Jeffrey Moskovitz added an important comment to my big mistake post from last week:
I read an blog yesterday, written by someone I respect, who asserted that investors know and even EXPECT that projected sales and profits will be overstated. Aware of this expectation, the entrepreneur plays the game by inflating the numbers, fully aware that the investors will give the numbers a “haircut,” and everyone will be happy.
Jeffrey didn’t think so and I agree with Jeffrey. Emphatically agree. The idea that everybody winks at inflated numbers is a really bad idea.
My view on this hasn’t changed at all, even as years passed and I moved from entrepreneur seeking investment to angel investor reviewing business plans as part of an angel group. Here’s the way the process works, step by step:
1. Is the sales forecast believable?
Sales forecast credibility is a matter of several factors: understanding the market, size and structure of the market, selling process, channels, decision making, and so on. Granularity is really important, like the details of distribution, margins, buying points, actual names of potential buyers. Real sales already made, letters and testimonials from customers or distributors, are also important. Real Web forecasts, page views, conversion rates, and so on, are important.
If the sales forecast isn’t credible, then investors lose interest in the rest of the numbers in the plan. An unbelievable forecast voids profitability, cash flow, and supposed future valuation and investor return. The process stops.
It is true that a dumb forecast doesn’t necessarily kill potential investment. If there’s good product-market fit, scalability, defensibility, growth potential, management team, and so forth, then bad numbers are forgivable. But a bad forecast is a huge negative.
2. If so, then is profitability believable?
One of the most common errors in business plans, almost pervasive, is unbelievable profitability. As soon as projected profits go over industry averages, I disbelieve the rest of the numbers. In some rare cases (one that I posted about here Monday) entrepreneurs have real justification of those high numbers. But those are uncommon. Most of the time, it means the entrepreneurs don’t understand the business. They’ve underestimated expenses.
Even without researching the specific industry, no industry averages profits much higher than 10%. Most are closer to 5%.
If profitability isn’t believable, then I stop reading the numbers. I have no interest in cash flow or future valuation if profitability is off.
3. If so, then is cash flow believable?
Only if both sales and expenses are believable, do I look at cash flow. Does the cash flow plan recognize the impact of industry and accounts receivable? Does it show the need for investment?
And from there, to be honest, I’m back looking at larger factors, like product-market fit, management, defensibility, and scalability. I still don’t put much stock in what the business plan says the investors will get as return on investment. ROI and IRR projected out five years is an academic exercise, not a real decision factor.