November 23, 2005
Not-so-Counter Cliche: Forecast Early and Often
There’s no "counter" in this week’s counter cliche, although this is a cross-post to two of Fred’s recent postings. In his VC Cliche of the Week, he talks about the need for early-stage companies to forecast often, and he was nice enough to cite Return Path as his case study. I thought I’d give some color on this from our perspective here.
Forecasting is a pain, so we adopted the model of as 12-month rolling forecast with quarterly reforecasts (and correspondingly quarterly incentive comp structures) out of necessity. For early stage companies in emerging industries, there are simply too many moving parts in the business to provide enough visibility to produce an accurate 12-month budget. There are really four factors at work here:
– Investment: you make investment decisions every day in the business, and you can get pretty good over the years at predicting the return on the investment, but predicting the timing of the return can be very difficult. Products "ship" late, customer seasonality can factor in, marketing campaigns can take longer to pay back than you expect.
– Competition: you have by definition even less of an idea what competitors will do, or for that matter, when new competitors will arrive on the scene. Any competitive activity can impact pricing and lengthen sales cycles in ways that are hard to predict.
– M&A: any acquisition you make throws the entire budget into chaos both on the revenue side and the cost side.
– Recurring revenue: for any business that has a recurring revenue model, missing your numbers in a given month or quarter makes it nearly impossible to get back on track for the rest of the year since next quarter’s number depend on making this quarter’s numbers. This is what Fred calls the New York Jets syndrome – once you lose 7 games, you know you’re not getting into the playoffs.
So forecasting early and often is a great solution to this problem, and it’s a particularly effective tool to keep the team motivated. And there’s no shame in doing this. Even large public companies consistently set new guidance to Wall Street at the end of every quarter for the following quarter and remainder of the year. But it is a little bit of a pain, so I’d recommend that CEOs and CFOs who want to adopt this model follow a few practices we’ve learned over the years:
– Make sure you have an incredibly flexible Excel model that supports the process. You can’t reinvent the model four times per year. It has to be able to handle multiple scenarios with easy-to-use toggles, and it has to be able to accept "actuals" as well as forecasts (see note on comparisons below).
– Manage expectations properly with the Board and with the team. As long as everyone knows what the process is, you can avoid a lot of confusion. The critical thing here is that neither constituency should feel like the system is being gamed or that numbers are being sandbagged.
– Compare to originals. Our model produces "waterfall" comparison charts showing how a given quarter’s forecast changed over the quarters leading up to it, and then how the forecasts compared to actuals. This is important mostly to produce learnings about how to forecast better in the future.
– Plan to work your way out of the process over time. Do quarterly budgets for a year or two, then move to semi-annual budgets for a couple of years, then try moving to full-year budgets.
I think it was unintentional on his part, but Fred’s other posting today, about M&A in the Internet space, is also relevant to this topic. It’s worth looking at the graphs in the original posting, but the basic point is that the preponderance of Internet companies either get acquired early on in their life (e.g., for less than $50mm) or once they have achieved escape velocity (e.g., for more than $500mm). He says that the space in between, or "the valley" on his chart, is where a lot of solid VC-backed companies sit and where good solid returns are made. I’d just add to it that "the valley" is exactly where it’s critical to forecast early and often, as that’s where businesses are working their hardest to grow from proof of concept to escape velocity, often with limited visibility 12 months out on their budget.