WHY FINANCIAL FORECASTING MATTERS FOR STARTUPS
Insights for Inventors and Tech Startup Founders
Technology startups need to be fast-moving, nimble companies that can respond quickly and adapt their approach to gain market traction. One of the key tools that enables them to confidently pivot when needed is rigorous financial forecasting.
Preparing a financial forecast forces a company leader to work through assumptions to understand the impact of different scenarios on financial performance. This is a foundational activity for all startups.
In this article, we explore why financial forecasting is so important, how it helps startups be successful, what is different for AgTech companies, and where to seek help.
What is Financial Forecasting?
Financial forecasting is the process of estimating future financial performance based on a set of assumptions. At the earliest stages, forecasting involves creating a financial model that can capture the key assumptions used to predict revenues, expenses and cash flows. It should be a numerical version of the business plan, and the two documents should match and support each other.
The process of thinking through assumptions that drive the proforma forecast model may also be useful for informing elements of the business plan such as product pricing or a subscription vs. one-time-payment revenue model.
What Financial Forecasting is Not
A forecast is not a budget. A budget is usually a one-year financial plan designed to guide operations and expenses in the near term. A budget that reflects the latest learnings is essential for managing cash flow and avoiding cash shortages.
A forecast is a forward-looking three-to-five-year projection of fiscal performance. This will be a very helpful tool for setting and refining the budget, but it is important to recognize they are different.
Financial forecasts are not perfect predictions of the future. In the real world, things will always progress differently than expected.
Financial Forecasts Help Inform Growth Strategies
Startups need to develop effective growth strategies to succeed in highly competitive and rapidly evolving markets. Forecasting helps you evaluate different strategies, test viability, evaluate risks and optimize outcomes.
For example, forecasting can help companies assess the financial impact of expanding their product lines, entering new markets, or increasing marketing and advertising spending. Forecasting also helps an organization plan its recruitment strategy.
Financial Forecasts Help with Risk Management
Startups face significant uncertainty in their early stages. Forecasting helps companies identify potential risks, test the impact on their financial performance and develop strategies to mitigate those risks. By forecasting revenues and expenses under different scenarios, companies can prepare for unexpected events and make informed decisions about how to respond to market conditions.
What is Different for AgTech?
AgTech startups face unique factors, which make financial forecasting even more important. These factors include seasonality, weather, biological variability and commodity price risk. They can create narrow logistical windows for important business activities, such as product development, field testing and sales.
These timing limitations directly affect cash flow, which is critical for startups. Financial forecasting can help AgTech startups understand the impact of these factors on operations and financial performance.
Forecasts Help with Valuation and Raising Capital
Valuing a startup is a complex process that is largely based on the company’s expected future financial performance.
Forecasts show potential investors, in detail, which market opportunity and risk factors the management team have considered and the associated assumptions they made. This detail makes investor conversations more objective, rather than leaving investors to make gut-feel decisions about the opportunity.
A thoughtful, well-prepared financial forecast helps startups demonstrate that there is a solid plan for generating revenues, managing expenses, and eventually achieving profitability.
Improving investor confidence can increase the startup’s valuation and improve its negotiating position. Through their forecast, startups show investors how they plan to use the capital raised to grow the business and increase shareholder value.
Best Practices for Financial Forecasting
Forecasting is as much art as it is science, but here are some best practices to consider when forecasting for startups:
- Quantify the Opportunity with a Top-Down Approach: A top-down approach can be valuable to highlight the overall market opportunity. This starts with quantifying the Total Addressable Market (TAM), then identifying the Serviceable Addressable Market (SAM), then the Serviceable Obtainable Market (SOM) within that.
- Bottom-Up Approach for Revenue: When it comes to forecasting revenue, many startups take a top-down approach, starting with overall revenue based on the market size and working down to expenses. However, this approach can be challenging as early-stage startups may not have a clear understanding of their market share potential. Instead, it may be more effective to use a bottom-up approach, starting with specific business models and revenue streams, then working up to overall revenue. The bottom-up forecast should validate that the top-down SOM is achievable, by executing the tangible steps outlined in the business plan and the forecast.
- Use Multiple Forecasting Methods: There are many different forecasting methods that can be used and it is often best to use multiple methods. For example, a startup might use a top-down approach to forecast overall revenue potential, a bottom-up approach to forecast revenue from specific products or services, and regression analysis to forecast expenses. By using multiple methods, startups can take advantage of the strengths of each approach and create a more comprehensive financial model.
- Be Conservative with Projections: Early-stage startups often have ambitious projections, but it’s important to be realistic when forecasting a financial outlook. Overly optimistic projections can make it challenging to secure funding and can lead to disappointment if financial performance falls short of expectations. To create more realistic projections, startups should take a conservative approach. This means assuming that revenue will grow more slowly than hoped and that expenses will be higher than expected. Because of the seasonality of revenue streams for some AgTech startups, over-estimating revenue during a short annual window of opportunity could set the company up to run out of money to pay expenses for the rest of the year.
- Regularly Review and Update Forecasts: Forecasting is not a one-time project. For the forecast to be effective, it needs to be reviewed and updated to ensure that it reflects the latest market conditions and business realities. This may mean adapting with new business models and pricing options and making adjustments to expenses in response to actual revenues. Regularly updating the forecast can help startups stay on top of these changes and make informed decisions about the future of the business. Typically, startups will update their cash flow forecasts at least quarterly in conjunction with board meetings, while operating budgets are usually refreshed annually.
- Seek Input from Industry Experts: Creating a thorough and well-constructed forecast requires a solid understanding of the market and industry dynamics. Startups should seek input from industry experts, such as advisors, investors, and potential customers, to gain a more comprehensive view of the market. Industry experts can provide insights into market trends, customer needs, and the competitive landscape that can inform the financial forecast. They can also help startups identify potential risks and opportunities that might not be apparent from the financial data alone.
Risks of Not Adequately Forecasting
Not putting enough effort into financial forecasting will expose a startup to real risks, which can significantly impact its ability to grow and succeed.
To be blunt, companies fail when they run out of cash. The risk of a cash crunch increases significantly if management does not understand their cash inflows and outflows.
In many startups, revenues from sales are insufficient to cover operating costs. This makes the risk of miscalculating the cash runway of utmost importance for planning expenditures and raising capital.
Inadequate or poor forecasting can limit a company’s ability to secure funding. Investors look for robust financial projections that demonstrate the company’s management have carefully thought through the business model, revenue potential and costs. If this has not been done, investors will downgrade the opportunity.
Overpromising company performance is also a red flag to investors. If a startup initially provides overly optimistic projections but fails to meet them, it can erode investor confidence and damage the startup’s reputation. Investors will look favourably on companies that present financial metrics that they truly believe they are able to deliver.
Quantifying Opportunity Costs
Effective forecasting helps identify potential growth opportunities and quantifies the resources needed to seize them.
Without a clear financial picture, a startup may not pursue expansion opportunities, enter new markets, or invest in product innovation out of fear. Whereas a solid financial model supports informed decision-making as to what is achievable.
Support is Available
While financial forecasting is a skill that requires specific expertise, there is support available for investors and startups.
If you’ve developed technology and are preparing to commercialize it, consider seeking the support of an incubator or accelerator program. These programs will help you build a solid financial model that will hold up to investor scrutiny.
If you are an inventor, another option is to seek the support of a venture studio like Carrot Ventures to commercialize your technology. Carrot Ventures forms and funds AgTech startups with the goal of creating commercial success and value for founders and investors.
Carrot Ventures provides substantial support to the CEOs of our newly-formed portfolio companies, and this includes helping them build and prepare a forecast model.
A startup formed by Carrot Ventures will have the benefit of professional-level financial forecasting that will greatly enhance its ability to plan, operate, and raise capital to support growth.
Carrot Ventures provides foundational support to portfolio companies. This includes engaged governance, and hands on experience to build the right processes and financial controls.
If you developed an agricultural technology with significant market potential and would like to learn more about Carrot Ventures, contact us to discuss your innovation.
