0.7.10: The Bull's-Eye Theory Of Forecasting: Shoot High

Contributing Editor: Joseph W. Bartlett of Sullivan & Worcester LLP

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. Indeed, careless, let alone dishonest, preparations may involve liability. On the other hand, the forecast is a critical element in the negotiation process. Thus, as one prominent source on business-plan preparation (the Arthur Young Business Plan Guide) 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.

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 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.

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. If, to reverse the example used in chapter 3, 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. If the founder is planning to raise $250,000 from the venture capitalists, then the founder knows a forecast that shows anything less than $1 million in net after-tax earnings in Year 5 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 one million times a price/earnings multiple (and that may be somewhere around 10, because, among other reasons, that number historically has often been seen 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 5 and find himself agreeing to take 12.5 percent of the company for $250,000 in Year 1 if and only if he sees (and believes) forecast earnings of $1 million or more in Year 5.

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.