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5 Things You Need to Know About Projecting Startup Profits

5 Things You Need to Know About Projecting Startup Profits

By Tim Berry, Guest Blogger
Published: November 24, 2015 Updated: November 24, 2015

This year alone I’ve seen several startup business plans projecting year three profits at 40%, 50%, or more, as measured by dividing net profits into sales.  And most of these are pretty good plans as measured by potential product-market fit, scalability, and credibility of the management team. What’s wrong with this picture?

By profits, I mean net profits divided into sales, also called profits to sales. Of course there are other ways to define and compare profits, such as gross margin (sales less direct costs), earnings before interest and taxes (EBIT), and EBIT less depreciation and amortization (EBITDA). 

So why have such unrealistic profit projections? No good reason I can think of. Overly optimistic projections make a plan look worse, not better. So please, if you’re planning a startup, get a clue. Here are five things you need to know.

1. High Projections Hurt Credibility

Unrealistically high profit projections almost never mean that your startup is going to be profitable. Almost always, they mean that the people doing the business plan failed to estimate expenses.

On the other hand, you might not be alone. Browsing for background on this post, I found the public thinks the average company makes a 36% profit margin, which is about 5X too high, according to a post by Mark Perry for the American Enterprise Institute.

(Source)

As the title suggests, multiple polls of the general public indicate people think profits are way higher than the 6%-8% that is a real average.

2. Industry Averages are Available

If you’re writing a startup business plan, do your homework. Industry averages are available. Check out this page from Yahoo Finance, showing average profits for different industries. The overall average is about seven percent. There are, however, some industries that do better. According to that source, some kinds of real estate developments average more than 30%. Drug manufacture advertises 22%. And among some of the high-tech categories that attract many startups, biotechnology averages 19%, electronic technology 17%, and business software, 14%.

To find averages for your industry, do a web search. Multiple sources are available. One cluster of sources compiles averages from among publicly traded companies, divided by industry. Another cluster uses aggregated tax data from different industries, combined together to protect privacy. Search for “average profitability by industry,” “industry data,” “industry reports,” and “average financials” to turn up vendors. Look also for websites of industry associations for your startup’s industries.

Don’t be afraid to project profits at levels different from industry averages. Lots of startups have good reasons to presume profits better than averages. Maybe they have better technology, or innovations in marketing or business model. What I suggest isn’t just to follow the averages, but rather, if you are different, know what the standard is, and be able to explain how and why your startup is different.

3. Startups Need Time to Break Even

Normal startups take some time to break even. That’s part of the rationale behind the concept of break-even analysis. It’s the main reason startups need startup financing, which is generally capital that supports the business while it’s new and still growing. That comes from SBA loans, friends and family financing, founders’ personal resources and savings, or outside investors. The rule is early losses. The exception is quick profitability.

4. Inherent Conflict Between Profits and Growth

Growth costs money. It’s a matter of common knowledge among business owners, experts, and angel investors. Businesses that generate high growth rates are almost always making lots of small decisions that channel available money into spending that increases visibility, awareness, leads, and sales.

Ultimately, it comes down to a simple trade-off.  Profits are what are left over when the spending is done. Business owners who want to generate sales growth decide not to take that money home as profits, but rather to put it back into the business as marketing expense. They spend it on more web presence, advertising, promotions, lead generation, sales expense, and even product research and development to support future growth. And of course they also spend it on struggling to grow, and making mistakes.

5. Good News: An Easy Error to Fix

So now for the good news. At least in the context of angel investors looking at startups, which is a process, I’ve been involved with for several years now. If you have a good team, product-market fit, potential growth, and a good argument for barriers to entry, scalability, and a long-term prospect of an exit, you have a good investment regardless of poor financials. Most investors will help you make better estimates. I’ve heard angel investors say it too, more than once: “poor financials are the easiest problem to fix.” 

About the Author:

Tim Berry
Tim Berry

Guest Blogger

Founder and Chairman of Palo Alto Software and bplans.com, on twitter as Timberry, blogging at timberry.bplans.com. His collected posts are at blog.timberry.com. Stanford MBA. Married 46 years, father of 5. Author of business plan software Business Plan Pro and www.liveplan.com and books including his latest, 'Lean Business Planning,' 2015, Motivational Press. Contents of that book are available for web browsing free at leanplan.com .