As many startups nowadays focus on market penetration and revenue growth as a core driver of their value proposition for investors, sales projections become more and more important for budgeting, valuation and cap raise. There are essentially two approaches to project sales: top down and bottom up.
Top Down Sales Projections
Top Down projections are a quick approach where founders base sales projections on market size numbers such as; total addressable market, serviceable addressable market and serviceable obtainable market (see our previous blog on market size (Blog - Market Size Estimates). They will then make an educated guess if they can capture a portion of the market, e.g 1% or 2% within a certain number of years.
A big limitation of this approach is that sales are estimated without much consideration for resources such as people, capital, competitive landscape and business model. Therefore, sales projections generated from this method can be way off the mark and often carry limited insights about the business.
However, a significant advantage of this approach is that it can be done very quickly and in certain contexts, it is a very useful early estimate. For example, if founders make a bold estimate that they can capture 10% of the market in 5 years but this sales projection still can’t support a required return profile for potential investors, they might need to make adjustments to their existing business models accordingly to be able to attract capital and push their companies forward.
As an investor, we also use this method on a frequent basis to screen investment opportunities. If a startup’s sales projection is $100M in 3 years and the target market size estimate in 3 years is $500M, we can quickly do the math in our head that the projected market share is 20%. Therefore, if the existing competitors, equipped with more resources, are only having less than 5% each, it is a big red flag for us.
Bottom Up Sales Projections
A bottom up approach requires founders to think more deeply about their business and how they plan to achieve what they want to achieve. Bottom up projections would be built on the awareness that the resources available to the startups are limited. Some examples include:
- Capital: startups have limited access to capital and have to build a business strategy based on this. For instance, it’s hard to grow 50% to reach $100M sales a year if there is only $1M budgeted for sales and marketing; Thus in a way, sales are often related to the availability of capital, especially in early years.
- People: most startups are small teams early on and what they can achieve is likely limited by the size of their teams and the particular skills that their teams have.
Other considerations include competitive landscape, business strategy, the nature of the products and market, etc. In a direct or indirect way, they all will have an impact on the sales of the business.
Some common mistakes that I observe when a bottom up approach is used are:
- Founders have limited understanding of target market and/or choose a wrong one for their products.
- Limited sales and marketing budgets are allocated but huge sales are projected. This is not impossible but is rarely realistic.
- Insufficient thinking on pricing strategy. If incumbents are charging for their products at a certain price, it doesn’t mean that a new product can command a similar price or higher without regard to other aspects of the product and business.
- Not much consideration involved for distribution strategy by founders. For example, whether distribution partners are local companies or global enterprises with a global outreach, would have substantial influence on the timing and size of sales.
- Sales cycle is not considered. For some consumer products at a low price point, sales cycle can be short but for high value B2B product, sales cycle can be many months or even years. Sales cycle of a product for SME is usually shorter than that for large corporation and government agencies.
I personally prefer a third approach where both top down and bottom up can be done simultaneously, as each of them provide valuable information, not just for founders but also for investors who are interested in investing in the business.
A founders’ ability to avoid many of the most common mistakes also has the added bonus of giving investors the impression that the founders are already thoroughly thinking through all aspects of the startups’ potential to generate sales in the future. Thus making the company’s sales projections and valuation more credible.