“Most startups are horrible at forecasting their revenue, and you’ll find us to be no different,” Barry, our chairman of the board said to a prospective investor.
Everyone laughed because there was a lot of truth in what Barry was saying.
Startups are usually horrible at forecasting revenue for two reasons:
A. Founding CEOs are way too optimistic.
You think your business is just going to take off when you launch your first product. Reality of course is way different.
Growth is slow, very slow. You may have to change your pricing, your business model, your go to market strategy and more before you gain traction. Plus…
B. You have no data.
Your first few attempts at forecasting are just calculated guesses because you don’t have any data. You’re just grasping at straws really.
But, over time, you do get better at forecasting.
Your forecasts get more realistic because your board (at some point) starts putting pressure on you to be accurate. Plus you start getting some data.
We used two simple methods to improve forecast accuracy:
A. Bottoms up forecasting.
Bottoms up forecasting is as old as dirt. You simply forecast by each customer what you expect them to do for whatever time period you are forecasting.
Focus on the 20% of your customers that make up 80% of your revenue. Then extrapolate the rest. Then…
B. Use “The Graham Technique.”
The Graham Technique is something we borrowed from Benjamin Graham. Graham wrote The Intelligent Investor an incredible book on value investing.
Graham would analyze the growth rate of stocks by taking the average of the last three years of a company’s earnings and comparing that to the average earnings 10–12 years previously. He would then have an average earnings growth rate for a company.
You can apply the same methodology to forecasting revenue. Take the last three months of company’s revenue and compare that the revenue 12–14 months earlier.
Now you have an average trailing 12 month growth rate that averages out any large swings up or down.
C. Then you compare your bottoms up forecast to your Graham forecast.
The nice thing about the Graham forecast is it’s just numbers. So you are forced to explain why you are expecting higher or lower growth to the trend.
It’s not perfect (nothing is with forecasting), but comparing the bottoms up to the Graham results keeps you honest.
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