The Top 3 Mistakes Early-Stage Founders Make When Forecasting

I know most founders today are planning for the new year, so sharing the top 3 mistakes I've seen early-stage founders make when forecasting. If you're forecasting for 2024, you don't want to miss this.

Chapters

• 0:39 Benchmarking
• 2:16 Revenue Per Employee
• 5:15 Linear Growth vs Compound Growth
• 10:30 Funding Rounds are the Wrong Milestone
• 15:41 Forecasting Without Proven Levers
• 20:07 Recap

Transcript

Speaker 1: 0:00

It's the end of 2023 And like a lot of founders that I speak with, I'm sure many of you are doing the same thing, which is that you are planning and looking forward to 2024 and doing a lot of kind of forecasting on what that should look like. And so I thought I'd go over what I think are the top three mistakes that early stage founders make when they are forecasting. Welcome to the product Market Fit Show, brought to you by Misra , a seat stage firm based in Canada. I'm Pablo, I'm a founder turned vc. My goal is to help early stage founders like you find product market fit. Before I jump into that, one of the things that I think is really important as you think through this is benchmarking. And let me kind of take, take a step back. One of the things I've been thinking about lately, it's really, really simple. I'm a really simple guy and if you think about it, every single person is trying , every single founder I should say is trying to build a great company that's obvious . Now, a great company has to have at least one of two things. It has to either be growing fast, which I would say is usually at least doubling year over year or it needs to be very lean, very capital efficient. Now ideally you have both and then you have like you know, a Shopify which doubles every year and and spits out cashflow. But you need to at least have one of the two. And as self-evident as that might seem, I can guarantee you there are many companies have raised serious amount of capital and are no longer growing fast. And so now there are bloated companies that are not growing fast and basically by definition they're not great companies, certainly not on the path to be great companies. So those are the two things that you really need to think about. And when I look at the benchmark, so there's this blog called Growth Unhinged comes from from called OpenView and they looked at 700 private companies. So this is where this data's coming from on the growth front, if you wanna be a top quartile company in terms of growth and you're in this kind of one to $5 million a RR range, which is this kind of pre-product market fit stage, you need to be, like I said earlier, doubling. So a hundred percent year over year growth, if you're doing from one to $5 million in top line revenue makes you top quartile in terms of growth rate. The other metric to think about is a RR or revenue per employee. This is probably the most apples to apples metric you can think about to compare and benchmark companies, different SaaS companies especially, but most software businesses in terms of efficiency, which is how much revenue are you generating for each employee that you have, the answer there in order to be kind of top quartile, top 25% is you need $150,000 of revenue per employee. So that means if you have 10 employees, you should have about $1.5 million in top light revenue. If you have 30 employees, you need to have $4.5 million in top line revenue. Which by the way, if you think about it like remember you need to just double in order to make top quartile doubling is not easy, but certainly at those numbers, 1 million, 2 million, 3 million revenue, I've seen many companies that double this other metric. A RR Proft is much more surprising, at least to me because I've seen many companies that have four and a half million dollars in revenue but have 60 or 80 employees. It's not easy to do four and a half million dollars in revenue, which is 30 employees, but that's what it takes If you want to be top quartile in terms of efficiency, in terms of leanness, and remember, you need one of the two things in order to truly be a great company. So that's one of the things you should have in the back of the mind as you think about forecasting, which is are you truly growing at two extra more? If so, you can afford to be a little less lean. It doesn't mean you need to be, but you can afford to be because first of all, at least you're growing fast. And second of all, the fact that you're growing fast means that your revenue is going to catch up to your employee base. In other words, if you have, let's say you're doing more like a hundred thousand dollars in a RR per FTB , and so you have 3 million in a RR and 30 employees, but if you're doubling, that means next year you're gonna go from 3 million to 6 million in a RR . If you don't also double your employee base, then you are naturally going to become top quartile in terms of capital efficiency. And so you kind of get a little bit more flexibility If you're not though, if you're not doubling or don't think that you see a clear way to double next year, then you really need to pay attention to the efficiency line. And I think this one again is really important, especially because if you've raised some money, even if it's a seed round, certainly if it's series A it's really easy to add bodies, it's so natural to add bodies and thinking that while you have this long runway, why wouldn't you invest a little bit more on your team? But if that means you become an inefficient company, then you're doing yourself and your team a disservice 'cause you're no longer building a great company. So let's jump into the three main mistakes , uh, that I've seen. The first one is conflating linear growth for compound growth. And I'll go back and I'll never forget this board meeting, it was really early actually it my days as a vc and it was this company, the SaaS-based company. Obviously I'm not gonna share the name because it's not important, but the company was , uh, for all intents and purposes doing quite well. I mean they raised a a seed round and they were growing, you know, they were growing pretty consistently and the founder was kind of taking the board through through a forecast and I believe at the time they were doing like 40 to 50 , let's call it 50 K in monthly recurring revenue, 50 K in in MRR and growing about 10% per month or or so. So the founder thought, and so the founders started to kind of forecast out the next year and you know, he said, I'm gonna be conservative on growth rate. You know, we've been growing kind of 10% or more per per month, but let's say we only grow kind of 7% per month. Well, we would more or less two and a half x through next year and this is the , the new people that we would hire this and that and so forth. And you kind of going through it and I'm looking at it and I'm like, well this, you know, this makes a lot of sense. It was very thought out. The , the forecast was like the , the spreadsheet obviously was super , um, not complicated but sophisticated I should say. And, and and and in general, you know, clearly put a lot of thought into this. And then one of the board members gets up and, and that board member, actually he wasn't one of the VCs, he was himself a founder and operator and CEO of a different startup. And he gets up and he goes to kind of the, the screen where , where the founder's sharing the spreadsheet, he points something out that had kind of just gone totally above my head. He said, look, look at your last six months of growth. You're telling me that you're growing on average by 10% per month. But if you actually chart out your new MRR per month, what you are doing is you're basically adding more or less $5,000 in MRR per month. It's not that six months ago you added 1000 and then 2000 and then three and then four. Now you're adding five. It's that six months ago you maybe added like, you know, 4,000 and the next month you added six and then you added three and then you added four. And then, and in general you kind of more or less are a business today that adds $5,000 in MRR per month plus minus a thousand or so. So what's the problem with that? The problem with that is you then you then extrapolate forward this kind of 10%, you become conservative, you say 7% of monthly growth, 7% of monthly growth today at 50 k of MRR is only like $4,000 or so. As you kind of double into let's say a hundred k in MRR , which you're , you're you , you think you're gonna be there by, you know, nine months into next year you now need to be adding 7,000 of MRR . And as you grow further and you're at 150 k or so of MRR , you need to be adding that much more. And today you have no proof that you can do that. I thought it was an excellent point. Uh, and I , I think actually the rest of the board agreed , um, and then the company went on to just ignore it frankly because for really the main reason honestly is that the company was able to raise a series A because they were able to show that looking back they had pretty solid growth, solid metrics and they raised some money and then guess what? They went and hired some people in order to be able to fulfill their forecast and in order to be able to two and a half x to three x. But here's what's happened, you know, now many years later and the company is still growing linearly, they're growing a little bit more than five kmr per month but not materially more. It's certainly not compound growth. And that's extremely important at these early stages is to really look back as you think through 2024 and what's gonna happen, think about last year and look very closely at how much new MRR did you add per month? How much new MRR did you add per quarter? Are you consistently adding more MRR this month versus last month, this quarter versus last quarter? If you are, then that means that you're growing at some sort of compounding rate because every quarter you don't just grow, you grow by more than the quarter before that. And that's what compound growth looks like. If on the other hand you have either flat in the sense that yes, you're growing but you're always kind of growing by similar amounts. Q1 you grew by 15 k of MRR Q2, you grew by 20 k of MRR , but then Q3 you grew by only 18 K of MRR , this sort of thing. And there's not a clear increment every single month, every single quarter, then you're probably growing linearly, which means when you forecast out next year, you have no evidence that you can grow. If you have in your model something that says I'm gonna grow leads, outbound leads or inbound leads, or I'm gonna grow any sort of part of my model by x percent per month, you are baking into your model compound growth. And if you don't have it yet, that is going to lead to very, very serious miscalculations. And I've seen it time and time again and what it does is it's going to first of all make you think you can get to a place that you actually, it's not that you can't get there, but you're certainly not driving towards and it's going to make you make hiring decisions that are wrong because your assumptions are just so off. Which leads me to a second mistake, or maybe I'll call it pet peeve, I don't know, but I, but it's become so , um, ingrained I think in founders to think about funding rounds. And so what , what we have at , at our stage constantly, right, is like, okay, I've raised a C round, here's what I need to do to raise my series A and that becomes like the golden kind of milestone that you're just, that everything is focused on this next funding round. And I have to admit, like part of me understands it not only 'cause I've done it myself because I've been guilty of kind of proposing that as a milestone myself as a vc, and again trying to do it myself as a founder, but also because I understand the reality, which is if your business is losing dollars and is not self-sustaining, then you're going to have to fundraise. So I kind of get it, but even then it's just the wrong milestone. It , it drives poor behavior. It's the wrong milestone because there is no inherent meaning in raising series A. There isn't. All you've done is you've sold off more of your business and you have more cash. It's on the net, it's a good thing, but on its own it doesn't mean anything. It doesn't mean you've created a great company. It doesn't actually mean you've found product market fit. It doesn't mean you have a formula to scale to 10 million in a RR . That is a meaningful milestone. 10 million in a RR because it's a revenue driven milestone and it means, by the way, only 12% of all SaaS startups get to 10 million in arr. So if you get there, that's a meaningful milestone. If you raise a series A, it doesn't mean much, it just means you have money to grow your business. So I don't think it's the right thing to think about and it drives bad behavior and here's how it goes. Okay, so we enter the year at whatever, 500 KA million in revenue, right? That's usually the stage that we're talking about. In order to raise our series A, we need to be at 3 million in a RR , let's say two and a half million of a RR . Okay, let's work backwards from there to see what we need to do to get to an A. I think on the face of it, it sounds like it makes a lot of sense, but then if you've, if you're the sort of founder , especially if you're listening, like if you're a repeat founder, you already know what I'm talking about. And if you aren't, you either will listen or you'll find out. Because what happens inevitably is you build a forecast that you actually believe and that it's full of just complete nonsense because you can't just put a number in the sky and work your way backwards to it at this stage. It's a different story. If you're an Uber, if you're a Shopify, if you're like a , you know, a multi-billion dollar top line company, you're a very late stage operation and you actually have mechanisms that you have proven that you understand that you can predict on how you could get to a target in that mindset, it makes sense to draw out a target 12 months out and work backwards on how to hit that revenue target. But if you don't have clear product market fit yet, then you don't have anything that's proven that you can actually invest in to get to that target. And that's gonna be my third point, but just to stick to this one, forecasting to a milestone like a series A is going to lead you to put things into your model that are completely made up. Instead, what I think makes much more sense from a forecast perspective, if your pre-product market fit is to just forecast out runway. Look at your last year, and this is, and this is another point that you , you'll hear like what happened last year and you understanding very deeply what happened last year that is based on actuals, that is based on fact. There's real signal as soon as you start moving towards forecasting, you are now in the crystal ball business, which is almost by definition just less meaningful. I'm not saying you shouldn't do it, but it's by definition less meaningful. So you should spend 10 times as much time looking at your analytics and understanding what's happened in your business than you should forecasting out the next 12 months. To the extent that you do forecast out the next 12 months. I think that the number one question you should be trying to solve is not so much what is my revenue gonna be next December? Again, it makes sense for very large companies, it doesn't make sense for unproven pre-product market fit stage companies. Instead, what you should be trying to forecast out is what is my runway? That's the question you should be trying to solve is with realistic assumptions and realistic means based on what I've proven so far, based on my actual cash balance , what cash position am I going to be in by the end of the year and what might toggle that, right? Like what might I have to do somewhere in between the year to either raise more money or increase my runway by whatever means necessary, or am I actually going to be in a good position by the end of the year? That's important to know for obvious reasons because it might actually drive actions, fundraising actions or cost cut cutting actions or whatever. It also frankly is a founder, it just helps you sleep at night to understand how much time you have so that you should do, but that's not based on assumptions around how many AEs you're gonna hire or how many leads you're gonna drive. It's based on understanding what happened last 12 months, what happened last six months, whatever you think is representative, and what happens if we do something very much like that. If we do that, how much money will we have? How much runway do we have? That is something that's worth spending time on. Which leads me to my third and final point. I was just doing this work with one of the founders I work closely with and we were going through the next 12 months. And so he had kind of a few things that that I that I saw, but one of the most important ones that I think I wanna highlight to get , which is probably the the top third mistake, which is forecasting without proven levers, which obviously he's tied to the other two in his very representative of pre-product market fit companies. In the early stages you get revenue whatever way, whether it's inbound or outbound or by whatever method it is that you're closing customers, but in many cases you don't have proven levers. You've kind of gotten what you've gotten . Not saying that you don't know what you're doing, you know what you're doing, but you don't yet have something that you could say, if I double that, if I triple that, I'll get two x or three x the output. That's very common. Now what the founder was doing in this case is he was saying, okay, like what happens if my leads, my inbound leads start to grow by 10% per month and all of a sudden, you know, everything looked awesome, <laugh> . But then I, but then I said to him, I said, do you have any proof that you can actually increase your leads by 10% per month? Let's go back to the last year. And lo and behold, the the leads, while they're kind of increasing, they're not increasing by a rate per month and they're certainly not increasing by anything that he knows like, oh, we did more of this and so leads went up, we did more of that and that leads went up. Leads are kind of going up, but they're going up for reasons that to yet are not fully understood. So to then forecast out an unproven lever, which is inbound leads are going to grow by x percent per month is just fantasy. It's fully made up similar on outbound, right? So if you think about outbound sales, what often happens is you have the founder who's doing most of the sales, and maybe by the time you're at this half a million million a RR , you're starting to get some signs of product market fit. You maybe bring on one or two other salespeople and then you think, okay, next year all I gotta do is get like five times as many salespeople and I'll get five times the revenue. And then the question is, have you actually done this before? You have at most one or two other salespeople, maybe they've worked out out and maybe they're doing quite well, but realistically, do you know what it actually takes to train a salesperson? Do you know what the onboarding ramp time is? Do you know how successful they're gonna be? How many AEs or BDRs you're gonna have to hire and what your churn is gonna be because some of them are not gonna work out. And then have you factor all that into your model? And the answer is probably not. If you're pre-product market fit, you probably don't have the answers to these questions. And so when you start to forecast out, it's very easy to build a model that just says, if my AEs drive this many leads and if I add four more AEs, then I'll have XX more leads, right? That's really easy to do, but what are you really solving by doing that? And so what I suggest instead is think of it in shorter timeframes because what you're trying to do in the pre-product market fit days is less so forecast out 12, 24 months and more. So trying to find these levers of growth because by the way, to the extent that you're thinking about a series A, the reason that a series A matters, the only reason that it's meaningful is because you have levers to invest into. And so what I would think about instead and what I suggested was let's look at this by quarter and let's think about, hey, this quarter, let's prove something out. Let's try out a few different experiments, few different things that we think could drive growth. So maybe it's, you know, conferences are gonna drive more leads or blogs are gonna drive more leads. Or some SEO who are gonna drive more leads paid is gonna drive more leads. Or maybe it's on the outbound side, we're gonna hire bdr, R and s dr , whatever it is, and that's gonna drive more leads. Whatever it is, you're gonna try something else. Maybe it's enterprise, maybe you're moving up market, doesn't matter. The point is this quarter, these are the 1, 2, 3 things that we're gonna try out and let's just see. And if they work, this is what it'll look like and if it doesn't work, this is what it'll look like. And then you go out and you try that and you see what happens. And if it works, great, that helps you forecast out further. If it doesn't work the next quarter you try something else and you keep trying things until you find a lever that you can actually prove you can dial up and get more growth out . Until you have that forecasting out, 12 plus months is not really worth it. You should think about your runway 12 plus months from now, and you should do that by forecasting based on what you've done up till now. But trying to understand how you're gonna grow in the future if you don't have proven growth mechanisms is a fool's errand. And so those are really the top three mistakes that I've seen, which is mistaking linear growth for compound growth, forecasting to targets instead of forecasting for runway. And then finally forecasting without proven levers. Never forget the two things. If you wanna build a great company, you need to either grow fast over a hundred percent per year, or you need to be lean, which is all about a RR per employee. Ideally you get both, but if you don't have one of the two, you need to get the other. If you've listened to this episode and the show and you like it, I have a huge favor to ask for you. Well, it's actually a really small favor , but it has huge impact. But whichever app you're listening to this episode on, take It Out, go to Product market Fit show and leave a review, please. It's going to help. It's not just gonna help me to be clear, it's going to help other founders discover this show because the algorithms, whether it's Spotify, whether it's Apple, whether it's any other podcast player, one of the big things they look at is frequency of reviews. It's quantity of reviews. And the reality is, if all of you listening right now, left reviews, we would have thousands of reviews. So please take literally a minute, even if you're just writing like great podcast or I love this podcast, whatever it is, just write a few words. Obviously the longer the better, the more detailed the better. But write anything, leave five stars and you'll be helping me. But most importantly, many other founders just like you, discover the show. Thank you.