Many founders and CEOs have seen their business plans upended by COVID-19. That’s because very few contingency plans accounted for the scale and nature of the disruption we’re all experiencing. In fact, even many of the largest and best managed public companies withdrew their guidance as the full impact of the pandemic became clear. The question is if they can’t foresee how their companies will perform in the short term, then how can investors be expected to gauge the value of those businesses?
The reality is that to some extent, they can’t. And yet, to some extent, they also don’t need to. In times of heightened uncertainty like these, it’s important to remember to focus on what you need to know about the companies you’re invested in. You can worry about any other stuff you’d like to know later on.
At the top of the list of things that are important (and knowable) is how much cash a company has, and how much it can access. And even though revenue forecasts might be highly uncertain, most managers have a good idea of how much it will cost them to operate their businesses under different scenarios. Those two data points tell you how much time a company has before it runs into real trouble, and therefore how much time you have to help it find solutions to its problems.
Under normal circumstances, venture lenders are comfortable with properly managed burn rates. In other words, we expect companies to lose money as they invest to achieve high rates of growth. But “normal circumstances” is an important qualifier here. When uncertainty abounds, our focus as lenders switches to the sustainability of a company’s operations. Spending for growth becomes a luxury that can be deferred.
Of course, just assuming the worst is almost as bad as assuming (and acting as though) everything will be okay, and simply continuing on as normal. Even when you’re guessing about outcomes, it’s important to structure your guesses in ways that at least give you a sense of how sensitive your portfolio companies are likely to be to changes in the environment.
What can be done?
We encourage our partners to use a number of techniques to ensure the quality and reliability of their financial forecasts. Doing so doesn’t just help us. It also benefits the other stakeholders, including managers, equity holders, and employees. These techniques include:
Collaborating across functions to build out assumptions. Forecasting for impacts of COVID-19 and economic downturn requires agile and responsive decision-making. Forecasting can’t be done in isolation, or from the top down, and alignment between financial and sales functions is central to creating accurate forecasts.
Including sufficient detail. At a minimum, we look for monthly forecasting that integrates the P&L, balance sheet, and cash flow statements. But sometimes we need more granular detail, such as weekly cash flow forecasts. Really robust forecasts rely on the drivers that matter most to the business. Supporting schedules including revenue build, headcount and payroll breakdown, and debt schedules are useful in understanding those drivers.
Customizing scenarios to particular contexts and challenges. The reason why we focus so obsessively on model drivers is because the only thing we know with certainty is that things won’t turn out exactly as planned. Sensitivity analysis and stress testing are therefore key components of a good forecast. At Espresso, we also pay special attention to the down-side or worst-case scenarios. Stress testing key assumptions and drivers is vital, and allows us to identify any downward pressure on liquidity and financial covenants before they happen.
Realistic forecasting to achieve plan. Balancing attractive growth targets with realistic forecasting is challenging. However, realistic forecasts are crucial to understand tighter liquidity points and any potential to breach lending covenants. And we’re not the only ones who want realistic business forecasts. Line managers and employees are also keen to avoid having unduly rosy pictures painted for them.
Monitoring and refining. Financial models are living creatures, and will need to be updated and flexed to reflect actual results and new developments. Our preference is to see real-time feedback loops between results and expectations, so that forecasts can be accurately calibrated to changing conditions and expectations conditioned accordingly.
Ongoing communication with investors and lenders. By definition, liquidity is harder to access in periods of uncertainty, so management teams should work with their board, shareholders, and other stakeholders to plan for longer fundraising cycles. Early and clear communication is critical, and we try to make sure that we’re actively involved in those conversations to whatever extent is necessary. There’s too much potential for confusion in a crisis, and ensuring that we’re all on the same page is easier if all the actors are reading it out loud together.
A disciplined approach to financial forecasting will help companies manage through times of uncertainty. In a downturn, companies must have a clear understanding of cash needs and be more conservative in runway forecasts. Companies should prepare for volatility by extending their cash runway and understanding flexibility in their business model. None of these steps in isolation offers us perfect security when everything is in crisis, but they do help us to understand the risks in our portfolio. Through that understanding, we’re better positioned to manage it and achieve the investment returns that we’re looking for.
This blog was authored by Espresso Capital. Republished with permission.