Feasible financial projections- A precursor for realistic expectations
SMEs need to restrain from over overambitious numbers while starting/growing their business and realistic assessment of parameters is paramount to manage the stakeholder’s expectations.
Recently there was an appalling news report that a food major is locked in a fierce boardroom battle with equity investors who made a substantial investment in his new food venture. The bone of contention was the inability of the company to reach the expected level of valuation that would have facilitated a profitable exit for the investors who stayed invested for more than five years and looking for an exit. The valuation is low because the company did not reach the projected milestones in terms of revenue, reach and profitability, it is observed.
The business under dispute is promoted by an entrepreneur of a highly respected business family in the industry. The founder had a very successful exit ten years back in the similar venture. The entrepreneur himself is well acquainted with in and out of the business.
The industry is well poised to support such an ambitious startup from a food veteran. Burgeoning middle-class families with working women are a major source of growth opportunity, the company seems banking on to build the business. The growing wealth and improving standards of living have prompted many food companies to innovate their products and delivery. The success of many large companies overseas even in developing countries probably prompted them to plan quite ambitious numbers.
The venture has many innovative items in the product basket and has the vision to make life easier for families through ready-to-eat and semi-cooked food items. Some are really unique in terms of the making life happier for families.
The core of dispute among the partners in the venture- Lower valuation than expected to facilitate profitable exit:
The reports indicate that the enterprise did not reach the expected level of valuation assumed at the time of investment. The equity investors are obviously restless as most of the private equity investors seek an exit in 5-6 years unless they decided at the time of entry to stay longer.
Secondly, we can make out in the reports that the investors also holding a significant proportion of convertibles (instruments that can be converted into equity shares at a certain multiple or PE Ratio). As the time has come to trigger the conversion, it became another of the source of discord between founder and investors. Because the profitability remained so low that the conversion likely to end the majority shareholding of the promoters and his family. Promoters, being the prime mover of this business, feeling uncomfortable to accept dilution of their majority holding.
Valuation of the firm and its relationship with projections into future:
Prima facie it was a startup; of course, built by the promoters who have a long history of success in this business. It adds to raise the valuation in the eyes of investors. In spite of it, it needs to be justified in terms of how the company and promoters look at the financial projections.
The discussion boiled down to the relationship between the financial projections made by the company presented to investors to convince on the valuation. In other words, the valuation squarely depends upon the projection and it is the promoters & the company solely responsible for building a financial model for the future of the company.
It is not uncommon to find many entrepreneurs building very ambitious projections. It is a common sight among the many SMEs especially in the growth stage to go very ambitious.
It is not to say that being ambitious is wrong. What is important for any business, while building the financial model and in turn higher valuation, they need to see that the projections are in sync with the industry characteristics, managerial strength, operational strategy and financial management. If the model ignores any of the above characteristics, it is more likely to become a non-achievable one. For example in the food business, it requires very long time to build noticeable brand however good one is at the business and once the brand is established, the growth will be exponential. Similarly, however attractive an industry is, it may fail to translate into financial numbers if the company lacks a good management bandwidth or lack a robust operational strategy to optimise the cost and maximise the profitability.
More important is –these characteristics need a fresh review for every new venture, irrespective of experience and past successes of entrepreneurs. History of success does not guarantee a repeat of the same.
Secondly having projected an ambitious target and made the investors believe into it, the promoters should show the magnanimity to accept the terms of investment and accept the investors’ decision with grace. Any action of preventing them to do so will result in the division with the board eventually the strategic direction will become weak and the enterprise value created so far will degenerate slowly. The business created with so much passion may become a liability should the differences persist.
Had the management shown little more attention to key assumptions while building such projections, probably the situation could have been different. Secondly being reasonable in dealing with investors and allow them to exercise their rights is paramount to grow the organisation and reap the benefits in the long run.
The financial projections are not be treated casually. It is an important statement about the intentions and strategies of the company. It is good in the interest of SMEs to build a feasible financial model and keep updating the same.