What I have learned to do is to back into my revenue calculation, using a worst case scenario analysis.  I start by building a spreadsheet that has all of my revenue drivers – assumptions used to derive the revenue calculations.  I then build out an income statement, once again, using the revenue drivers to calculate the top line of the income statement.  Finally I build a cashflow statement that ties to the income statement in a couple ways, but primarily via the net income.

When doing a traditional business analysis, it’s easy to get wowed by the “estimated return”.  Some folks will do a sensitivity analysis on the estimated revenues, maybe the estimated expenses, and come up with equally wow’ing returns which do nothing more than distract you from the real question at hand – is this opportunity viable.  As I’ve mentioned, the problem is that while guestimating expenses and start-up captial requirements can be done with relatively fair accuracy, in many business plans doing the same for revenue isn’t possible.  That’s why this approach is so valuable.

So, once you have your revenue assumption sheet linked to your income statement and likewise linked to your cashflow statement, you can start the process of backing into revenue.  On the income statement, you can start by putting in reasonable expectations for expenses, taxs, etc.  On the cashflow statement, you probably have a reasonable idea of how much start-up capital you have access to, or will need to operate the company prior to having a stable revenue stream.  In addition, based on the net cashflow you can do some simple hurdle rate calculations such as net present value (NPV) or internal rate of return (IRR).

Once all of those things are set, then go back to the revenue assumption page and start entering assumptions until you get to a point where the business plan is just able to get by.  The spot where, “if at a bare minimum we are able to do this revenue, we can keep our doors open for business”.  This is really the make or break revenue of the company assuming that your access to start-up captial is limited to some ceiling.  At this point, you can now step back and take a holistic view of the revenue assumptions and projections and focus on the companies ability to meet those revenues.  The question then becomes about “can we make this revenue, or not?”.  Hey, if the company actually does 2x your assumptions down the road, congratulations, it’s a good problem to have!  But in your analysis, assume worst case, and back into the minimum revenue that you can derive to have a operable company (or opportunity you are willing to invest in), and if you have confidence that your company can meet those minimum requirements, you might have a winner.

Where it’s not so easy is around sales and estimating revenue.  The level of complexity around this estimation is dependent upon the nature of the business plan.  As an example, if you are writing a business plan for a new hotel that you want to build or purchase, it might be a little easier because your business by nature is bounded.  If I build a hotel that has an occupancy of 100 rooms, I can safely estimate that my revenue is going to be a factor of the occupancy rate (between 0 – 100%) for any given day.  A difference of 60% occupancy versus 70% occupancy might make or break a business opportunity, but at the end of the day, it’s basically a 10% difference in revenue over that period.  There are some methods to try to fine tune your estaimates, probably the most useful is comparables (often referred to as “comps”).  You can go to neighboring hotels and count cars in the parking lot to determine your competitions nightly occupancy.  You will likely not get the same occupancy the day you open, but your business plan can start to become more realistic when you have that type of data at your disposal.

Now look at what the internet has done for us.  A web based business plan is open for business 24 hours per day, 7 days per week.  It’s open in literally every region and country of the world.  It is not limited by only having 100 rooms of occupancy.  I always hear the guy that invented the pet rock is a millionaire.  I don’t know if it’s true or not, but lets say that when he invented it he had the internet at his disposal.  The inventor creates a web site, puts a picture of his pet rocks on the site for the world to see, and puts an order form on the site so that anyone in the world can order his pet rocks.

There are a number of unknowns with the pet rock business plan.  What is the size of the market, are all 6.7 billion people on this earth your market?  Probably not, only about 24% of the world’s population has access to the internet.  And what percentage of those internet users will ever see your site, not many?  Once on your site, what percentage will actually go about filling out the form and paying for the pet rock?  You see where I’m going, you end up with click through rates times conversion rates times other rates I haven’t even mentioned – a myriad of compounded rates.  What you end up with is a revenue estimate that is very sensitive, a conversion rate on your website of 2% versus 3% might make or break your business plan and mean the difference in millions of dollars of revenue.  There are industry standards that you can lean on, but in the end you have to use your gut feel for what washes out to be some sort of revenue estimate.

My advice to people is to ask themselves, does this revenue model feel right in my gut.  Does the revenue make sense, does it grow smoothly or are there huge spikes?  Is it conservative, did you back into the revenue?  If you are comfortable with those things, then it’s likely that your business plan is realistic and hopefully will have legs.

I see it time and time again – many times from people making major financial decisions for their company.  Some will argue that it is a bug in Excel, and according to some articles I’ve read the behavior is different between different versions of Excel, I don’t know if that is the case or not.  My argument is that people should understand the concept prior to blindly using the formula – and perhaps some clearer user instructions from the software providers.

What am I talking about?  Improper use of the NPV (net present value) formula in Excel and OpenOffice.

Net Present Value is the comparison of a dollar today versus the value of a dollar in the future.  Presumably if someone offered to give you a dollar today, or a year from now, you would pick today.  If I were given a dollar today, I could invest it at some interest rate and one year from now I would have a dollar and change.  That obviously has more value than being given a dollar a year from now – the difference being the change.  NPV is one of the primary analysis tools for valuing business opportunities.  Those decisions might include plant expansion projects, purchase of a new company, etc.  At the end of the day companies and entrepreneurs typically spend money today to make money in the future and NPV takes those expenditures (cash outflow) and profits (cash inflow) and gives you the “net value of the opportunity”, in today’s dollars accounting for inflation and returns in a discount rate.  Now, it is important to note that without a crystal ball, future cash flow from an investment is typically based on estimation, but that’s a different discussion.

What should be understood about the NPV formula in Excel and OpenOffice is that it gives the net present value of FUTURE cash flow.  If you include time 0 (today) cash flow you are improperly discounting the value of today’s dollar.  The net present value of a dollar today, is a dollar.

See the example below.  This particular example was done using OpenOffice, but you will get the exact same result using Excel.

NPV Calculation in OpenOffice

What you see is a series of cash flows, a year 0 (today) cash outflow of $1M, and then a series of outflows and inflows ending in year 7 with an inflow of $1M.  For the sake of this example, a discount rate of 10% will be used.

There are two results shown below the cash flow series, the top NPV result ($175,653) being incorrect and the source of many mistakes that I see from time to time.  The bottom result ($193,218) is the proper calculation for the NPV of this cash flow.  The mistake, which in this case causes for an understatement of the value of the investment, is caused because the cash flow series is being treated as if it were all in the future – and that is not the case.

The proper use of the equation when calculating an NPV on a series of cash flows is shown on the bottom result, ending in a NPV of $193,218.  The NPV formula, when used properly, should include the range of FUTURE cash flow, and that result should be added to the time 0 (today) investment.

Happy NVP analysis!