The role of financial projections in startup valuation

The valuation of early stage companies is a one of the more complex and contentious topic in the startup world. On one hand, it is regarded as a finger-in-the-air exercise to get an approximate price for an intrinsically risky asset class. On the other hand, there are some strong feelings about the right way to go about it, and the precise methodology to use. It’s too easy to get lost in the nuts and bolts.

One topic which allows us to peer deeper into the logic behind early stage valuation is the role of financial projections.

Ask 10 early-stage investors whether they are interested in financial projections and half will roll their eyes. How can they possibly be accurate or believable? It’s all optimistic guesswork!

And yet… the whole pitch from a startup at this stage is optimistic guesswork. That your team can execute well, that your product will find a fit with the market, that people will be willing to pay what is required by your business, and that the market will prove to be sufficiently large? These are all projections of a sort.

The fundamental question comes down to your startup’s story, and whether the investor believes in it.

Why should investors care about your financial projections?

Pitching a startup is an exercise in storytelling. Business ideas both great and mediocre have won investment thanks to the power of narrative, and the person delivering it. Tell me something I don’t know, right? This is well covered ground. Less well discussed is the power of illustrating that story with numbers.

If you’re going to ask me to believe a story about your team, your product, and your market, then it’s useful to see how it looks in a model. Show me how you see that journey playing out in terms of revenue, costs, cash flow and EBITDA.

I’m not obliged to believe those numbers any more than I’m obliged to believe your estimates on TAM and SOM, but they provide valuable quantification of the future you are selling. They also demonstrate the degree to which you understand entrepreneurial finance, your market, and the economics of growth.

Projections corroborate the strategy

The usual path when presenting a startup:

• Ambition. What’s the big headline goal that you are trying to achieve? What’s the impact you want to have
• Strategy. How are you going to get there? What’s your edge? Why is now the right time for this problem?
• Financials. How does that looks in terms of revenue?

Founders suspect they’ll be asked for projections, so they’ll go through the motions of putting the model together. They’ll know roughly what kind of revenue growth that investors would like, and they’ll have an idea about what seems likely, and they’ll shoot somewhere in the middle and cross their fingers.

What the majority miss is the crucial step of closing the loop, and producing a truly cohesive story – reflected in both story and numbers:

• According to your financial projections, are you able to afford achieving that ambition?
• What level of growth is required to hit that target, and is it reflected appropriately?
• What kind of costs are associated with that level of growth, in that particular market, and have they been accounted for?

It is in that process of tying it all together and working back through the loop that you can make sure the vision appears feasible, and that your approach is believable. That’s why financial projections are important, even at an early stage, and connecting them up with your growth strategy is a valuable exercise for your own thought process as much as it is for anyone else.

More data means better decisions

Understanding the application of financial projections is just one aspect to the complex problem of valuing early stage companies, but it illustrates an important principle: it’s not always a calculation with a dollar output. Sometimes, it’s as simple as informing an investor’s ‘judgment stack’ with a more diverse set of inputs.

For another example: you may find that intangible assets are too difficult to usefully quantify into value, but you could still offer useful perspective on that with the Checklist method which aims to do exactly that. You don’t need to press forward with the valuation it suggests, simply include it as another data point for assessment.

Similarly, DCF models are widely dismissed as being inappropriate for startup valuation. Again, what if it’s not about precisely pricing the deal? What if it’s about exploring the potential cash outcomes, and offering a view on the margins and costs of the business model. What can investors learn about your business there?

If early stage startups were easy to value then it wouldn’t be such a (potentially) lucrative asset class. That doesn’t mean that either side should give up on rigor. The more information that can be offered on a proposition, the more perspectives that an investor can use to examine it, the closer you will come to rational agreement on valuation.

Better decisions mean a healthier market

In a low information environment (e.g. deals moving too quickly) the fallback for investors is to rely heavily on benchmarking against comparable deals. It’s a quick way to arrive at a ‘market passing’ valuation, but it leaves all participants – founders and investors – more vulnerable to irrationality. Trends are compounded, making the highs precarious and the falls stomach lurching.

As a founder, you’ll get a better outcome (a healthier valuation, not necessarily a higher one) if you arm potential investors with a more complete picture of your business. Reduce the asymmetry of information, demonstrate your competence, and ensure they appreciate the key features of your proposition.

Crucially, the more we move in this direction, the more inclined the industry will be towards processes and practices which make this kind of valuation practical. Investors may begin to make slightly slower decisions with overall better outcomes, rather than faster decisions with overall worse outcomes. Founders will approach fundraising with a much clearer picture of the potential outcome, and better preparation for it.

None of this will change the fundamental power law distribution of venture capital, but it might put it on some more rational rails. Valuation is a fundamental driver of how capital is allocated to innovation, so it’s always worth considering how we prioritize financial gain versus overall market health.