Let’s just start off by making one thing clear – almost no one understands how to forecast the future of a startup business. If anyone thinks there are these genius MBAs with some startup oracle of knowledge that are running stats and probabilities to get these scientific models for the future – they’re wrong!
Everyone guesses – and generally speaking – everyone guesses wrong. And that’s OK.
Startup finance is built around making a series of educated guesses about how things might go. We make assumptions for how much customers will pay for our product, how much it will cost us to acquire a paying customer, and how many times they will keep paying us over time.
We make all of those assumptions to get us started. Then we find out we’re totally wrong. Then we make more adjustments. Then those are wrong too. Then we keep adjusting until eventually, our numbers are right!
That’s precisely what we’re going to cover in this Phase. We’ll also demonstrate how just a few main assumptions (like the cost of acquiring a customer) are really all that matters.
In order to better understand assumptions, let’s look at an example.
If we assume that our average customer will pay $40 for our product, do we really know they will? Of course not! We probably haven’t even started our business, so right now we are just assuming $40 might be a correct number.
Think of assumptions as a placeholder value that we will use to begin building a forecast for our business. In most cases, our startup probably hasn’t been around long enough to know whether any of these values are accurate – and that’s OK.
For the time being, just know that all we need to build our first financial model is to know what the assumptions are and then make a reasonable guess as to what the values might be.
In the early years of a startup, we’ll spend more time forecasting our business than tracking our finances. That’s because in some cases we won’t even have a business launched quite yet and therefore we’re working on a theoretical forecast for what will happen when we finally do launch.
A financial forecast is just what we’d think it is – a guess about how the business might go.
Now of course, we’re freaked out that we’ll make bad assumptions and the forecast will be based on numbers we can never hit. Thereafter our startup spirals out of control and the entire planet gets struck by a giant meteor and we return to the era of the dinosaur! (I’m not really sure how dinosaurs get re-introduced to our biome in this scenario, but let’s just run with it Jurassic Park-style.)
The reason startups don’t understand forecasting is because they tend to think it’s based on information we have on hand right now. Forecasting isn’t intended to predict the future specifically. It’s intended to provide a working model to show us what happens when different assumptions we’ve made will change.
So, let’s just think of our future forecasting as a simple “if/then statement”. “If” our costs per product are too high “then” we’ll need to increase our retail price to maintain the same margin. Our forecasts are just us moving all these levers until we find the right balance of revenue and costs for our business.
Assumptions and Forecasts go together like peanut butter and chocolate. Like Run and DMC. Like Ninjas and Pirates. Like… well, point being – they work well together!
Our assumptions allow us to make really specific guesses about things like what a customer will pay or how much it will cost to produce the product. Our forecasts simply take those assumptions and calculate what will happen if those assumptions are true.
Here’s an example of where just 2 assumptions can tell us exactly how much revenue we can forecast per month:
“If” those assumptions are true “then”…
Forecast (automatically calculated): Each month we’ll add $400 in revenue. ($40 per sale multiplied by 10 customers)
Notice how we’re not “guessing” how much revenue we’re making each month. We’re making assumptions that lead to a forecast in revenue. By focusing our efforts on the assumptions (like how much the product will sell for our how many customers we acquire) we can let our forecasts simply be a calculation.
Once we learn how distilling our business into assumptions gets us closer and closer to numbers that we can actually understand and predict with more accuracy, this whole business of guessing starts to become a heck of a lot easier!
With that said, let’s first dig into how assumptions work, and then once we have a handle on that, let’s see how those assumptions can build a forecast for us.