How to build great financial forecasts for your buyer

Your financial forecast is a critical document in your business sale.

That's a spreadsheet, plus presentation and commentary, showing how you expect your revenues, costs and profits will change over the next 3-5 years.

These numbers tell the buyer how bullish you are, and form the starting point for their analysis on valuation. They also give a second layer of insight around where growth will come from, how margins will evolve and how the cost base needs to adapt.

Building these forecasts is stressful for many sellers. The process itself is daunting, and there's this great concern over how to balance bullishness with credibility.

How do you build a great forecast? What are the pitfalls, and how can you avoid them?

We'll break down the top-down and bottom-up methods, and run through common forecasting mistakes to help you build an exciting, ambitious but also robust and defendable forecast.

A note on advisors

If you are working with an M&A advisor, they will take the lead on building out your forecasts.

They have lots of expertise here, and will have a team of Excel wizards to pull this together. So you should lean on them for guidance.

But you know your business best, and how it's likely to grow and evolve. So you need to lead them, rather than the other way around.

That means you need to get clued-up on how to build forecasts so you can give them clear guidance on what you want – and then let them to do the spreadsheet work to bring it together.

The top-down forecast

This is the best way to get started.

Top-down forecasting means starting with your financial results for the last 5 years, and simply applying a growth rate to revenues and costs each year to get to a first guess at what your forecast numbers would be.

So if you've grown from £4m sales to £8m sales in the last five years, you might say that in the next five years you could realistically double again to around £16m in sales. You can repeat for your key cost areas, to give you an idea of profitability.

If that sounds like an overly simplistic, 'finger in the air' approach – don't worry, it's supposed to be. This just gives you a point of reference and helps triangulate the detailed modelling that will come in the 'bottom-up' process below.

At this point, you should sense check against the 60% rule we shared in The Goldilocks Problem: How to get your forecasts 'just right'.

You want your numbers to be ambitious enough to get buyers excited about future growth (and faster growth will give you a much higher price), but also credible and defensible. So, you should set a forecast that you feel you have a 60% chance of achieving.

The bottom-up forecast

Next, you can move onto building your "bottom-up" model. This will give you the detailed spreadsheet that you will eventually share with buyers, plus all the granular data that you will use to answer their detailed questions in due diligence.

As the name suggests, you start with the granular inputs of your business, and work through how those will grow over time. Usually on a monthly basis.

Revenue

Let's think about revenue first.

Your spreadsheet will build bottom up (hence the name) from the inputs that drive your revenue, model how these will change over time, and then output the expected revenue.

The expected inputs will vary based on your business model.

For example for a SaaS or subscription business, your inputs start with new customers per month, less customers churned. Then you estimate the average price per customer (less discounts) and calculate through to get to monthly and annual revenue.

For a project-based business, like a recruitment consultancy or design agency, the revenue inputs will be clients sold and average project value.

You should also break revenue up by geography, by product or by other segments to get some additional insight to share with buyers.

You can then play around with how fast you add new customers, how slowly they churn and the average price to adjust the end revenue.

This exercise will force you to think through some interesting strategic questions:

• What is the most likely and credible way for me to increase my revenue?
• Where am I most likely to come up against challenges?
• What is the right combination of more customers, reducing churn, increased pricing, launching new products and launching in new markets? Which of these are powerful levers and which are limited?

You can then cross check with your top down forecast to see if the two align. If they are meeting up around similar numbers, you are on the right track.

Now that you've looked at the revenue in detail, you should check if you're still passing the 60% rule. Or in hindsight could this be moved up or down?

You then go through a series of iterative loops – sense-checking and editing inputs and seeing how them impacts the overall revenue growth.

Costs

Once you are comfortable with how the revenue is building up over time, you can then think about the cost side.

This is pretty simple – you already understand the cost base of your business, and so you can think through what investment it will take to deliver the revenue you have forecast.

Details matter to your buyer here, so you need to be super granular in how you build up your costs. That should flow down into detail around number of team members in each team and average salaries, for example.

This might be straight-forward, but it's easy to make a silly mistake here that you will regret when a bidder starts to look into your numbers.

The most common mistake here is heavily undershooting on costs, and not giving the business enough resource to actually deliver the great revenue growth in the forecast. Smart buyers are hyper-focused on this, and will sniff it out quickly.

Here are some examples:

• You don't budget for enough sales people, so the new revenue per sales person has to get to levels that the buyer doesn't believe.
• The marketing budget isn't realistically sufficient to drive the growth, especially if you are planning to launch new products or in new markets.
• You hire loads of juniors with no managers, so the org chart doesn’t work. Or you broaden the business in new markets and expands the product set without the necessary team. Or you grow the team without adding support functions like HR or finance.
• You don't factor any pay rises into the salaries.
• You double the headcount but don’t change overhead costs like office or IT costs.
• You plan for international growth but don't factor travel costs to deliver that revenue.
• The costs of software licences, insurance and similar items don't scale as the team grows.

EBITDA

Once you're happy with you revenue and costs forecasts, your model can spit out a number for EBITDA or operating profit.

Buyers don't tend to want to see more detail below this line for things like depreciation, interest costs and tax. However, if you have an asset-heavy business, or expect to need large amounts of debt, these items are material and you should forecast them too.

Sense checks

At this point, it's crucial to run through some really important sense checks.

Many models get picked apart surprisingly quickly, when a buyer finds something important they don't believe. The M&A teams at sophisticated buyers are super smart analysts, who've spent their whole careers looking through models like this. If there are errors, they will find them.

You are checking for things which are impossible or at least highly implausible. Here are some examples:

• Revenues grow so large that you'd need to get >80% market share in your niche, which is already competitive
• Pricing grows to a point that would be way above the competition
• Cost structure is way undercooked for the revenue (see examples above)

You want to also dig into some KPIs to see how these are changing in the forecasts compared to your historical data. Think about gross margins, average price, costs to acquire a customer, churn rates, output per sales person and so forth.

Putting these into charts to visualise can be really helpful. If you see major step changes that can't be justified, or just KPIs that get so good they are just hard to believe, you might have over-cooked the forecasts.

Here's an example. Over the last five years, your cost to acquire a new customer has reduced from $80 to $60 as you've increased your marketing efficiency. But by year 4 of your forecast, this has dropped to below $10. A savvy buyer would call BS on this!

Build out your evidence base

Most people will close Excel at this point. But there's another key step in the process that could save your bacon later.

You will be asked to explain your inputs and assumptions to the buyer as they go through their diligence, often in great detail. You might find yourself locked in a conference room for a whole day, printouts of the model on the table, with the buyer's team asking you to defend your assumptions to prove they are reasonable, and asking for more supporting data to back them up.

Often, you finish the modelling and then move onto another task, and all of that work is forgotten. When a question comes in, like "How can you justify a 20% drop in CPA next year?", and you are stumped.

So we recommend keeping detailed notes as you build the forecast. You can keep these notes within the model, jotting them down as you go.

You then remove them from the before you share, and turn them into an accompanying notes document which you share with the buyer.

This walks through the model line by line, explains your thought process at each stage and provides supporting data, cross-checks and justifications.

The CEO won't bother to read it, but M&A team will. They will be impressed. If they come in skeptical, with lots of questions, you will answer them upfront – clearly and with data. 

Present the data

At this point, you have a robust and thoughtful model which will stand up to inquiry from a smart buyer.

But you don't want the data to be hidden within a model which may run to 100s of lines and multiple tabs.

So you need to bring out the key points, and present these in beautiful charts. These charts can drop into your CIM, and you might also prepare an additional data pack which you can share with the model. This should show the growth of revenue over time, the split by product or geography, how margins and the cost base are evolving, and run through some KPIs and how these are improving.

It's lots of work, but worth it.

Work with the buyer

In Behind the Bid: How buyers model their price, we explore how a buyer uses their own financial modelling and scenario planning to calculate what to bid.

A key tip from that is to work together with your buyer to help them through their modelling as they calculate what to bid. You should be thinking: "What can I share to help you validate our growth forecasts?"

That means you need to get your supporting data ready in advance, so you can get it over to them quickly. Your financial model should be tidy and easy to read, and come with supporting charts and commentary. And make sure your numbers are well supported. There's nothing more alarming than a seller who doesn't know their numbers, and looks like they are making them up on the spot.