Anyone who has ever been around entrepreneurs and early-stage companies knows that early-stage business projections (revenue, cash flow, profit) are overly optimistic. Experienced investors always cut them down before analyzing the company. And experienced investors also know that a top-down set of projections (such as, “We’ll get .5% of a $10 billion market and that’s how we’ll become a $50 million company.”) are virtually worthless.
But I’ve just identified another type of problem–I need to come up with a clever name for it– that for now I’ll call RED (Revenue-Expense Disagreement). RED is when the expense line doesn’t match up to the (usually overblown) revenue projections.
Let’s say you had an idea for a new type of body scrub made from the broken pieces of cookies that are at the bottom of the bag. Nobody eats those anyway, right? Its a free raw material, so your margins will be huge, right? My point here isn’t to evaluate the merits of this particular innovation, but rather to use this as a hypothetical example of a RED error.
I chose this example because, according to Hoover’s, the beauty products industry is a $10 billion industry. You’d only need a minuscule, should-be-easy-to-achieve .5% market share to make the numbers work.
Suppose you come up with a revenue model that gets you to $50 million. You just need to sell 10 million bottles per year at $5 each. Simple. But is your pro-forma P&L statement internally consistent? Do you have enough employees built into the model to give an accurate portrayal of the headcount you’ll need at $50 million? Do you understand how much you need to spend on marketing to support that level of sales? How will you get your product into the 13,000 beauty stores? How much working capital will you need to finance the inventory that’s required to support that level of sales? Do you understand the credit terms in this industry because they will have a profound effect on your cash flow. Answering these questions will make the difference between getting your business financed or always wondering why “they don’t get it.”
New business ideas sometimes get shot down because the ideas seem outlandish. I actually think that most great ideas initially merited a reaction of “You’ve got to be crazy.” I’m talking to a lot of young entrepreneurs these days who are very eloquent and spirited about why their vision makes sense and why the world needs their idea. I’m not trying to convince anyone that their idea won’t work. Who am I to make that judgement?
But I see a lot of RED errors in their presentations. I worry that when they go out for funding, they’ll get shot down not because their vision isn’t meritorious, but rather because they haven’t described a financial model of the business that will make sense in the long run. Good investors will spot this.If you’re susceptible to making this kind of mistake, be sure you get some assistance from a good financial modeler and someone who knows the industry.
A crazy idea rationally presented with a solid financial model has a chance of getting funded. A sensible idea with inconsistent financials most certainly will not. Are you seeing RED?