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Tuesday, June 28, 2011

Using reasonable business plan assumptions is critical - Published in the SB News Press in May of 2011

The process of writing a high-quality, effective business plan involves many key steps.  Throughout the process, the writer must make numerous assumptions about the future needs and performance of the company.  Often, business owners feeling optimistic about the prospects for their business, and make optimistic assumptions that may be unrealistic.  Even one unrealistic assumption can stop a potential investor or lender in their tracks, resulting in a lost opportunity for the business owner to secure the funding they need.

There are multiple reasons for an entrepreneur to write a business plan.  Securing funding for a startup or business expansion certainly requires a top-quality, professionally written plan.  Often writing a plan is a means by which the entrepreneur can decide if the business concept is financially viable.  Another reason for having a good plan is to secure a long-term lease.  Still another reason is to examine the current operations of the business to determine why the business is not achieving targets, or to identify opportunities for improvement.  The structure of the plan can change, depending on the purpose of the plan.  To a limited extent, the assumptions used in the plan will vary, depending on the purpose of the plan.

One way to organize assumptions is to divide them into two broad categories—revenue assumptions and expense assumptions.  Within revenue assumptions, the business owner needs to determine all of the possible revenue drivers the business will have, not just today, but into the future.  A good business plan will contain a financial model with at least 3 years of pro-forma statements and supporting tables, and preferably 5 years of data.  If using a 5-year pro-forma, the entrepreneur should spend some time thinking-through the coming five years to determine all of the potential revenue producing activities of the business he or she expects during that time-frame. 

Once all revenue drivers have been identified, each can be projected using a detailed revenue model.  This is where the assumptions come into play.  For each revenue driver, the entrepreneur must determine when the specific revenue source will begin to produce sales.  Next, the magnitude of those sales, as well as a reasonable growth rate, must be assumed.  Using a spreadsheet program, such as Excel, the business owner must then project the estimated revenues from that source for the coming 5 years.  While using annual assumptions and estimates is adequate in some instances, a monthly or at least quarterly pro-forma is much preferred. 

Once each and every potential revenue driver has been evaluated, specific assumptions have been identified for each, and each has been modeled for the entire five-year period, a complete revenue model can be created using the spreadsheet program.  I find it very helpful and time-saving to take the time to write formulas into the spreadsheet so that, if I need to make adjustments to my assumptions later, I can simply change the assumptions, and don’t have to completely recreate the spreadsheet from scratch.  I do this by creating a “Drivers” page, which contains all of my assumptions on one page, and then I write my formulas referencing those drivers.  Then, if any changes are needed (and there are always changes needed), I can simply go to the drivers page and change the assumptions; automatically updating all of my pro-formas.

Using at least quarterly estimates, and preferably monthly estimates, offers some significant benefits and realism to your pro-formas.  First, you may have a business that experiences seasonality.  For example, if you are in Santa Barbara, and your business caters to tourists, you will likely experience more sales during the summer months than during winter.  If this is the case, you will definitely want to create a monthly revenue model that accurately reflects these fluctuations in your revenues.  Most businesses have at least some fixed costs, so if revenues fluctuate and costs remain fixed, cash flow can get strained.  Investors and lenders will want to know that you have taken this into account, and that your financials reflect this reality.

A second and equally important reason to use a more detailed financial projection is to show the monthly assumed growth in revenues.  Most businesses, and especially startups, will experience rapid growth on a monthly basis during their first few years of operations (at least we hope this will be the case).  It is difficult if not impossible to accurately reflect growth using only annual projections.  At a minimum, the reader will not get a true sense of the pace of growth from reviewing solely the annual projections.  While we want our plan to accurately reflect growth on a realistic basis, we also want to convey the excitement of the growth of the business to potential investors and lenders.

Once revenues have been accurately modeled, based on realistic assumptions, we can move on to expenses.  This is a much broader category because it includes not just operating expenses, but also your start-up costs as well, if the business is new.  (If expanding a business, there will be upfront costs associated with the expansion as well.)

For a startup or expansion, some of the expenses to keep in mind are equipment costs, construction costs, initial inventory costs, hiring costs, initial lease or building purchase costs including deposits, licenses, permits, broker fees, etc.  For each of these costs, the business owner can usually get accurate estimates either from quotes obtained from suppliers, sellers, vendors, brokers, etc., or from doing some fairly simple research in the local market where the business will be located.  For Internet-based businesses, or businesses that will have a web presence, there will typically be website development expenses, domain name acquisition costs, etc.

Ongoing operating expenses include your cost of goods sold (COGS), labor costs, payroll services, payroll taxes, sales taxes, consumption taxes, rent, utilities, property maintenance costs such as CAMs (Common Area Maintenance), credit card processing fees, marketing expenses, professional fees, website hosting and maintenance, and marketing costs, insurance, security costs, depreciation/amortization, supplies, miscellaneous expenses, taxes, etc.  For each of these, the entrepreneur must make key assumptions for the entire 5-year period.  Typically as volumes increase, COGS and some other costs, will come down somewhat, so it is important to include efficiency gains in your model.  Taxes must include your effective tax rate for both federal and state taxes.  You may also have other taxes and/or fees associated with doing business in other states or countries.  If your business will show losses for some time up-front, the tax-loss carry-forward should be included in the model.

As mentioned above, seasonality and growth rates must be consistently modeled throughout the financials, so any impact that these factors have on expenses must be accurately and completely modeled within the financials, with proper assumptions for each.  Only by making appropriate assumptions and modeling all revenues and expenses on a monthly basis will the business plan truly reflect the potential performance of the business for the reader.

The final, but equally important point is to provide a thorough, detailed explanation of all assumptions used in the financial model and plan overall.  Do not assume that the reader will understand anything about GAAP accounting principles, industry norms, local operating conditions, etc.  Lay everything out for the least common denominator reader.  I always assume the reader doesn’t know anything about the business and has weak financial and accounting skills at best.  It is better to be safe than sorry.  First impressions, when it comes to investors and lenders, are everything.  Put your best foot forward by providing a detailed, well-conceived, accurate financial model and complete business plan, based on realistic assumptions that are appropriate for the business, industry, operating environment, and current economic conditions, and you will have the best possible chance to secure funding, and to build your business to success!

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