Business Plan Forecasting: Valuation Effects

The art of preparing forecasts in a business plan–and it is an art, not a science–involves the founder in a delicate balancing process. On the one hand, a forecast is a representation of a fact–the founder’s state of mind–and an intellectually honest founder will represent his state of mind accurately, for careless, let alone dishonest, preparations may involve liability. [1] On the other hand, the forecast is a critical element in the negotiation process. Thus, as one prominent source on business plan preparation has noted:

The entrepreneur should be careful to avoid negotiating in the business plan. For example, the entrepreneur who indicates he or she will sell 20 percent of the company for $200,000 has just established the upper end of the negotiating range. Sophisticated reviewers will realize that at worst they can acquire 20 percent of the venture for $200,000, and that they might be able to negotiate a better price. [2]

The problem is that the forecast is an “indication” of price and value since it drives valuation, even though the business plan says nothing about “20% for $200,000.” Potential investors, reading the forecast as an offer by the founder to value his company at a given number, will decode the standard language of venture capital valuation. Consequently, it would be ingenuous to prepare a forecast without at least knowing how the investment community will read it. To be sure, if the founder does nothing more than work backwards in the forecasting process, targeting the valuations he wishes to achieve and then filling in the forecast behind that number, he may have made less than a bona fide effort to be candid. Nonetheless, ignorance of how the audience will react to a forecast is not bliss in the venture universe.

The answer, then, is that the forecast should be prepared with two considerations in mind. It should represent the founder’s best thinking as to likely future events. But, at the same time, the founder should not close his eyes to what the consequences of his forecast will be; accordingly, he should at least understand how venture capitalists approach the forecasts in the context of the valuation process.

Most venture capitalists contemplate a five-year time horizon on the theory an exit strategy is feasible at the end of five years. Therefore, the founder’s forecast should go out as far as the investors are looking. [3] Depending upon the maturity of the company and the ability of its product to excite, an informed founder can usually estimate what kind of compounded rates of return the venture capitalists are looking at over a five-year period. If the founder “guesstimates” that the venture capitalist will be looking for a 38 percent compounded rate of return, a quick calculation shows the venture capitalist will be anticipating its investment will quintuple in five years. If the founder is planning to raise $250,000 from the venture capitalists, then the founder knows a forecast which shows anything less than $1 million in net after-tax earnings in year five will mean he has to surrender more than 12.5 percent of the company. To illustrate, the venture capitalist can then be counted on to multiply 1 million times a price/earnings multiple (and that usually is somewhere around 10 because, among other reasons, that number appears often in the marketplace and is easy to work with); once the venture capitalist comes up with a $10 million valuation, he will then calculate that his $250,000 should be worth $1.25 million in year five and find himself agreeing to take 12.5 percent of the company for $250,000 in year one if, and only if, he sees (and believes) forecast earnings of $1 million or more in year five.

A final word on this point. Borrowing from the speech of Kenneth Olson to the 1987 M.I.T. graduating class, [4] the forecast is both a prediction and a target. If you don’t shoot high, the Law of Self-fulfilling Prophecies dictates that you won’t reach high. Exuberance in preparing one’s forecast, if intellectually honest, is an integral part of a founder’s mental terrain.

Lest one get the impression that the previous discussion baldly suggests the forecast should come out exactly where the founder wants it to, it should be remembered that professional venture capital investors are not stupid. They will test the forecast and explore thoroughly the assumptions used, smoking out numbers that are intellectually dishonest or, to put it in the vernacular, do not pass the “red face” test. A very steep climb in earnings in some remote period, for example, will be suspect. Because it is easier to kibitz a forecast in the early years, a spike upward in year five, when anybody’s guess is as good as anybody else’s, will reveal itself as result-oriented. Moreover, an intellectually dishonest set of projections may provoke a negative reaction or outright rejection without further investigation. Furthermore, many investors view the forecast as a quasi-promise [5] by the founder, a representation that he proposes (albeit not legally bound) to make the forecast come true. The forecast is not so much a prediction of the future–five years is too long a time frame for precise predictions [6]–but an undertaking by the party in control to accomplish a given objective. Indeed, a confident forecast of summary results may become a critical issue in the financing negotiations. Experienced investors are accustomed to confront the founder with his rosy forecast, agree to a valuation based thereupon, and then insist that a system of penalties be institutionalized, taking equity away from the founder if and to the extent he fails to achieve the projections he authored. As elsewhere noted, most venture financing’s entail multiple rounds and, accordingly, are of the benchmark variety even if not explicitly so provided in the Purchase Agreement. The second-round investors, generally the same parties who invested in the first round, will be influenced in their pricing decision (in turn driving the founder’s dilution) by the founder’s record measured by the forecast. On occasion, the inability to meet an overly optimistic forecast may be the trigger for a control “flip”–ousting the founder from office.



[1] In the public venue, the case of Beecher v. Able, 374 F Supp. 341 (S.D.N.Y. 1974), suggests that the forecast must be based on facts that would lead one to conclude the results are “highly probable.” Id. at 348. The overall atmosphere has changed since that case was decided, spurred by the SEC’s more tolerant attitude toward forecasts and the Private Securities Litigation Reform Act.

[2] Siegel et al., The Arthur Young Business Plan Guide (1987). The art of forecasting is sometimes known as the “bull’s eye” theory. Under this theory, one shoots the arrow first and then paints the bull’s eye around the arrow wherever it happens to land.

[3] See generally Haslett & Smollen, Preparing A Business Plan, in Pratt’s Guide 31 (1994).

[4] Olson, Learning the Dangers of Success: The Education of an Entrepreneur, New York Times, July 19, 1987.

[5] See White, The Entrepreneur’s Manual: Business Start-Ups, Spin-Offs, and Innovative Management 147-48 (1977).

[6] In Regulation S-K, Item 10(b)(2), the SEC, while it “encourages” forecasts in public disclosure statements, appears to endorse the conventional view that long-term forecasts are misleading. The Commission is correct, of course, but that view is not apposite in a venture placement. The investors know the forecast results will not come true unless the founder somehow makes them come true.

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