The Bull's-Eye Theory Of Forecasting: Shoot High
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The art of preparing forecasts in a business plan–and it is an art, not a science. This preparation involves a delicate balancing process by the founder. 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. Indeed, careless, let alone dishonest, preparations may involve liability. On the other hand, the forecast is an element in the negotiation process about price.
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 percent 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 disingenuous 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.
Thus, most venture capitalists contemplate a five–year time horizon, on the theory that 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. 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. 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 his investment will quintuple in five years.
Investors expect a glamorous projection, following the classic "hockey stick" or "J curve" patterns. The current year is flat, a/k/a realistic, the next year elevated and then years 3, 4, 5 elevate close to the vertical. Those investors expect the "hockey stick" does not mean, however, they pay much attention to it. The absence of unbundled optimism would be, on the other hand, a negative.
Occasionally the investors will turn a hockey stick to their advantage. They propose a milestone deal. So much is invested, $500,000 at the pre–money stage and you as the Founder, want the next $500,000 in six months assuming you meet your predetermined numbers. If this is not the case, renegotiate.
A final word on this point; borrowing from the speech of Kenneth Olson to the 1987 M.I.T. graduating class, 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.