FINANCIAL MODELING: FORECASTING REVENUE 101
Envol Capital has worked with founders and executives of mature companies that are seeking an exit or growth funding and we've also worked with start-up’s seeking seed capital. No matter what our object or the size of the company we always analyze, in detail, the growth projections and in particular the revenue forecast. We are meticulous when it comes to forecasting revenue and make it a focal point of our analysis when working with a partner. But, forecasting revenue for a start-up can be more art than science. Building a forecast for mature companies however, can be tedious, complicated and protracted. The following summary describes our initial approach to forecasting revenue during the preliminary pre-engagement agreement phase with our clients.
There are usually multiple revenue streams for a business and the executive team is our best source for understanding each stream. We often help start-ups better define their monetization strategy during this phase and provide valuable feedback on Cost of Goods Sold (“COGS”) related to the service or product offered. Our financial analysts work with the company’s executives to understand their growth strategy and what they feel is required to achieve their forecasted objectives. We separate revenue streams into three distinct buckets and our forecast method can be very different depending on the revenue type.
· Recurring or Service Revenue – Recurring revenue is when a business offers a subscription or ongoing fee for a service or product. A good example of this would be Netflix or a car lease.
· Consumable’s or Product Revenue – Consumables revenue is when there is a product that is sold only once to a customer and there is no recurring revenue. A cup of coffee would be a consumable revenue stream.
· Contract Revenue – This is a revenue stream most often associated with the construction industry. A good example would be the construction of a building or manufacturing plant that produces parts on a contract basis.
A company can have revenue streams that fall into different buckets. We have worked with IT companies that have Service Level Agreement (“SLA”) contracts with clients and also work on one off short-term projects; different revenue types can utilize contrasting resources and expenses. The key to forecasting revenue for any company, large or small, is to understand the COGS, price per unit, product or service provided, turnover rate (inventory, service or clients), key growth/sales channels and external market conditions.
Once we have a thorough understanding of the company, market conditions and all the information above, we can start building the revenue forecast. A lot of variable expenses are associated with sales forecasted and a good portion of the P&L will be linked to the forecasted sales. Financial analysts will sometimes start with the expenses to understand the company and sales; they pay particular attention to variable expenses linked to revenue. Envol Capital focuses on revenue streams and the market first so we can understand what the company sells, who’s buying their product or service, and market conditions. We reverse engineer based on the revenue to calculate COGS and other variable costs associated.
The revenue forecast and associated expenses are the corner stones of building an accurate financial model. We have worked with clients that have realized after our analysis that their monetization strategy is not sustainable, helped them change and avert loses in the long run. Remember, if a company forecasts they can generate $100 million in revenue but they have negative 10% income that means their paying $110 million to generate $100 million in revenue. Simply asking the right questions can uncover weaknesses, threats, opportunities and avoid potential loses.
Last but not least, the revenue forecast is key to building the financial statements and it’s important to understand how to company recognizes revenue, promotions or discounts allocated and they follow Generally Accepted Accounting Principles (“GAAP”). The best revenue forecast will fall apart if you don’t recognize it properly on financial statements or fail to understand the cash position, which could lead to a cash shortage or even criminal charges. Envol Capital works with CPA’s that have Big 4 experience and understand our methodology to ensure accuracy and compliance.
Our overall goal is to focus on the company’s ability to generate a profit, their ability scale quickly, involve the executives at each step and build a realistic forecast. We believe it’s best to keep things simple and thoroughly understand the sales process. Our initial projections and preliminary financial model builds the framework for the in-depth and detailed forecasts that add immense value to the organization when fundraising or structuring an exit.