Four steps to help small business owners evaluate the financial wisdom of new business-building initiatives

When you are considering investing in a significant new entrepreneurial initiative as a vehicle for growth for your small business, you will face the challenge of developing financial expectations without direct operating experience. Making projections to set financial expectations is a distinct challenge. Sadly, many small business managers choose to either skip the step or forgo entrepreneurial initiatives altogether. Instead, I say, meet the challenge head on with an entrepreneurial approach to financial projections!

Here are some tips to get started.

• Don’t worry about being right because you won’t be. Trying to be right will only get you bogged down. Instead aim for a process that helps you understand where things can go off course as well as the upside potential. Use your small business knowledge and operating experience where appropriate and be prepared to make new assumptions and guesstimates where needed.

• Good assumptions take time, thought, research and discussion. Taking time to form good assumptions minimizes the ‘garbage in – garbage out’ risk. For example, don’t assume you can attract 200 customers a day spending at least $10 a piece to your new coffee shop because that’s what you need. Take time to consider how many people pass your planned location, what percentage might stop in if your shop were there, and how much they typically spend.

You can research this question by reading available industry research and, most importantly, watching what people in your target demographic do at similar existing shops. This will give you insight into your planned location as well as your customer traffic and spending projections.

• Use four different types of projections: top-down, bottom-up optimistic, bottom-up pessimistic and bottom-up realistic. Use a top-down approach to define the financial performance you would need to make the initiative worth pursuing, e.g., assuming we invest $X before we start and $Y in annual expenses we need to be profitable with Z% annual growth by 2015.

The three bottom-up approaches often share a common spreadsheet but are driven by different assumptions about the economy, interest rates, operating milestones, trends in the marketplace, growth in your customer base, unit sales, pricing, competition, cost of goods sold, and so forth. Thoughtful development of optimistic, pessimistic and realistic assumptions sensitizes the entrepreneurial team to potential financial, market, and operational pitfalls and windfalls.

• Analyze results objectively and flexibly. If all three of your bottom-up scenarios meet or exceed your top down projection (and you have been tough-minded about your assumptions) you can feel encouraged about investing in the new initiative. If instead the three bottom-up projections all fall short, you should be prepared to radically overhaul or stop the initiative on the grounds that it is unlikely the investment will be successful in any case.

Of course most often bottom-up and top-down projections partially overlap and the decision to move ahead is not so straightforward. For these cases, use the projections to identify the risks and use your judgment to decide whether or not to move forward. It is often wise to structure early efforts around mitigating risks and proving assumptions true or false. In this circumstance, set triggers for pulling the plug or doubling down as you learn more.

For example, an entrepreneurial team inside a software company has an idea for a new breakthrough product that will transform the way existing customers operate. Financial projections show that this idea has outstanding potential but only if a broad range of customers are open to it.

The entrepreneurial team recognizes two risks: Can they make the software reliable enough for a commercial application? Will existing customers accept the new approach? Management decides to invest on a limited basis to determine whether customers are likely to adopt the new software. To that end the entrepreneurial team is funded to develop a prototype that can be offered as a beta test to determine customer interest and inform future product development. The financial projections will be used to evaluate the results and make a go/no-go decision before additional budget is allocated to the project.

Too many small business owners and entrepreneurs make the mistake of going the “build it and they will come” route because doing financial projects takes time and isn’t necessarily something they’re comfortable with. Don’t make that mistake. Take the four steps recommended here and position yourself to make a well-informed decision about your next business-building initiative.

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Karen Utgoff, principal of Karen Lauter Utgoff Consulting, is a market-oriented business strategist based in Amherst, MA. Learn more at http://www.utgoff.com.

© Karen Lauter Utgoff Consulting 2012. All rights reserved.

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