Revenue and profit projections are a fact of life for entrepreneurs and business people. This post is not going to make them go away nor should it. If you are going to invest money – your own or an investors – in anything, both you and your investor need to have an understanding of what your return on investment (ROI) might be like. If your projected ROI is around what T-bills return but your risk of losing all the principal is significant, you’d clearly be better of if you did not waste your time. The US Government won’t pay you a lot to borrow your money – at least not for now – but it’s not all that likely that you’ll lose your invested principal either.
So what’s the problem with revenue projections?
As most anyone who has been associated with a mid to large company has experienced, “the plan” (and beating it month over month) is a kind of sacrosanct concept. Management teams and executives spend weeks, if not months, a year putting together elaborate spreadsheets – with 10s, if not 100s of assumptions/variables – that attempt to project where key metrics like revenue and profitability will be in a quarter, a year or five. Companies like GE were well regarded for always meeting or exceeding their projections and their stock price went up and up – consistently and predictably. Until they didn’t.
The problem with the revenue/profit/key metric projection business is that those metrics are lagging indicators. They are the effect – not the cause and you cannot control them directly. Companies that can control them directly are playing accounting games or worse. Managers and leaders who are rewarded based on their ability to predict the future – vs create the future – are being given huge incentives to either sandbag their numbers (create a number they know they can get above) or to play accounting games.
But yet misguided executives and boards at so many companies – and startups are not excluded from this – spend a large percentage of their board meeting time centered on the projections game. Why? Because it feels very official and very organized and disciplined and because it’s easy. It’s what you think business is supposed to look like. The professional manager CEO that the board hired to bring in “adult supervision” has his spreadsheet and his clipboard and presents well and confidently and the whole experience of being told what the future holds is very comforting which is fantastic since startups are inherently stressful and uncertain. For a VC board member who sits on 10 to 12 boards, he (it’s still rarely a she) can sleep well at night knowing that the CEO has got the numbers under control. Never mind that anyone can put any number they want into a financial model. “If sales go up 5% a quarter and costs come down 10% a quarter…” You get the point.
In a small company when the, needed, projections you sell yourself or your investors turn into a plan that needs to be hit month over month, quarter over quarter, you are subtly but surely creating strong incentives for the team to manage the results instead of the cause and also eliminating one of the major assets a smaller company has – it’s ability to react in near real time to the data it is collecting about how it’s plans are actually working. After all, reacting in real time means not hitting the short term plan.
Since small companies become big companies when they, first and foremost, excel at creating something that customers really want that they can’t get elsewhere, it’s critical to insure that management incentives are structured to encourage working on the cause of the numbers, not the effect. Further, it’s critical that the management structure acknowledges that trying to predict the future on a month by month or even quarter by quarter basis is a fools errand. When you consider that the effect of today’s actions (causes) don’t often show up in the results for months or years, this is particularly important to instill in a company’s culture very early on.
This does not contradict the importance of measuring the critical metrics in your business. Just be careful what you measure. Are you measuring the cause or the effect? Beware trying to manage the lagging indicators.
