This article, co-authored by Simon Pearson, Anna Faelten and Thomas Buggé from EY’s TMT Corporate Finance team, takes a look at how tech entrepreneurs can work towards a successful exit from the ‘get go’.
The Art of Forecasting
Your Business Plan Forecast is key to a successful exit: how to get it right
Forecasting is notoriously challenging, whether harvesting and analysing data for weather forecasts or guiding the markets as the CFO of a listed company. To many it can feel like evaluating the myriad of real-world variables impacting the business is a futile task, and so just the mention of a budget is often met with a resounding groan.
One can’t expect reality to match a Business Plan, but recognise that the discipline of creating it can help focus on what will drive future success. For fast growing businesses, the process of forecasting is an invaluable tool both for internal management and as the business approaches an exit.
- Why is forecasting important?
Forecasting as a management tool
Setting forecasts forces a business to understand and track the right KPIs (Key Performance Indicators) – the drivers impacting growth, cash-flows and eventually value. Assessing performance trends at this more granular level, allows a business to spot issues or out-performance on a continuous basis and use this insight to manage the business.
Going through the iterative process of forecasting and tracking performance should help you make correct decisions quicker and drive growth faster.
The value to prospective investors
As businesses consider an exit or fundraising, granular forecasts are a fundamental requirement for prospective buyers or investors. Where there are gaps in logic an investor will draw their own conclusions, typically adopting a conservative stance and this may impact value.
Andersen introduces Alexa-integrated voice controlled EV charger
Forecasts are important to an investor to support the ‘equity story’ of the business. Explaining the market, product fit and unique proposition are all key, but in the end investors are focused on numbers, so it is important to translate this into revenues and cash flows. Investors will perform detailed due diligence on businesses’ financials, analysing historical trends of KPIs as well as market benchmarks in order to critique the forecasts. Where there is a divergence, explanations should be prepared or investors may scrutinise plans.
- How to put together your forecasts
- Historical vs. Forecast
The essence of a forecast is to present what drives the business in the real-world: what drives top line, what levers can management use to achieve this, and how does this flow through to profitability and cash flows. When it comes to making assumptions around key revenue and cost drivers, a useful starting point can be a ‘roll-forward’ of the historical levels achieved, providing a logical provenance for any assumptions. Alongside this process you should sense-check these numbers against peers or market metrics, perhaps adjusting for the maturity profile of your business (as the business matures revenue growth rates may slow down, but margins may improve through economies of scale).
Naturally, as the business evolves through its life cycle, there may be acceleration or inflexion points where historical data does not support the forecast. At these points the detail of what is driving those divergences need even greater explanation and reasoned analysis.
For example, a subscription business may go through an initial phase of losses before forecasting healthy profits; to explain this transition you may need to look at ‘unit economics’ and prove the lifetime profitability of each client you win at a granular level in order to demonstrate the long-term profitability of the business as a whole.
eRDS launches COBie-compliant cloud-based software
- Bottom-up vs. Top-down
Next, to produce the level of granularity required to generate a valuable end product, most forecasts will require an initial ‘bottom-up’ approach, perhaps driving revenues from quantity and price levels, and growing the cost base from the envisaged direct costs, staff numbers and other overheads required to support the expected revenue growth. This necessitates assumptions around key drivers of top-line growth and profitability, notably:
- Sales drivers (consumption trends, direct vs. indirect channel growth, average spend per customer etc.)
- Future price movements
- Direct cost inflation
- Consider the sensitivity of your costs and revenues to FX movements
- Employee numbers, sales force productivity and evolving remuneration structures
- Stepped changes in fixed cost variables like office space expansion, IT infrastructure upgrade etc.
But having built a detailed bottom-up model, applying a ‘top-down’ lens provides an invaluable sense-check. This can be done in a numbers of ways, leveraging market reports and sector benchmarks across various KPIs:
- Revenue growth rates compared with market growth
- Direct cost growth assumptions against macroeconomic variables like inflation
- Average cost per employee relative to similar sized businesses in your industry
- Long-term EBITDA margins relative to peer group companies
- EBITDA to cash conversion ratio relative to peers (do you show correct capex and working capital cycles?)
- Reasonable effective tax rates assumed in cash flows
- Make the forecast flexible
Given any forecast is going to evolve over time to become a core tool for future performance monitoring, ensuring that the key assumptions made are able to be ‘sensitised’ or updated in new iterations, will reduce the amount of time and effort required to refine the forecasts as the business develops.
What we really mean by this (from a practical perspective) is clearly identifying input assumptions (e.g. consolidating onto a single tab in excel) and ensuring forecast values drive directly from these, such that a quick review and refresh of these assumptions is all that is needed to update the model.
FSB report assesses FinTech developments and potential
- Optimistic and realistic
Any business plan forecast should be aspirational but achievable. For internal budgets this can be crucial in incentivising employees with performance related bonuses or options.
When approaching an exit it can be tempting to inflate expectations to drive up value, but remember a sale process can take some time and your trading KPIs may expose you during diligence if you’ve been a little too audacious. Where a disconnect develops between the buyer’s diligence findings and the vendor’s projections you may face an ‘earn-out’ structure, where a portion of the deal value is held back in the form of performance linked payments one-to-three years after the transaction. Or at worst all buyers can lose faith in the management team and a deal may abort.
Once you have produced your forecasts, incorporating the points above, some worthwhile ‘commercial sense-checks’ for almost any business include the following:
- Can you support your customer acquisition cost based on the numbers presented?
- What is the cost to serve a typical customer in your forecast?
- Which costs are truly variable and which are largely fixed – have these been modelled correctly?
- Are the ‘unknowns’ (e.g. new product/service launch, or geographical expansion) supported by a track record of successful delivery or a detailed execution plan?
- Finally, for every line item in your forecast, ask yourself “can I support it with data, either from the broader market, or my trading to date”?
Taking the time to build a detailed business forecast remains at the heart of preparing any business for a successful exit. So develop it over time, benchmark actual performance against it and use this to refine your approach and methodology.
As future articles will illustrate, once the M&A process begins, time spent preparing data on the fundamentals of the business for diligence will feel increasingly valuable!