We need to talk about your costs

Founders are highly optimistic by nature. To do what we do, you need to believe that the impossible is possible. We believe that we are the Alan Turing of our industry: the only one that can crack the enigma code.

Mostly, this is a strength but it can also be a weakness. Unfortunately, it’s often a weakness when it comes to your financial model.

Over the past year, I think I’ve reviewed at least 200 projections. I reckon at least 185 of them have wildly underestimated how much it is going to cost to run their business.

How do I know it’s unrealistic?

This what a typical set of start-up projections looks like:

This is what’s known as a ‘hockey-stick’ growth, so-called because the graph looks a bit like a hockey stick: it starts flat then just keeps going up and up and up.

It is possible to start a business where income increases exponentially year on year. It is very rare but it does happen. It generally only happens in what’s known as ‘venture-backable’ companies, i.e. start-ups that can achieve exponential growth in a short period of time. Even in this context, the type of growth shown in that graph is unlikely. For example, US-based SAAS venture-backed start-ups are generally considered to be the fastest growing companies.

According to this research, the average rate of growth for smaller (less than $1m in revenue) SAAS venture-backed start-ups in 2021 was 100% per year. This is well under the hockey stick projections I see in the start-ups that pitch.

However, in the unlikely event that you can achieve that type of income growth, it’s pretty much impossible to achieve that level of profitability.

If you are going to grow like that, it’s likely that you will have to spend a lot of money acquiring customers, building your team, working on your product, etc. The costs precede the revenue growth which usually means you are loss-making during that period.

realistic projections

If you are one of the few companies aiming for exponential growth, your projections should look more like this

In the graph above, you can see that the start-up is spending a lot of money to generate the growth, which is necessary to achieve those revenue targets.

To help you with benchmarking, the average EBITDA for established software companies (i.e. mainly publicly listed very large companies) in 2023 was around 25%. This level of profitability can only be achieved after many years of growth and when the company is more stable. It’s unlikely that you will ever achieve more than 30% consistently and it’s almost impossible during the first few years of growth.

Realistically, most companies will never achieve that level of growth so should probably aim for something like this:

This may look boring to you but this graph is still showing 100% growth year on year – that’s still very fast! This is a more achievable rate of growth and profitability for the first few years. Although it might not be enough to excite a VC, it’s exciting enough for an angel investor who could make a nice return on this type of growth, especially when you factor in S/EIS.

If you are struggling with the costs you might be missing, in my experience the two areas where start-ups underestimate costs are marketing and staff. For B2C businesses, customer acquisition costs can be expensive and it takes a lot longer to build up customers. Most businesses also underestimate the cost of back-office roles such as HR, finance and general administration.

What do investors want to see?

As with all questions regarding investors, the answer is ‘it depends’.

If you are targeting VC investment, they will want to see exponential growth very quickly.

However, it’s highly unlikely your start-up will be eligible for VC funding because it has largely dried up. The ones they do fund are likely to be later stage businesses that have already proven their potential for high growth.

Realistically, you are better off targeting angel investors who are more likely to invest at an early stage and are more flexible on returns.

In my experience (and it’s just my experience), angel investors have become sceptical about hockey stick projections and companies that promise the moon on a stick. They want to back ambitious companies but they don’t want to see businesses wildly over-promise.  

As always, please do share your thoughts about projections and pitching them to investors. We love to hear the feedback.