I’ve been building financial models for startups for 10 years and still have not found a solution to the Catch-22. Even when we build a forecast as bottom-up as possible and using as much reasonable-ness as possible, there is still the perverse tendency to ramp up to somewhere near $100m in 5 years.

I think Joe’s comment hits it on the head– although most founders know such revenue ramps are pretty much fiction, selling this fiction at least buys the *possibility* of hitting the forecasts, whereas forecasting too low (and not getting funded) means the probability is automatically zero.

I also agree with you, Steve, that most models are built for an existing market curve, whereas most startups are really selling into a new market. But again, there is an underlying bias toward getting to cash flow breakeven within 2 or so years; if we truly modeled 4 years of Death Valley followed by a hockey stick ramp, most investors would hit the eject button pretty quick.

I do think many founders can do a better job of managing expectations early on– once you’ve got an investor hooked, there is usually a small window prior to closing the round– the ‘honeymoon period’ so to speak– to layer on the caveats (aka “are you sure you want to do this deal? keep in mind that….”).

The financial model can help in this regard, by putting some ranges around the downside risk– such as cumulative negative cash flow if sales ramp much slower or if we need to double marketing spend.

I’m working on an article for my blog seedstagecapital.com that will focus on financial modeling for startups– namely, how to bring reality to what is mostly an exercise in fantasy; I’ll post a follow up comment when it’s up.

Thanks again for a great post!

My advice tends to fall into a flow chart:
- Option 1, find VC’s who share the vision and understand market type. You may find out that your analysis of market type is wrong and investors may have a better insight.
- Option 2, get the money from VC’s that don’t get market type – but ensure that you do. Spend the time educating VC’s (rather than fighting with them.) Make them part of the solution, not the problem.
- Option 3, as in the example in the post, ignore the conflict between what you know in your heart it will take with what the plan you committed to. Deal with the consequences.

Your interests and the VC’s are aligned (at least to get liquidity) so most will be interested to work with you to get the right plan.

steve

Did you hit one of my hot buttons! I absolutely hate all the abuse that centers around the whole “tell them it’s a big market” thing. See my two recent posts:
http://www.thricearoundtheblock.com/2010/02/markets-are-fantasy-customers-are-real.html
and
http://www.thricearoundtheblock.com/2010/02/madeup-billion-dollar-markets-for-your.html

Thanks for the common sense wisdom.

I think the majority of startups figure out that unless they “get the money” they aren’t going anywhere anyway so they choose fighting it out at subsequent board meetings rather than never getting a second meeting during the fund raising process.

In other words, I suspect most Series A fund raises are “Catch 22″ affairs. The exception probably being “gold plated” entrepreneurs with amazing track records and the occasional “Google”-type idea combined with perceived very smart founder types.

Steve, if the company can’t get a VC to back the 5 year plan, would you advise the founders to go Catch 22 or start over with another new market product or an existing market product? (or keep looking?)