7 Deadly Sins of Startups from a Valuation Perspective: Unrealistic Growth Expectations

Planning for too little growth and trying to play catch up when growth exceeds expectations creates a number of challenges, such as the need to expand operations and capacity and the resulting requirement for capital expenditures and potentially, additional financial resources. However, planning for too much growth is just as bad, if not worse, in that overinvestment in equipment and materials reduces asset efficiency and return. As mentioned before, some startup businesses are likely to experience extremely rapid growth in the first few years of operations. However, the growth of a startup is not limitless and is bound by, among other factors, the business’s capacity to produce its goods and services.   It is easy for an entrepreneur to exhibit “irrational exuberance” when it comes to growth. In creating growth expectations, the entrepreneur should first consider the maximum potential output of its goods or services based on available equipment, human capital, etc. Growth over and beyond that level will require additional capital investment, as well as more financial and human resources. In forecasting growth, the entrepreneur should, of course, also take a close look at the potential demand for its goods and services by considering the markets being served, the competition, and the potential market share that the company may gain given the size, scope, and competitive landscape.

Unrealistic growth expectations typically are easily spotted. For example, a maker of gourmet marinades has initially good growth potential. However, its facility can only produce enough cases annually to equal a 1% total market share. Based on the competitive landscape, the company would need significant investment in advertising to build brand awareness in order to potentially increase its market share to 5%. However, the revenue expectations as expressed in the company’s financial projections suggest production in the second year that is beyond the facility’s capacity and the financial projections do not account for additional capital expenditures or advertising campaigns. Fixed costs grow by only 2% in the financial projections, yet by the fifth year, revenues for the company imply a market share of over 15%!

Based on these inconsistencies, the growth expectations obviously are “pie in the sky”. The business appraiser will likely notice this glaring error, which tends to undermine the integrity of the financial projections as well as the credibility of the entrepreneur. As a result, the value is likely to be negatively impacted.

 

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