Will Price from Hummer Winblad had two good posts recently on revenue and sales forecasting for start-ups (but equally applicable to more mature growth companies). This is real-life, useable advice you can sink your teeth into:
Will's first post is on forecasting revenue from the bottom up, ie based on how many sales people you can hire and how productive they can be.
The second is about forecasting next quarter's sales through tight management of the pipeline and using a tool like Salesforce.com.
I like his approaches in particular because following them forces entrepreneurs to pay attention to sales productivity, which is both a great indicator of company potential and the best basis for pacing investments in a growing business. Entrepreneurs who get this can reduce the risk of running out of cash, and generate higher returns on their equity.
When we evaluate companies that sell direct to enteprises (as opposed to consumer plays), we use a simplified formula to determine whether and how much it is sensible for the company to invest in sales expansion. Basically, we take the gross profit generated per sales team and divide by the fully loaded cost of that team (and adjusted for the time it takes to ramp up a new sales person).
If the gross profit to cost ratio is 3x or higher then the company has a highly leverageable business model and it is worth investing aggressively in expanding the sales team. With high ratios it makes sense to raise capital from investors to fund expansion. If the ratio is between 1.5x and 3x the company needs to improve revenues per sales head or reduce the cost of customer acquisition, and it probably does not make sense to raise capital to invest in growth.
In the chart below you can see how a 50%-gross-margin business whose sales team costs, say $500k/year, needs to generate revenues per team of $1.4m to make external investment worthwhile:
If an entrepreneur really understands his sales productivity metrics (and these have been proven to be repeatable across teams), he can determine whether:
- To grow slowly in bootstrapped mode (because the cost of capital is higher than the return generated by adding sales people); or,
- To raise capital and invest in sales expansion (because the returns generated from increased sales outweigh the equity dilution of raising capital).
The calculations can be a bit involved but they're not rocket science. Understanding the sales productivity (actual or predicted) of your business helps protect the value of your equity. And as an added benefit, demonstrating this understanding (and the alternative growth paths it provides) will impress your potential investors.
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