While financial projections are always important for startups to grow your business in a structured manner, it is also what every investor looks at when you approach them for funding.
The crux of every business plan is the business model. The crux of business model is financial model and crux of that is financial projections.
Jay Krishnan, CEO of Hyderabad-based startup engine T-Hub, also an entrepreneur prior to that, talks about what kind of financial projection model works best for startups and everything that needs to be kept in mind while making one.
Financial projections are always forward-looking and there are two ways these are made - top down and bottom up.
“While there is no right or wrong one, I love bottom up. It forces the entrepreneur to think. It is very easy to do a McKinsey-style top-down projection but entrepreneurs should not be doing top down,” Jay says.
When you do a top-down, you are looking at the market size and where your product will fit in and in a bottom-up approach, it is on account of how much bandwidth do you have in your team.
However, Jay believes that at some point, both must converge. “When you pitch to a series A investor and if it’s a reasonably good investor, if you pitch top down, he or she will ask you to do the same bottom up for sure. If anyone pulls off funding without that I will be reasonably surprised.”
So what is a top-down approach and what’s bottom-up?
Top-down approach
The first step to a top-down approach is looking at the market size. These can often be found through industry reports done by large consulting or research firms. This helps you understand what you are going to be dealing with.
However, the challenge comes when you are in a niche space where you probably won’t find reports or ready information on the market size.
The next step is to look at the competition and this is important because they eat away into your market.
“It is important to understand that while there exists a big marker, whoever is eating into the market is your competition and you need to figure out who you are working against. Depending on the space you are in, the biggest competition is the other people like you in the room,” Jay says.
But as entrepreneurs, your focus should be to think big. Focus on the big guys and not those who may take away a few of your pennies.
Jay Krishnan, CEO, T-Hub
The next step is to identify what you bring to the table – the value proposition.
Jay says that what differentiates you allows you to understand which part of the economy you serve apart from the competition that has already eaten into your market.
But the real answer is not always what your value proposition is but ‘how’ you are different.
“We always tend to think of solutions in form of what. It’s the how that differentiates you from the rest and that’s how you identify your value proposition,” he adds.
The final step in the top-down approach is the market share estimation in 3/4/5 years. Jay says that it is always best to estimate for the next 3-5 years and not less or more than that.
Bottom-up
When working on a bottom-up approach, the assumption you start with is omitting the market size. You ignore the market size completely and work your way up to the market.
The second step here is looking at costs. Within your cost structure, there are fixed and variable costs.
Fixed costs are those you have an easy control over, while fixed costs are hard to control.
“When you look at fixed versus variable costs, the thing to keep in mind is that there comes a certain stage in your product life cycle where fixed is going to get controllable. But if you don’t have a control on your variable costs, it will eat into your margins and you have nothing left in terms of free cash flow to go back into the business,” Jay says.
For example, how much time are you spending to service one customer? That time could be dedicated to building the next product.
Next, you look at the cost of customer acquisition and then the channel strategy costs. Here also, the importance of keeping a check on variable costs comes in.
When you do a bottom-up approach, the next thing you need to have is conversion rates.
While as far as ground reality is concerned, the higher the conversion rate, the better; as far as projections are concerned, lower the better.
“Keep in mind as entrepreneurs, always undersell and overachieve. Entrepreneurs often make the mistake of doing it the other way round. It is always better to go to an investor and say I think I'm going to do Rs 1 cr this year and go back and say you actually did Rs 2 cr, as against the opposite happening,” Jay says.
In the entire process of financial estimation, one of the thumb rules is to always focus on expenses and not revenue.
“Expenses is something you can have a control over. Not revenue. Early stage entrepreneurs should focus on controlling expenses. Everything else is nothing but a spreadsheet,” he adds.
Another thumb rule is that while estimating marketing budgets, always estimate 2x. Marketing costs are always something you will not be able to control, so whatever you project, budget in double of it.
While estimating for legal, insurance, tools and licences, Jay suggests that companies registered in India should always estimate 2x, while those registered in the US estimate 4x.
Activity-based costing (ABC) should be done after the third customer. ABC lets you figure out how much money is going towards each customer and helps you service them according to how much you get from them. The closer you get to it, the better off you are.
Finally, while it is always better for entrepreneurs to look at a bottom-up approach, it is best to converge the two. This way, you force fit your solution.
Jay suggests that an early stage entrepreneur should always go back and look at the spreadsheet at least every week and revise it depending on learnings.
This article has been produced with inputs from T-Hub as a part of a partner program.