One of my pet peeves in pitches is the triple whammy of absurdly high profitability projections. I’ve seen entrepreneurs promising 30, 40, even 50 percent profitability in their projections.
Why triple whammy? Projecting excess profits, at rates way beyond the normal, are bad for at least three reasons:
- Kills credibility regarding industry knowledge and realistic projections. It doesn’t take much research to turn up standard profitability rates of different industries. A decent web search will turn up several different sources of standard industry ratios for less than $100 per industry, broken into NAICS codes. Projecting much higher than average profitability usually means a lack of understanding what real expenses will be.
- Kills credibility regarding startup experience and understanding what investors want. Success for investors comes with growth, so investors look for growth potential in the projections, much more than profits.
- Kills credibility regarding long-term growth and the way things work. Even if that startup could achieve excess profitability, in that case profits above the level needed to sustain growth are money that should have been spent on generating more growth.
For more on this, Mark Suster does a great job explaining the critical trade-offs between profits and growth in Should Startups Focus on Profitability or Not? on his Both Sides of the Table blog. He writes:
I find it amusing when a journalist writes an article about a prominent startup (either privately held or preparing for an IPO) and decries that, ‘They’re not even profitable!’ I mention journalists here because they perpetuate the myth that focusing on profits is ALWAYS the right answer and then I hear many entrepreneurs (and certainly many ‘normals’) repeating the same mantra.
He goes on to explain several cases and contexts in detail. Most companies should focus on profits, he says (although he isn’t talking about excess profits); but there are some notable exceptions. He also points out the critical difference between profits and cash, which is always a good reminder.
If you’re working on financial projections for angel investors, read Mark’s post in detail.
All opinions expressed are those of the author, and do not necessarily represent those of Gust.