The Numbers Dance

dancing.gifOne of the most useful skills as an entrepreneur is number crunching. If there is one thing about numbers that I’ve learned over the years, it is that I can make them sing whatever song I deem fit. Numbers are like rules – they are meant to be pushed.

For example: My blog gets a few thousand unique visitors a month. Not bad for a niche business blog, but I’m certainly not going to feed my family by blogging (nor would I want to – how boring). My blog is a fun, yet professional diversion, but lets face it, the traffic is relatively low.

However, did you know that statistically speaking, this blog is currently ranked in the top 1% of all of the blogs on the Internet according to Technorati? Yep!

Of course, my actual ranking is around #39,000 (at the time of this writing). But, since Technorati tracks over 51.5M blogs, that puts me squarely in the top 1%! But “Top 1%” sounds a heck of a lot better than “#39,000” :)

One of the things that entrepreneurs have to master is the art of spinning numbers.

Typically, when approaching an investor, you’ll hand them a 1 or 2 page executive summary of your idea or business. The believability of that document will hopefully lead you to the next step, which usually involves a 20-30 minute “pitch” of your idea or business. Hopefully, of course, you will continue down the path of capital glory by entering due diligence, and reaching a climactic ending with a term sheet. However, it all starts with that 1 or 2 pager.

I recently handed our one page executive summary to a potential investor. This person commented that our financial projections were “probably unachievable. ” I looked him in the eye and asked him what numbers he’d like to see instead? He was caught by surprise a bit. He told me that “numbers didn’t work that way – that there had to be a model behind it.” Of course, there was a model behind those numbers – they just didn’t add up to something he liked, or something he thought was sane.

I told him that I could make the numbers look like whatever he wanted to see. “Hell, I’ll even give you an inch-thick spreadsheet model that justifies those new numbers. It doesn’t matter at the end of the day – neither one of us knows how this business will ultimately perform. What do you want to see for revenues on this one pager? I can promise you that I can not only show those numbers, but I can defend them. So what will it take to end this silly charade so we can get to talking about my venture?” :D

The next day, I handed that same document to another investor. This person thought those same numbers were very conservative, and probably undervalued the company, given the market we are in, and our approach to addressing it.

Welcome to the world of subjectivity.

At the end of the day, it is a complete toss-up, as every investor is going to have their own pet peeves about your numbers. However, here are a few basic tips for you, or at a minimum, some things to keep in mind:

1. Close the gap: If your top line revenue after 4 years is $50M, and your operating expenses are $2M, this is going to be a red flag. That would be an EBIT of over 90%, which would make you the most brilliant businessperson to ever grace humankind. This tells the investor that either you are grossly overestimating your revenues, or wholly underestimating your expenses. Take a hard look at the assumptions in your model. You need to close this gap. You also have to keep in mind that investors are most likely going to apply the “rule of twos” to your model. They will divide your revenue projects in half, and double your expenses. Use this knowledge to your advantage and create a set of financial projections that takes this into account.

2. Don’t climb the mountain in one giant leap. If your 3, 4, or 5 year projections looks like a ridiculous hockey stick, give some thought to how you can flatten out the curve a bit. There are very few businesses that are going to hit $100M in 3 or 4 years. No offense, but chances are, yours isn’t one of them. Investors expect to see growth year over year, but they don’t expect you to have a near-vertical ascent! Whatever model you decide upon, you can bet on one thing: investors are going to challenge your assumptions behind that model. Be prepared to defend them!

3. Don’t forget about the human capital factor (headcount). If your projections call for a 10 person company to be responsible for generating $50M in revenue, this is going to be a red flag. This will tell the investors that (again) you are either overestimating your revenues, or you are underestimating the level of effort that will go into it. Take a look at your revenue per FTE (full time equivalent). Take your revenue number for a given year and divide it by the number of employees you will have during that year. That is your revenue per FTE.

The following info is from a 2005 study done by SHRM (Society for Human Resource Management):

Revenue and net income are strategic financial indicators of performance for most organizations. When total revenue is divided by total employees (FTEs), the resulting number is a marker of efficiency.

This ratio, termed revenue per FTE, conceptually links the time and effort associated with the firm’s human capital to its revenue output. To illustrate, for an organization that has $100 million in revenues and 300 employees (FTEs), the calculation yields a ratio of $333,333 per FTE. If the revenue-per-FTE ratio increases, it indicates that there is greater efficiency and productivity because more output is being produced per FTE. If the ratio decreases, it indicates there is less efficiency and productivity.

The following chart also appears in the study. This shows you what the industry averages are. Of course, this data was taken from more established companies (i.e. they had an HR director on their staff), but it should give you a feel for where established companies are regarding this particular metric. Click the thumbnail to view the larger image.

revftechart.png
ORGANIZATIONAL DATA

Revenue and net income are strategic financial indicators of performance for most organizations.
When total revenue is divided by total employees (FTEs), the resulting number is a marker of
efficiency.

10

This ratio, termed revenue per FTE, conceptually links the time and effort associated
with the firm’s human capital to its revenue output. To illustrate, for an organization that has $100
million in revenues and 300 employees (FTEs), the calculation yields a ratio of $333,333 per FTE.
If the revenue-per-FTE ratio increases, it indicates that there is greater efficiency and productivity
because more output is being produced per FTE. If the ratio decreases, it indicates there is less
efficiency and productivity.

Table 9: Revenue per FTE (by Industry)

Industry
Revenue per FTE

n
25th Percentile
Median
75th Percentile
All industries
422
$77,778
$145,455
$241,667
Educational services
19
$74,667
$94,070
$152,376
Financial services
37
$53,045
$156,190
$197,878
Government
19
$57,692
$109,874
$147,368
Health
39
$70,542
$92,000
$140,541
High-tech
33
$135,545
$167,500
$241,667
Insurance
19
$154,545
$444,444
$846,407
Manufacturing (durable goods)
55
$107,692
$178,182
$261,250
Manufacturing (nondurable goods)
15
$157,143
$185,328
$278,261
Service (nonprofit)
29
$58,286
$69,767
$140,500
Service (for-profit)
35
$40,000
$114,286
$223,100
Transportation
11
$81,464
$151,515
$249,558
Utilities
10
$251,986
$404,444
$554,522
Wholesale/retail trade
24
$97,902
$333,333
$505,451
For-profit (all industries)
288
$98,361
$167,939
$317,204
Nonprofit (all industries)
134
$65,022
$102,179
$159,091

Note: Industries with less than 10 organizations responding were omitted from the table. They were: agriculture, forestry
and fishing; construction and mining; library; oil and gas; publishing and broadcasting; and real estate.
Source: SHRM Human Capital Benchmarking Study

If you want to see the full report, click here. It is a very interesting read. Also be sure to consider your expenses-per-FTE as well (although this is not nearly as important as the revenue per FTE, IMHO.)

My message in all of this is simple. Whatever numbers you give to an investor upfront will go a long way toward determining whether or not they want to continue to have a dialog with you. If they are too high, your head is in the clouds. If they are too low, then there is no real business there. This is a delicate balancing act. Put together a working business/financial model for your venture, and then apply some of these simple metrics to it to see where you stand. Your potential investors will also be applying these metrics in their head, so keep that in mind.

Enough rambling from me. Go change the world.

If you have your own thoughts around financial metrics, and presenting them to potential investors, I welcome you to add them via a comment below. Comments are moderated, so unless you’ve commented on this blog before, I have to approve them – FYI.

Cheers.

3 Comments

  1. I’d like to suggest that a point worth amplifying is that although the revenue projections were the red flag, they were perhaps symptomatic of more profound issues. The revenue numbers should be the end of the story, not the beginning. The story itself is how you get there. What is your customer base? How much are they likely to spend on your product or service and how frequently? What is your game plan (sales and marketing activities, staff and budget) for acquiring those customers and what are the hard numbers that hold the entrepreneur accountable for success or failure?

    For early stage ventures, and from an angel investor’s perspective, the revenue projections are less meaningful than one might think. The key is what case does the entrepreneur make that is convincing that there is a customer base out there screaming for the product, and what is the tactical, month by month plan for converting that customer base into money? Even if the plan calls for $10.92 of monthly revenue, it might as well be zero if there isn’t a credible plan behind it.

  2. Hi there, Mike – thanks for dropping by!

    Interesting thoughts …

    In the context of the scenario I used in my original post, I was referring to the “financial snapshot” on a typical one page executive summary. Unfortunately, there is only so much of a “story” that you can share in such a limited amount of real estate (or even in a quck pitch.)

    What I am trying to explore is:

    1.) How can the entrepreneur avoid “obvious” red flags, as it were, when handing his or her one or two pager over to an investor (from a financial modeling standpoint.) How do they survive that first contact?

    2.) How they can best get to the next level of discussion.

    Granted, once you move beyond that initial intro, the points you make with respect to customers, game plan, etc. all become more evident. Clearly, any investor is going to need to see the cohesiveness and feasibility of the plan.

    See you on Thursday at the Ritz Group, by the way. Going to be fun.

    Full disclosure: Mike serves on the HiddenMarket advisory board.

    Cheers.
    Scott

  3. To me, the red flag comes up when the summary says anything other than “Here is the amount of money we are going to make, and here’s where that number comes from, and why it’s achievable from a market opportunity, sales, and operational/execution standpoint.” That should be quickly followed up by “Here’s how much we have to sell to break even on a cash basis.” If those things aren’t spelled out right up front – it’s hard to get traction. That information is generated wtih the help of the bottom-up modeling approach.

    The other reality is that the red flags are frequently like pornography – hard to define precisely, but I know it when I see it. No two investors react alike to the same opportunity, unless the opportunity is just blatantly not credible. Other (actual) investors may have different criteria than those I articulate above, but that is what I require of any client that asks me to help connect him or her with an investor.

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