How to do forecasting for startups
In order to be a successful founder, you first have to be delusionally optimistic enough to start a startup when most fail within five years and only a tiny fraction of founders make any real money. This optimism is a double-edged sword; it’s required to be a good founder, but it also means when you begin to build forecasts they will not, most likely, be grounded in any sense of reality.
At Ibex, our finance team is often viewed as the dream crushing machine. However, IMHO the second most important step of becoming a successful founder is putting your dreams out there and allowing them to be absolutely crushed from every direction. I believe how you respond to that exercise determines your success.
How much delusion is the right amount of delusion?
The key here, especially when it comes to big decisions for your company, is to dream big but take calculated risks. If you’re like most founders, the attitude that makes you delusionally optimistic enough to start a startup has made you successful early in your career by ignoring people who tell you “no” or “that’s not achievable.”
Speaking from personal experience, the determination to prove others wrong (I have been told the technical term for this is “spite”) can be an incredibly powerful motivational tool.
However, where this trait tends to land founders in trouble is when they flat-out refuse to accept reality and try to brute-force their teams into achieving something that is, by all accounts, impossible. For example: we'll close this many deals by that date, we’ll raise this much money by that date, we can expedite shipment and get paid earlier without facing any quality issues. If we just believe and work hard enough we can do it!
At Ibex, the members of our leadership team have all held executive roles in early stage startups. We have seen “under the hood” of dozens of companies from inception to series B, and we have experienced the good, the bad, and the very, very, ugly.
What we have found in our collective experience is that a good forecast solves many of the major problems that startups face. Mismanaged cash? Hired too quickly and have to lay folks off? Didn’t hire enough to support growth and customers are unsatisfied? Fundraise fell through? Internal strife from the executive team? Lack of alignment on the direction of the company? Some of these can be avoided, and the impact of all of them can be significantly reduced, if you actually have a good forecast.
Ask yourself: What if everything we want to happen happens? And then: What if everything that could go wrong went wrong?
By visually showcasing the financial impacts of big decisions and plotting out the major assumptions from the exec team we help startups navigate the waters of uncertainty and avoid any major shipwrecks.
At the very least we’ll start with two lines in the sand that show: “what if everything goes exactly as planned” and “what if everything goes wrong.”
This will give you the “target” forecast you may want to put in front of investors and the “burndown” forecast you manage against internally. It also helps eliminate decisions based solely on gut feelings, or disagreements about what is or isn’t possible. It changes the conversation from “this needs to happen” to “if this happens, what do we do?”
Even if the future is unknown (every forecast ever made is wrong) we can eliminate the feeling of uncertainty by helping determine “if X happens we should do Y” proactively, and before emotions are running high, so when things hit the fan, as they always do, there is already a plan in place and it’s all about the speed and accuracy of tactical execution vs trying to make the strategy in the first place.
And the reason this all comes down to finance? Because you can’t lie (for long) in finance. You can argue about your weighted sales pipeline until you’re blue in the face. It’s a made up statistic. Your revenue and expenses last year were reported to the IRS and if you do it wrong you’re going to have problems.
So how do you actually make a useful forecast?
There are many factors here, but these are the core principles we operate on:
1) It all starts with accounting
We have a very high standard for accounting work. The reason for this is simple: garbage in, garbage out. It is impossible to do profitability and cash flow forecasting if the data you are starting with is inaccurate. In our experience most accounting teams lack experience in the nuances of both startups and government contracting, or at the very least lack the assertiveness required to get data from busy founders.
1a) Get your infrastructure right
Along the same lines as above, poorly designed accounting infrastructure leads to unnecessary time spent gathering and transforming data. By the time you raise your first dollar you should have an accounting system. It should be QBO. You should organize your chart of accounts so an income statement collapses to a neat structure showing Revenue, COGS, R&D, SG&A, Other income, Other expense.
If your accounting infrastructure doesn’t roll up to a simple parent structure similar to this, and isn’t organized by account codes, you need accounting help.
1b) You need accurate, up to date, financial data
After your infrastructure is in place, the key is to use it. You should be closing your books once a quarter at minimum. If you are forecasting more frequently than that you need to move to a monthly close. Your accounting team should be presenting financials to you, maybe with a few questions, and you should be analyzing the data to make sure it makes sense. Is your invoicing accurate? Are you missing vendor bills? How are your KPIs doing? What is Cash on hand? Cash burn? Gross Margin? Net operating? Net income? Are they going in the right direction? How close is reality to what you are forecasting?
There are lots of tools that make these easy to see in a report or dashboard view, and these can help foster important discussions with your accounting team such as: why is cash going down when revenue is growing so fast? Are our margins in the right place? What operational things should we change based on this data? It’s important to discuss these types of things regularly, and if your accounting team is just emailing you excel statements, you need to switch.
2) Know what type of forecast you’re making
Once accounting is in a good place, we can start looking forward. But before we start our forecasting there is a simple binary question we must ask ourselves: what type of forecast are we making, and for whom?
At its most basic there are two types of forecasts: those for internal use and management purposes, and those that live in borderline fairytale land that you show potential investors: i.e. an 18 month - 5 year pro-forma that shows the best possible outcome of what could happen if everything goes right.
These two forecasts are used quite differently. The internal one is used to manage cashflow / burn and make tactical short to mid-term decisions (e.g. how much can we pay this new hire). The other is creative storytelling and painting the picture of what could be. Know your audience and what they expect.
If you show “reality” to investors, they’ll likely discount it by at least half anyway, so to a certain extent you should be bold and paint the picture of “what if everything goes according to plan,” while making sure you can back into those numbers with a set of assumptions that are at least plausible.
This is the the first step of scenario planning. You should start with a baseline forecast based off the the most recent rolling 3 / 6 / 12 month actuals, which you use for operational decision making, and then build a target scenario on top which shows a rosier view of potential upside.
3) Technology is your friend
It is 2025. You have to use financial automation technology if you are going to be competitive. If you are manually doing forecasts in excel (and you are established enough to have a year’s worth of accounting data in a real accounting system) you’re doing it wrong. That statement will likely upset many people, but the amount of innovation in this space in the past 10 years is insane. We love Fathom and Ibex Consulting probably wouldn’t exist without it. We are constantly observing the product development in this space, and there has been an explosion of tools in the past 10 years such as Liveplan, Pry, Runway, Forecastr, Casual, Data Rails, and many others, but the scenario modeling, microforecasting, and report-creation features of Fathom make it the best in our eyes.
Regardless, all of these tools integrate directly with your accounting system and eliminate the QC needed for baseline / actuals, and they make building forecasts much faster and simpler. They also make scenario planning a breeze, which is very, very hard to do manually in excel. Scenario planning is key because early on there are many different paths your organization could take, and understanding the potential financial impact of those is a critical piece of decision making. Additionally, getting that data in as close to-real time as possible vs a few weeks later when the finance team has finished modeling it can be the difference between making a decision that kills the company and one that gets you to your next key milestone.
4) What kind of company are you building? What is the end goal?
The most important thing for co-founding teams to agree on at formation is the type of company you are building and the funding plan. Are you going to sell? If so, to whom? At what point? What items are most important to those acquirers? Many times strife in the executive team comes from disagreements here and they are often only uncovered in later years. At the very least, you need to agree whether you are building a high-growth tech company vs a small business and agree upon what success means to you. In other words, you should start with the end in mind and use your forecast to back your way into that goal.
E.G. the plan of:
“We are looking to be acquired by one of the three major players in our space, because our tool will open up an entire market segment they don’t have access to right now and will allow any of those three to cross sell against their existing tech portfolio. We’re targeting $80M+ exit post-series A without diluting the founding team more than 50%, and given what we see in the industry’s future we think a 12x EBITDA multiplier will probably be fair, so we should target around $7M EBITDA in year 5 or 6 to hit our exit goal”
is a much different long-term plan than more common refrains such as: “we plan to IPO” or “I want to run this business for the rest of my life and make a good living” or “profitability is irrelevant, it’s growth at all costs.”
There is a lot of nuance here to discuss especially between top-down vs. bottom up forecasting, but we’ll save that for another post.
5) There are only 6 items that determine whether you live or die, leave the rest to averages
Oftentimes, especially with engineering founders, forecasts can seem daunting because you’re striving for the same level of accuracy across every single account and it can feel like an overwhelming task to try and routinely forecast. A technical CEO once asked us for an edit to make R&D supplies and materials 3.75% of R&D salaries (it was a rolling 12 month average and ~5% in the first draft). The R&D supplies and materials account was less than 1.5% of total expenses. It’s a waste of time to focus on tiny tweaks like that. Generally, there are only 6 things that determine how your company performs financially:
1) Your revenue
2) The COGS associated with generating that revenue
3) Your people
4) Your professional fees (lawyers, accountants, marketing consultants, etc)
5) Capex purchases
6) Fundraising events
Forecast these accurately and you’ll be 98% of the way there. Leave everything else to a rolling 3 / 6 / 12 month average or a % formula. (Caveat: depending on your stage and industry marketing and advertising costs may be a big player as well, but these shouldn’t determine whether you live or die).
You should maintain a forecast from day one
Early on, forecasts are usually made for the purposes of fundraising, then put on a shelf and ignored until cash gets too tight and another fundraise is imminent. This is a poor strategy that can set you up for failure, especially as you progress past seed-stage. Even if you don’t have any revenue, you need to get in the practice of forecasting your expenses and cash position, reviewing what you thought was going to happen a quarter ago, and adjusting for future quarters as you learn more. Know that your forecast will always be wrong, and the most important thing is to get into the practice of explaining where the variance came from vs. getting every account perfect. If you get good at analyzing financial performance and explaining variance, you will not only naturally get better at forecasting, but you will understand your business to a level that most executives do not, improving your decision-making capabilities and increasing your chances of being part of that small fraction of a percent of founders that make real money.
Want to get help with forecasting and financial operations? Book a discovery call and let’s talk!