Dealing with revenue forecasting can be a headache for any sized business. There are different models, and it can feel like more of an art than a science. Building forecasts with accuracy takes time, but in the interest of building in public you can use this method from our leading venture studio instead:
There are 11 metrics that are common on any P&L statement. Brian Feroldi explains it well in his Twitter Thread and breaks it down like this...
Most bootstrapped founders care most about “Net Income” because at the end of the day this is how much money ends up in the bank account.
But oftentimes founders hide this number and promote their “Revenue” forecast instead because it is by far the largest number to brag about and easiest to compare to others.
I have met founders with $18MM in annual recurring revenue and $50K in Net Profit before the owner draw.
I have also met founders with over $20MM in revenue and 50% margins.
In both of these examples, the number of employees was under 20.
But recurring monthly revenue is hard to predict. Invoices fluctuate, seasonality occurs in all businesses, customers cancel, wars start - the list is endless.
The conversation of a founder with his team will traverse something like this…
This year I made $1,000,000. Last year I made $100,000. This means next year I plan to make $10,000,000. It’s basic math man - it’s like 1000% growth right?
Looks great on paper, and makes you feel like a champ - but it is not reality.
Revenue is very hard to predict because there is no anchor. Revenue is the accumulation of multiple metrics.
A SaaS company's revenue is based on the movements of their customers' subscription plans and uses a multitude of three-letter acronyms to understand. MRR, LTV, CAC, ACV, and Chuuuuuurn. (Ok, not three letters.)
Even net new annual revenue is a calculation from the addition of new customers + expansion customers - churned customers.
This graphic doesn’t even begin to understand the Cost of Acquisition of each customer and if that is sustainable at scale. Also, what if you are doing 1-to-1 customer support this year and plan to achieve revenue growth 10x? Well, this means you need to grow CS 10x too - not so fun when you think about it that way.
But there is a better way. It does not involve even thinking about your revenue.
There are only 4 metrics you need to know about to predict Revenue in almost any company.
It is really that simple.
First, let’s address your immediate reaction. “This is not possible in my business because my growth rate is fast.”
There are only a handful of business owners I have ever met or read about that this will fall apart for various reasons - but mostly because these founders are basically succeeding beyond us mere humans. (I will write another thread about who if there is interest.)
But for the rest of us. Four metrics will do.
Let’s start with how to use these four metrics to calculate annual recurring revenue.
Start with last month. You know the Cost of Goods sold because you just closed the month and paid the employees for their time, or you paid off the invoices for inventory or calculated WIP for the month.
In an agency or SaaS company, COGS should house your engineering team, project managers, quality engineers, and any other personnel that delivers the software to your customers.
These cost structures are relatively linear. You hire when you feel like you are understaffed, and fire when you are overstaffed. The movement of employees will generally increase and decrease with demand and is fully controlled by management - not outside forces like revenue streams.
Because these costs are linear - COGS are easy to predict and forecasting is simple.
All other employees, consultants, administrators, and sales fall into this bucket.
Just like COGS, in a software company, these costs relate to people. The sales team, marketing team, hr team, and any administration services are housed here. If you thought COGS is easy to predict, SG&A is even easier.
Look at your last 12 months, draw a forecast-based linear line - and you will get pretty close to your future monthly SG&A cost.
Operating expenses are any costs that a business incurs in its day-to-day operations. Software, lawyers, insurance, classes, shipping, advertising, etc. Again, relatively linear.
After everyone is paid, all expenses are paid, all invoices are paid (and in our case all Credit Cards are paid), the money left over can be “drawn” for the owners. Surely, not 100% of the net profit can be drawn - but most bootstrapped companies, plumbers, and small business owners draw the same amount of recurring revenue each month.
Most people separate out owners' draw from the P&L. In fact, almost all accountants do and maybe we should too - but why? Isn’t the owners drawing an expense on the business?
Owners gotta fly first class while eating caviar and sipping champagne right? So they should be considered an expense on the business and something that is calculated before the net profit is considered. Sure that is not “standard accounting” but it's just common sense. The rest of the money can be left in the business for cash flow.
If you are not venture-backed and care about profitability then your pre-tax profit goal should be 10%. Period.
“At 5% a company is on life support; at 10%, you’re a good business; and at 15% you’re a great business. Anything over that point, [Greg Crabtree] advises to take it while you can.” ~ DEKSIA
What this basically means is that after all of your costs are accounted for you should be left with AT LEAST 10% in the net - pre-tax- profit. Remember, this is after your owner's draw too. Treat the owners like employees and therefore the 10% profit can be used to healthily grow the business - not used for dance parties and expensive art. Those practices don't make for successful business models.
We now have all the pieces to predict the next months, next year, and next ten-year revenue. Revenue is simply what is the unknown variable when you subtract all of your costs including the assumption that you have a 10% net profit. The equation, with one unknown, looks like this.
Each known variable in this equation is relatively linear and has historical data you can predict very accurately - without assuming the fluctuations of invoices or cash flow.
To 10x your forecasting ability, run your prediction through Forecast.ETS in excel. Microsoft defines Forecast.ETS by saying it calculates or predicts a future value based on existing (historical) values by using the AAA version of the Exponential Smoothing ETS algorithm.
Simply put Forecast.ETS is a magic wand.
There you have it. The ability to predict your business will result in 4 lines. Revenue, Cogs, Operating Expense, and Owners Draw. All are based on a 10% net profit. You will start to notice that your future will diverge. This is good :)
10% net profit means that you need to increase your revenue separation gap from COGS as well. It will also lead to a larger owner draw - which is good for the owners.
In our forecast, there are a few things that I absolutely nerd out about. At NineTwoThree Studio we have more expenditures at the end of the year due to the nature of our business. The Forecast.ETS model picks that up and predicts that going forward for every December.
Also, if I calculate the forecast for the last 2 years based on actual occurrences - the forecast model was off by less than 5%. Surely, there were months when we crushed it - and there were months that we felt like we were going to crumble - but just like the Vegas roulette wheel the Law of Averages takes over and we balance to the mean.
What else do I nerd out about? If you have three great months, your sales forecast and revenue forecast model are automatically adjusted for your new future. No need to recalculate your new hires to support the new reality - and no need to recalculate a new type of business model. The four metrics above will be adjusted with each actual month that passes.
The best part, is all you have to do is enter four numbers every month to update your forecast. Those four numbers are all cost based and very easy to find on your P&L. It is 5 minutes of work - seriously.
Pretty neat huh? Let me know how your company does forecasting and if your team will switch to this model - which we ideated from Greg Crabtree - the OG of forecasting.
Taking the time to learn how to do revenue forecasting in this way will help you get a jump on many of the other important operational steps you need to take in your business. Spending the time to understand these models early on will save you plenty of heartaches in business planning later.