MBA Mondays - Business 101 for startups by Fred Wilson

Building a company: Scenarios

In last week's MBA Mondays, I introduced the topic that we'll be focused on for the next month or so; projections, budgeting, and forecasting. In that post, I described projecting as a "what if" exercise that is done at a higher level of abstraction than the budgeting and forecasting exercises. I said this about projections:

These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. They are aspirational and are often done with a "what could be" perspective.

Since projections are not budgets and are much more "big picture" exercises, it is important to use a scenario driven approach to them. I generally like three scenarios; best case, base case, and worst case. But you could do as many scenarios as you like. It's not the results that matter so much, it's the process and the learning that comes from the projections exercise.

If you build your projections with a detailed set of assumptions and if you can assign probabilities to each assumption, you could easily do a monte carlo simulation in which literally thousands, or tens of thousands, of scenarios are run and the outcomes are charted on a bell curve. I don't recommend doing projections this way, but my point is simply that the number of scenarios is not important, it's the process by which you determine the key drivers of the business, the assumptions about them, and the probabilities associated with them.

A few weeks ago on MBA Mondays we talked about key business metrics. It is very important to identify your key business metrics before you do projections. These key business metrics will drive your projections and your assumptions about how these metrics will develop over time will determine how your scenarios play out.

Let's get specific here. I'll assume we are operating a software business and we are selling the software as a service over the internet using a freemium model. Everyone can use a lightweight version of the software for free, but to get the fully featured version the user must pay $9.95 per month. So here are some of the key business metrics you might use in projecting the business; productivity of the engineering team, feature release cycle, current outstanding known software bugs, total users, new free users per month, conversion rate from free to paid, marketing dollars invested per new free user, marketing dollars invested per new paid user; customer support incidents per day; cost to close a customer support incident. These are just examples of key business metrics you can use. Every business will have a different set.

The next step is to lay all of these metrics out in a spreadsheet and make assumptions about them. As I said, I like three assumptions, best case, base case, and worst case. Best case is not the best it could ever be but best you think it will ever be. Base case is what you genuinely expect it to be. And worst case should be the worst it could ever be. Worst case is really important. This is your nightmare scenario.

You then calculate your costs and revenues as a function of these metrics. There are some expenses that will not vary bases on the assumptions. Rent is a good example of that in the short term. But over time, rent will move up if you need to hire like crazy. I would go out at least three years in a projections exercise. Some people like to go out five years. I've even seen ten year projections. I don't think any technology driven business can project out ten years. I am not even sure about five years. I believe three years is ideal.

Getting the assumptions right and building up to a full blown projected profit and loss statement is an iterative process. You will not get it right the first time. But if you build the spreadsheet correctly the iterating process is not too painful. Do not do this exercise all by yourself. It should be done by a team of people. If you are a one person company right now, then show the results to friends, advisors, potential investors. Get feedback on your key business metrics, assumptions, and results. Think about the results. Do they make sense? Are they achievable?