Forecasting Revenue for Startups and Scaleups: Never Just Top-Down...

Highlights

• Forecasting future cash flow is critical to any company for assessing both future risk of failure and current company value. This forecasting process starts with revenue.
• For more mature companies, the optimal process for forecasting revenue starts with the most recent actual revenue, and adjusts for external forces and internal growth or changes.
• Early-stage and fast-growing companies tend to rely more on either a Top-Down approach or Bottom-Up approach.
• The Top-Down approach focuses on market and product demand. For motivated companies, it is an easier technique that is driven by assumptions on these critical external variables.
• The Bottom-Up approach concentrates on a company's more manageable internal variables. This process takes longer and the result is operation-driven, offering a more calculated and granular result.
• Generally, between the two approaches, the Bottom-Up is preferable to the Top-Down approach for its operational focus, real-time data utilization, and risk management capabilities.
• For earlier-stage companies with less of a track record, the optimal real-world revenue forecast takes the Bottom-Up result and applies it against close competitors, to the market and across scenarios to test its validity against assumed demand.

Introduction

Forecasting future cash flow is a requirement for any business. At its core, future cash flow directly represents both the future risk of failure and the current value of the company. The initial and most important step in forecasting future cash flows is forecasting revenue.

For companies that are more mature with less disruption, revenue can be forecast using a spectrum of possible formulas. These companies usually begin with a “Left-to-Right” approach as a basis, taking actual revenue from previous years to ground the forecast, then applying changes in variables to adjust on a weighted basis.

However, for companies that are in a growth-phase, previous revenue are less telling or even non-existent, leaving the forecast more difficult. Further, the importance for growing companies in building a forecast that can survive the scrutiny of potential investors makes the process of even greater importance.

Companies with less of a track record tend to rely heavily on either a Top-Down approach or a Bottom-Up approach to forecasting revenue.

The Top-Down Approach

The above image represents a pure Top-Down approach for forecasting revenue. For VC investors, the above image has been seen many times in investor presentations. It is part of the very important (but usually misused) "TAM SAM SOM" slide.

The Top-Down approach is a demand-focussed forecasting method. In its purest form, it starts with the largest measure of the overall market involved, adjusted for any market growth rates, to provide the Total Addressable Market (TAM).

From this, the market size gets adjusted downward to the company's Serviceable Available Market (SAM). This adjustment is based on the company's target segment or niche (the area of the market that is directly targeted by the company’s product).

A final adjustment then carves out a portion of the "SAM", which represents the part of the market the company is expecting to capture (Serviceable Obtainable Market or SOM).

On the positive side, this Top-Down approach does provide a target for a company’s overall market size and focusses some awareness on the company's competition over the long-term. It also is a quick calculation that relies more on the inference of product market existance and size and less on the details of expected operational performance.

For a mature company, these assumptions are backed by previous years' numbers. Here, the use of prior actual revenue numbers bring a deeper proof of market fit and size of the target market, the potential of products or services of the business, and an understanding of the business drivers.

For fledgling companies however, especially companies that have a unique or potentially disruptive product, this simple Top-Down calculation adopts all of the critical assumptions - the existence of a market, the fit of the product in the market appropriate and the assumption of capturing a portion of that market - as given.

For a company looking to generate investor interest, ignoring the importance of fully addressing these assumptions can lead to a poor understanding of the product market and too much focus on external variables, leaving potential investors unconvinced.

The Bottom-Up Approach

The Bottom-Up approach is a more supply and company-focussed forecasting style that is built on a number of key operations-based calculations and objectives.

Using a pure, supply-based form, the Bottom-Up method starts with a measure of "inventory", with the additions of the total possible production based on the company's production constraints (cash, labour, supply-chain, supplier or manufacturing limitations). This provides the first pool of size (or limitation) for revenue forecasts.

From this possible production pool, rates from the sales funnel are then applied to the “inventory” (along with unit price points) to provide the amount of revenue for the period. Here, the demand for the product is baked into sales abilities of the company, a more internal metric capturing demand.

This overall process focuses more on the available inputs and the abilities of the company. It immediately focuses on the company, its skills and management, providing objectives for KPIs along the way to the revenue number.

Simple Example Comparison

Let's look at a simplified set of examples for both examples using a manufacturing company.

Top-Down Approach
Let's assume the global market for widgets is $1 billion (TAM). Assume you sell only copper widgets, which is a market worth $10 million (SAM). Your company, based on assumptions, expects to gain 10% of your direct market, for $1 million in annual revenue (SOM).

This is your revenue forecast, based primarily on the external forces of the market to underpin your forecast.

Bottom-Up Approach
Again, in a simplistic form, a Bottom-Up approach starts with inventory levels and the amount of cash available (and other inputs) to manufacture more, then adjusts for the forecast rate of manufacturing itself, to arrive at the total inventory possible. Let's assume that you undertake an assessment of your company's capabilities and inventory levels to arrive at a market value of $250,000 in existing inventory and $1 million in likely production - based on fully planned operations and objectives.

We then look at the sales abilities for the company to feed market demand. With what would be based on comparisons and any track-record, if the sales team had a objective of 80% of annual-available-inventory-to-sales, this provides a total annual forecast revenue of $1 million.

Even though both arrive at the same number, the Bottom-Up approach provides a more company-focussed and grounded forecast. The optimal next step here would be to compare the Bottom-Up forecast to a Top-Down expectation, to validate the Bottom-Up forecast.

The Benefits of a Bottom-Up Approach

When comparing the benefits of a Bottom-Up approach versus a Top-Down approach, the keys are the benefits to the company from the Bottom-Up forecast exercise itself, the objectives set for KPIs that result from it, and the favourability of the approach to investors.

• Reflects Actual Operations and Capacity: Because it begins with the company's actual resources and capacities (such as production limits, sales team size, etc.), the Bottom-Up approach aligns more closely with what the company can realistically achieve in the given timeframe.
• Empowers Operational Decision-Making: By focusing on the granular aspects of the business, Bottom-Up forecasting provides insights that are crucial for operational decision-making and short-term tactical adjustments.
• Responsive to Internal Changes: Bottom-Up forecasting is more sensitive to internal changes within a company, such as shifts in sales strategies, operational improvements, or product developments. These factors significantly impact revenue and are better captured in a Bottom-Up model.
• Real-Time Data Utilization: The Bottom-Up method often uses more current and direct data sources, such as recent sales trends and customer feedback, which can lead to more informed and timely predictions.
• Risk Identification and Management: The detailed nature of the Bottom-Up approach helps in identifying potential risks and challenges at a more granular level, enabling better risk management.
• Useful Across All Business Sizes: Unlike the Top-Down method, which requires a broad market perspective and could be argued only somewhat suitable for larger, established markets, the Bottom-Up approach is effective for businesses of all sizes.
• Enhanced Investor Credibility: Investors often view Bottom-Up forecasts as more credible because they are based on concrete, operational data and realistic assumptions about sales and market penetration.
• Strategic Planning and Goal Setting: By understanding the limitations and capabilities at a more detailed level using Bottom-Up, companies can set more realistic and achievable goals, leading to better strategic planning.