How founders can avoid presenting ‘laughable’ sales forecasts to VCs

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This article is part of Tech in Asia’s partnership with SOSV, where we publish articles that feature the firm’s valuable insights. For more articles in this series, go here.

Let’s say you are an entrepreneur thinking about raising money from VCs. To do that, you need to create a financial forecast to help prove the scalability of your idea. That financial forecast will likely end up as a slide in the investor presentation you’ll send to potential VCs.

The ironic, circular-reasoning-ridden truth behind these projections is that the VCs know that the forecasts mean absolutely nothing. Sometimes, the numbers we are presented with are downright laughable. So, how can an early-stage startup get this part right?

What not to do

Among the 100+ startups I’ve advised on sales forecasts, I’ve seen the same incorrect assumption made on nearly every teams’ first pass.

Do not use a top-down approach. The top-down method takes an existing known market size and assumes a projected percent penetration of that market and grows that rate. Voila! Sales forecast done.

Here is an example:

There are many variations of this approach, and most teams add substantial amounts of detail to get to what are essentially massively inflated market penetration rates.

The justifications startups often use for employing this method are:

• Using primary research data to assume purchase intention: A founder asked 10 factory owners if they would be interested in purchasing a new industrial robot. Five said yes, leading to a 50 percent market penetration rate.
• Using market segmentation data to justify a percent range: 20 percent of the market for a certain consumer electronics product are young males. A certain product is targeted at exactly that demographic, so it should be fair to assume that, in five years, a 25 percent penetration rate of this market is a fair estimate.
• Using “comp” (competitor) penetration rates: When [fill in the blank] major company first launched, they had 1 percent of the market, and it grew to 10 percent in 5 years. A startup plans to follow a similar trajectory.

To further illustrate this problem, recognize that most startups want to solve major problems that are associated with large market sizes. For example, the market for headphones in the US is projected to be US$4 billion in 2018. If a startup assumes a market penetration rate of 1 percent in the first year of sales based on one of the above methods, that’s US$40 million.

Let’s say a team does the math and agrees that this is too high, so they arbitrarily deflate the estimate to 0.1 percent penetration rate in year one. Now, we’re at US$4 million using almost no logic. Applying a yearly growth rate to the year one sales estimate further compounds the problem.

What to do