The Rules of Forecasting for an Effective Sell of a Business

The Rules of Forecasting for an Effective Business Plan Through practice trial and error of writing up my own effective business plans, I have developed a set of rules regarding forecasting that I apply in writing business plans. I share them with you in this article in the hope that you will find these rules worthy of adopting in your efforts to write business plans as well. Investors expect the forecasts in a business plan to present realistic, achievable goals. One of the best ways to have your plan rejected is to demonstrate that projections Ire not prepared thoughtfully and, therefore, the numbers are not defendable. This is most often demonstrated by not showing the details (if any) that went into the projections. It is important to remember that investors typically review the projections first, at least in a cursory manner. This makes sense when you realize two things: 1) they are most interested in the money they might be able to make, and 2) they can easily spot common mistakes made by sloppy entrepreneurs (in order to quickly reject poor plans). Rule 1: For a forecast to be valid, it must portray realistic expectations. An unrealistic forecast is useless to anybody. The entrepreneur is unlikely to achieve the goals and the investor is unlikely to recover their investment, let alone make a profit. Corollary 1A: A pessimistic forecast is equally as invalid as an optimistic one. Conservative estimates are good as long as they still demonstrate a high likelihood of achievability. However, if the projections are perceived as too conservative, or even pessimistic, it looks like the entrepreneur is trying to build too much of a "fudge" factor into the numbers. On the other hand, an overly optimistic project demonstrates the entrepreneur is trying to make the project look better than it should. The best approach is to make the projections as realistic, achievable, and defendable as possible. In other words, show that you have done your "homework." Corollary 1B: The first year of a realistic forecast should become the operating budget. The investor will expect at least this level of confidence in the projections. If you can’t make a realistic projection for the first year that can be used as a budget, more homework should be done. Corollary 1C: Budgets must be prepared within the context of the long-range forecast. If you Ire to plan an automobile trip from Denver to New York, it would not make sense to start by driving to Los Angeles. Likewise, make sure that the short-term activities and expenditures are in keeping with, and support, the long-term goals of the company. Rule 2: Don’t blindly rely on a "rule of thumb" to forecast the future. Rules of thumb are techniques many people use to help them prepare forecasts. These rules can be useful when used as clues to guide the forecasting process, such as by comparing your past or future performance against that of similar companies. The problems come in when these techniques are used without regard to making sure they apply to your specific situation. Corollary 2A: Don’t use percentages as a "crutch" in forecasting growth or trends. You must be able to defend your projections. If your numbers are determined by "blindly" applying a percentage, the results become less defendable. For example, I had a client who initially projected a sales growth that, within five years, would require every person on Earth--now and in the past--to be a daily customer. Obviously, this was an unbelievable and un-defendable result. Rule 3: Make sure each and every assumption in the forecast is supported. You should expect an interested investor to place your projections "under a microscope." Therefore, never underestimate the degree to which you may need to defend an assumption. Rule 4: Validate and verify every calculation. I had a client whose business used equipment manufactured in Europe. Therefore, he had to convert the machine’s input and output from kilograms to pounds. The projections showed a relatively conservative, but realistic, profit margin for his particular industry. When I reviled the plan, I checked his conversion factor (from kilograms to pounds) and found he used the wrong factor. When the correct factor was used, his net income changed from a profit to a loss--a very significant result that would have been a disaster had it been discovered by an investor. Corollary 4A: Don’t trust published calculations. Published numbers have been found to be wrong. There may be a misprint. It doesn’t hurt to verify the numbers and you become more of an expert in the process. Rule 5: Question basic assumptions. It is always a good exercise to question the basis for any assumption. You may find the basis is not defendable. You may even learn a better way to develop or present the assumption. Corollary 5A: When a forecast is developed around a specific policy or procedure, question that policy or procedure. Rule 6: Develop forecasts in the context of the entire system and properly reflects all relationships. It is important to understand that everything in the company affects everything else. For example, if you need to adjust the number of employees, you may also need to adjust the office space needed. Rule 7: The granularity (time divisions; e.g., monthly, quarterly, etc.) of the forecast must match the granularity of the system. Corollary 7A: The granularity must match the frequency of review and decision-making. It makes sense that you should review your projections whenever you review your actual operations. Most businesses are managed on a monthly basis. Therefore, their forecasts should be based on monthly numbers. Corollary 7B: Use the same granularity throughout the forecast. Changing the granularity of the forecasts often introduces errors. The longer the time period of the forecast, the more you have to rely on averages when reviewing your progress. See my article "Business Plan Mistakes--The Phantom Growth Rate" for a good example of this. Rule 8: Build projections using the most basic assumptions as a foundation. It is much easier to defend basic assumptions that are used to "roll up" into the larger forecasts. For example, if an investor Ire to ask you to reduce your payroll from $1,000,000 to $750,000, you may not be able to adequately explain why that would not work unless the payroll total was determined from the more basic assumptions of personnel counts and pay scales. Corollary 8A: A forecast should show its basic assumptions. More plans are rejected because they fail to show the basic assumptions than probably any other single reason. Rule 9: An exception to a rule is valid if it can be defended. As in any other system, every rule has its exception. Just make sure you can adequately defend the deviation from the accepted norm. Rule 10: Every forecast must have at least two supporters. "Two heads are better than one." When is comes to defending a number or assumption, it helps to have allies. Corollary 10A: Even if a forecast is intended for your sole use, it helps to have it reviled by someone else.