Writing a financial forecast is probably one of the least exciting tasks in the early days of your startup, but unfortunately it’s a necessity – if you want to raise capital, you’ll need a solid business plan with a set of realistic projections that you can stand up and present to investors.
Unfortunately, a lot of people struggle with this and get it very wrong. I’ve seen countless pitches with financial projections that are completely insane. I’ve even delivered a few of them myself:
Many forecasts are produced by plucking a revenue figure for the first year out of thin air and then applying a multiplier to this for the next 3 years before constructing a believable story about what is going to drive this growth.
Year 1 Year 2 Year 3 Revenue £100k £300k £1m
While producing an accurate set of figures can seem like a black art, fortunately there is a relatively easy formula you can apply to produce a realistic set of projections for your business.
The Magic Formula
At the very heart of your financial forecast are two key metrics and the following formula:
marketing spend / customer acquisition cost * customer lifetime value
This will drive your yearly revenue projections and also determine how much money you need to raise in order to allocate the correct marketing budget to achieve your targets.
Let’s break this down and explain each part of the formula.
What is my Customer Acquisition Cost (CAC)?
This is the amount of cash you need to spend to acquire a new customer, calculated using:
marketing spend / number of signups
You run an Adwords campaign to promote your business on the Google search results page and you pay a small fee every time someone clicks your ad.
You then need to calculate how many clicks it takes before someone signs up (conversion rate) and then work out how much it costs for each new signup.
- You spend £200 on an Adwords campaign that costs £1 per click
- This generates 200 clickthroughs to your homepage
- 6 people sign up and start paying for your service
From this simple experiment, you now know that:
- You have a 3% conversion rate (6 signups / 200 clicks)
- Your customer acquisition cost is £33.3 (£200 / 6 signups)
It’s likely that you’ll acquire customers through multiple marketing channels, so you need to calculate the customer acquisition cost for each of these channels independently using the same formula.
Why? Because the cost of getting a customer in each channel will vary; the CAC through Adwords is likely to be more expensive than Twitter.
So now you have the first important metric, we just need to calculate one more.
What is my Customer Lifetime Value (CLV)?
This is how much revenue your average customer will generate over the total length of time they will use your product or service.
For a typical SaaS business, this is relatively easy to calculate.
If you charge a subscription of £10 per month for your service and on average a customer stays with you for 2 years:
£10 x 24 months = £240 CLV
Building The Projections
OK, so now we’re armed with the two metrics that will drive the output of your financial forecasts (revenue projections). Now you just need the input values (marketing budget) for each year of your projections.
Let’s say you’re raising a seed investment of £300k and you’re going to spend £150k of this on marketing in the first year.
We can use our formula to calculate the first 2 years of revenue based on our first annual marketing budget (remember, our CLV spans 2 years).
marketing spend / customer acquisition cost * customer lifetime value
£150k / £33.3 * £240 = £1,081,200 revenue over 2 years.
At £33.3 to acquire each new customer, your £150,000 marketing budget will buy you 4,505 customers who will each generate £240 of revenue over two years, totaling just over £1m.
Next, we need to apply the same formula for Year 2 and add the result to the £540k (£1m / 2 years) to produce the second year projections.
Remember – our average customer lifetime is 24 months so the customers aquired in year 1 will still generate revenue in year 2 as well as the revenue generated by new customers.
Year 1 Year 2 Year 3 Marketing Budget £150k £500k £1m Revenue £540k £2.3m £5.9m
You can then replicate this across Years 3, 4 and 5.
This is a very simple example and your business is probably more complex than this. For example, you might have multiple pricing tiers; for this you can either calculate the overall average or split the projections into multiple tiers for more accuracy.
Of course, no-one can predict the future and you might not hit your projections (hopefully you exceed them!) but with this approach you have a much more realistic and meaningful set of numbers that can be easily explained.
But I’m a startup and I don’t have any paying customers yet?
I know what you’re thinking – all this sounds great when you have an existing marketing budget and paying customers, but how can this be applied to an early stage startup?
While it will be difficult to establish an accurate CAC and CLV in the early stages of your business, there are small experiments you can do to help with this.
I’m a firm believer that before you even begin to build a product, you should test your idea by running a basic marketing campaign.
You can do this relatively easy with a basic one page website that explains your product and has a form to collect email addresses.
You can then run a small £500 marketing campaign and test out different channels to drive traffic to the website and calculate your conversion rate and the CAC based on the number of people who register their interest.
Calculating the CLV will be impossible until you have some people using your product and you can determine the average length of time they remain engaged, but you can make an assumption on this – just don't be too optimistic.
You're No Mystic Meg
While these numbers will enevidbly change as your business develops, having a set of projections that you have tested and qualified through this process is a much better approach than applying guesswork.
Performing this exercise as soon as possible will also help you properly validate your business model. In the previous example, we calculated that the average customer will produce £240 over their two year lifespan with your product. If it costs you £300 to acquire this customer, then it’s indicative that you have a flaw in your business model.
Always Seek Professional Advice
If finance isn’t your strong point (it certainly isn’t mine) then it’s always a good idea to get some secondary professional advice, especially if you’re raising investment – you'll want to make sure your projections add up properly and there’s no room for anyone to pick holes in them.
Having an experienced financial consultant help you with your projections is a solid investment, this is one of the elements of your business you can’t afford to get wrong.
I highly recommend the team at Nuvem 9, who specialise in startup finance, or your accountant should be able to help you out.
Download the Free Excel Template
To assist you develop your high level projections, I've included a free Excel spreadsheet with formulas included to help you.
Disclaimer: This is not a financial model that you should send to an investor, it's a tool to help you determine your high level revenue projections which you can use to build your detailed financial model, or take to your financial advisor for further help.