to two million potential clients is irrelevant for business decisions, because it’s enough.

So this is just one example. Accurate in market description is a matter of combining what can be known with what can’t be an has to be estimated.

 Accuracy in Financial Projections

Financial projections are always wrong, by definition, but they’d better be laid out correctly, reasonable, transparent, in line with industry standards, and, above all, credible.

  1. The goal is to connect the dots in the financials so that spending is in proper proportion to sales and capital resources, and cash flow is sensitive to factors such as sales on account and inventory that make it different from profit and loss. Show that you understand how the financials are going to work in the real world. What drives what.
  2. The sales forecast has to be credible. Make sure you lay it out from the details up, not from top down. That means transparent assumptions about drivers, so for a product in retail channels it’s something like monthly sales per store, and stores carrying the product; and for a web business is traffic via organic, traffic via PPC, and conversion rates; and so on. Definitely not a top-down forecast, meaning show a huge market and a small percent of market.
  3. Profitability has to be credible. One of the most common flaws I see in business plans for competitions is absurd profitability, 30%, 40%, and more as profits to sales, in an industry in which the major players make 5% or 10% on sales.  That’s a huge negative. Accuracy in P&L means having realistic percent of sales for marketing expenses, general and admin expenses, and development expenses.
  4. Cash flow has to be credible. Another common flaw is failing to understand how sales on account and accounts receivable affect cash flow for business-to-business businesses; and yet another is failing to see the cash flow implications of having to buy product inventory and carry it before selling it.

Accuracy in the main body, descriptions, etc.

For the rest of the plan, industry information, competitive information, and so on, what’s really important is that you clearly distinguish between factual information from valid sources and guesses and estimates.

One of the worst things you can do in a business plan competition or pitching investors is to get caught presenting as fact something that one of the judges or investors knows is inaccurate. If you aren’t sure, clarify, disclose, call your guesses guesses. And it’s particularly bad to fudge the facts regarding your personal history, your business history, or those of your team members. Don’t cross the lines of accuracy related to degrees, job positions, and past jobs. You need to protect your integrity. And if you blur the truth on purpose, such as saying you studied business at Harvard or Stanford when you were just there for a few weeks in a special course, or when you failed to graduate, that can kill a deal.

5 Steps to Better Financial Projections

Business Financing, Business Planning, , , , ,

(Note: this is reposted from my post Monday on Amex OPEN forum. It had a different illustration there, and I’ve changed it to the hockey stick here in honor of so many sales forecast charts that looked like hockey sticks)

Every spring, I read and review dozens of business plans as a member of an angel investment group and a judge at several business plan contests. I love it. The plans I’ve seen are better than ever this year. But, for some reason, their financial projections are the worst I’ve seen.

How can the plans be better while their financials are worse? I think product/market fit, defensibility, scalability, market need and management experience are much harder to fix than bad financials. A good business with poor financial projections will survive and grow.

Still, it’s a damn shame. The worst, and by far the most common mistake, is absurdly high profitability. So, in honor of this epidemic of bad financials, here’s my five-step plan for better financial projections.

1. Start with a sales forecast

Make it bottoms-up, always; never tops-down. This means that you start with unit and price details and build up to sales from specific, concrete assumptions. For example, if it’s a website, base your forecast on metrics you and others can compare to other websites, such as unique visits, page views and conversions. If it’s a product going through distributors to retail stores, then look at the number of stores you can reach and the distributors required to reach them, and forecast units per store per month.

Never get caught forecasting a market by assuming the total market size and then projecting your market share. That doesn’t work. Nobody who matters believes it.

Do it monthly for 12 months, then annually for the second and third year. Think of it as a spreadsheet with months and years horizontally across the top and category names vertically along the left-hand side.

Your sales forecast should include your direct costs (also called unit costs) and costs of goods sold (or COGS). This is how much it costs you in direct costs, unit costs, per units sold. These are costs you don’t pay if you don’t sell. They go up and down as sales go up and down.

If you have no idea, don’t throw your arms up in frustration; don’t say “but it’s a new business, how could I know?” Break it into unit economics and unit assumptions. Get some comparisons from similar industries to show you what gross margin (sales less costs of sales) might be, and average profitability. Google “standard financial ratios” for leads, and don’t expect to pay more than $100 for one industry profile.

And if you still have no idea, then: 1. keep your day job; or 2. find some partners who know the industry.

2. Forecast running expenses

We call these operating expenses, such as rent, utilities, payroll, advertising, websites, travel and so forth. Here again, if you have no idea, you need to find financial profiles, take in a partner, talk to somebody who’s done it before, or maybe keep your day job. You don’t want to have no idea.

This is also a spreadsheet, with the same months and years as in the Sales Forecast horizontally across the top, and the categories vertically down the left side.

By the time you’re done with expenses, you’ve got everything you need to do an estimated profit or loss analysis. The standard format starts with sales, then subtracts direct costs to calculate gross margin. Then you subtract operating expenses to calculate profit before interest and taxes (called EBIT, with the E standing for “earnings.”)

If your projections have profits higher than 10 or so percent of sales, you’re not done. Either you have underestimated your costs or expenses, or you have an unusually strong business. It’s almost always the former.

Hint: No matter what industry you’re in, if your pretax profits are more than 15 percent, then I suggest you subtract 15 percent from your projected profits and add that amount back into operating expenses as marketing expense. Having profits too high usually means you aren’t projecting all your expenses. And marketing is where most people underestimate expenses. And besides, in a real business, well-spent marketing expenses are better than profits because they grow your business, which makes it more valuable over the long term.

3. Startup costs

Make a list of expenses you’ll have to pay before you start. Common startup expenses are legal expenses, website development, logos, signage, fixing up a location, computers and so on. Then make a list of assets you’ll need. Those are things like vehicles, equipment, furniture, startup inventory and starting cash in the bank.

The cash in the bank is the toughest. If you go back and look at your running profit and loss, that will give you an idea. You have to have money to support your early losses. Read the next step and then revisit it.

4. Understand cash flow

Unfortunately, making a profit doesn’t mean you have cash in the bank. The biggest problems here are the business-to-business sales, which typically mean you get paid a month later; and product businesses, because normally they have to buy things to sell before they sell them. If you’re a business that paid two months ago for what you sell today, and is going to get paid for that three months from now, then cash flow is both critical and unintuitive. You’re going to need money in the bank (you can call that working capital) to handle running expenses while you wait to sell stuff and get paid for it.

On the other hand, If you’re selling to people who pay immediately in cash, check, or credit card, especially if you’re not putting money into buying and keeping products, then cash flow is more predictable.

If you have no idea, and you do have business-to-business sales and inventory, then look at templates, or software, or books, or tutorials, or somebody who can help you. Don’t take cash flow for granted, even if you expect to be profitable. Ironically, some of the worst cash-flow problems come with high growth rates.

5. Review and revise regularly

Yes, you should forecast for 12 months and the two following years; but no, don’t expect your forecast to be accurate. They never are. You do the financial forecasts so you can set expectations and link spending to sales, but that’s just the start. Review your results every month. Compare actual results to what you had planned. And make corrections.

Final thought: all financial projections are wrong, by definition. We’re human and we don’t predict the future accurately. So don’t expect accuracy. Go for plausibility, and then follow up with regular plan versus actual analysis, review and revisions. We call that management.

(Image: Nicolas McComber/Shutterstock)

5 Ways to Make Your Projected Profits Realistic

Business Financing, Business Plan Contest, Business Plan Marathon, Business Planning, Venture Contests, , , , ,

I’m well into my business plan marathon again this year, in Houston today looking forward to judging the Rice Business Plan Competition, one of my favorites.

Regarding business plans, instead of just complaining (again) about unrealistically high profitability projections, today I have some specific suggestions. And this has nothing whatsoever to do with the six excellent plans I’ve read for my part of the judging today. dollars

But, as my mother used to say: “if the shoe fits, wear it.”

The underlying problem is that projecting high profits doesn’t usually mean you have a great business plan. It almost always means that you’ve underestimated expenses or direct costs. It’s usually a bad thing, rarely a good thing.

So here are those concrete suggestions:

  1. Compare your projected profitability (net profits or pretax profits as percent of sales) to standard industry profiles. The most well-known source in the Annual Statement Studies published by Risk Management Associates (RMA). These will give you standard profitability rates for more than 700 common types of business. I searched the site for information business, narrowed it down to software publishing, and I was offered a download for $120. Oxxford Information Systems competes with RMA with more profiles for more different types of business. And Business Plan Pro bundles the Oxxford Information profiles with a searchable database linked to the ratios table [disclosure: I’m the conceptual author of Business Plan Pro and my company publishes it.] And there are other competitors in that market. Standard profitability isn’t that hard to find.That doesn’t mean that I recommend your projected profits always match some standard industry profile. Not at all. What it does mean, though, is that you should know what profits are reasonable for similar industries, and don’t project huge profitability that’s 5 or 10 times higher, in percent of sales terms, than the standards. That kills credibility.
  2. Compare your projected profitability to results of publicly traded companies in your industry. You don’t need an exact match, but you should know how different your projections are, and you should satisfy yourself on why they’re different. The publicly traded companies tend to be larger and more established than new startups. Sometimes a startup is so new and innovative that it is much more profitable than industry leaders; but that’s rare. If you don’t know where to find financial reports of publicly traded companies, start with Yahoo Finance.
  3. Do a good web search to see if you can find comments on blogs or in interviews where entrepreneurs talk about actual profits in real businesses like yours. Maybe you’ll find somebody who might be a competitor. People give a lot of information away these days, in blogs, and on the web.
  4. Try to find somebody with actual experience in a similar company. Use social media, use your mentors, talk to the nearest business school or chamber of commerce. Get somebody to tell you, from real-world experience, what kind of profits are likely.
  5. If all else fails, remember that across the real world of business, normal profits run about 5, 10, maybe 15 percent of sales. If you’ve done your best and it still shows 30 percent or more, take a good look at your payroll, headcount, and marketing expenses. When it doubt, add marketing expenses to take your projected profits down to a credible level.

Is this you? Does your business plan project profits way above standard levels? That doesn’t make your plan look better. First, make it credible. Only then are the numbers really interesting.

(Image: Elnur/Shutterstock)

Your Profits Are Way Too High!

Angel investment, Business Plan Marathon, Venture Capital, Venture Contests, , ,

Business plans everywhere. I’m reading, annotating, filling in score sheets, and getting cranky. I explained that on this blog last Monday.

So what’s with the unrealistically high profitability projections? This year it seems like I’ve discovered a new 50-50 rule of profitability in business plans, as in, 50% of the plans I’m looking at project 50% or higher profits on sales.

That reminds me of a song my youngest daughter used to play: “That Don’t Impress Me Much.”

Occasionally a very successful startup will come up with something so new that it can, for a while, chalk up very high profit margins. That’s extremely rare. Out here in the real world, though, nobody really makes much more than 5-8-10% or so profits on sales. The real startups might make 15% or even 20%.

Projecting 40%, 50%, and even 60% profitability on sales doesn’t tell me you have a great business; it tells me you haven’t done all of your homework. You’re underestimating cost of sales, expenses, or both.

I find this particularly galling in business plans with some social implications, related to health care, or education.

What would I like to see instead? First, find out average profitability for the industry you’re in. Put that number into your plan. Then explain why your company’s projected profitability is higher. Proprietary technology, specialty niche market, new processes? Okay, I can take that; just be aware of what the normal is, so you know what you’re up against. Please.

Standard financials are available from several vendors, for less than $100 per industry (and here I can’t resist adding that they’re bundled with Business Plan Pro, my company’s software product. Sorry. I’m an entrepreneur. I can’t help it.) You can also get those from Oxxford Information Technology, or the Risk Management Association (RMA).

Anyhow, that’s my opinion.