Using the waterfall...

One of the toughest jobs of a startup CEO is putting together an accurate revenue forecast. While it's always difficult to predict the timing/sizing of revenues in a brand new company, I strongly agree with Fred Wilson that it is important to forecast often.

One of the forecasting tools I recommend to my portfolio company CEO's is a Waterfall Forecast. Typically, this is an Excel spreadsheet that allows a company to show how the forecast for a given month (or quarter) has changed over time.

Over time, a waterfall forecast creates an environment of accountability and allows a CEO (and Board of Directors) to determine key trends. Are revenues shifting month-for-month (ie, did a sale get pushed back by a few days into the next month) or is there a non-linear shift (ie, did revenues get pushed back by several months)? Is the company getting better or worse at forecasting revenues over time? If the company is missing its revenue forecast, are they able to adjust their expense forecast accordingly?

I've attached an example waterfall forecast for Ashloooogle.com (a made-up company). Let's walk through their Revenue forecast. Their revenue budget is highlighted in green (row 9). The next row (row 10) shows how they did in January (the yellow cell, B10) and what they forecasted for the remaining months. The next row (row 11) shows how they did in February (the yellow cell, C11) and what they forecast for the remaining months. And so on.

You can learn a lot by reading a waterfall forecast. For example, you can see that despite revenue shortfalls in January and February, the management initially refused to lower their forecast for the year -- they just reallocated the revenue to future months. In this case it only took two months for the management to realize their plan was too aggressive -- a surprisingly quick reaction time. In March (where revenues were just 37% of plan) they drastically cut their revenue forecast. They also tried to control their Operating Expenses -- their March forecast was 15% below their budget -- but notice that they weren't able to cut Opex dollar-for-dollar...

If you were a board member of Aschloooogle.com, what would you have done at the end of February? The end of Q1? The end of Q2? The end of Q3?

Model Waterfall Forecast - http://www.firstround.com/ModelWaterfall.xls

Another good perspective on forecasting can be found here - http://onlyonce.blogs.com/onlyonce/2005/11/notsocounter_cl.html

Comments

[PRoales]

Thank you for making the XLS available.

Very nice to be able to not only read about it, but see it in action.

[Brandon Watson]

As a first time CEO, but recovering private equity guy, my additions would be the following. They would make this easier to read for me anyway:

1) a calculated waterfall for the gross profit margin

2) a calculated waterfall for the opex as a % of revenues

3) gravy addition would be a waterfall of % delta from original projection for each of the revenues, gross profit, opex and cash balance. In that way you could see what got reigned in and when, and see if the right decisions were being made (i.e. pulled in revenues but not opex).

There's a lot of good information in here, but it could be tough to extract without having some of those guide posts to help guide the thinking about what went wrong.

So that's my addition...happy to make the changes for you in the XLS and send over if you want. It's the ex-investment banker in me.

[Rick]

Ditto above thanks for making the excel file available. You can spend 2 years at business school and not learn to make a decent, simple forecasting xsl doc.

It obviously took some time to make - thanks!

[Zoli Erdos]

Josh, Great post - let me show you the online version of your spreadsheet:
http://www.zohosheet.com/public.do?fid=25554

I took the liberty of importing your xls into Zoho Sheet. It's still beta, and needed some cosmetic changes, as it did not handle the hidden "K" column quite well. That said it's a a great collaborative spreadsheet.

[lucinda]

great spreadsheet - thanks for sharing it. i've been forecasting this way for years (are you the one who suggested it to me?) but haven't ever thought to put this focused sheet together.
and a follow-up question: any thoughts on how to use the waterfall in incentive compensation schemes? in more mature companies, i like to bonus senior management on "making plan" but at the very early stages plan is so fluid - as you illustrate - that it's difficult to say what "plan" is by the end of the year.

[Gil Friend]

This is very helpful. Forecasts always change, of course, and it's been both tedious to update them and frustrating to not be able to keep efficient track of the changes. Thanks.

[David Belove]

Great topic. As a sales consultant, I spend a lot of time with clients on this. A couple of comments:

+ Spreadsheets are okay but baking a waterfall into Salesforce.com makes the monthly meeting preparation much easier. I know how to do it if you are interested.

+ Another suggestion would be to color code the figures that are below plan in yellow and red and make the ones that are above plan green.

+ Also note that Salesforce.com has an Excel link that allows you to refresh the data in a spreadsheet with the latest figures.

Another issue to bring up is that most start ups use less than optimal methodology such as using sales stage-based probabilities and expected revenue value summing to calculate their forecasts.

These issues, in my opinion, should be a major focus for VCs since they can cause major forecasting errors. I can provide more details if you want them. Just send me an email at dave@mxlpartners.com.

[David Belove]

One additional suggestion that I would make to your waterfall is to add the actuals in to each row. This way, you can add the actuals to the forecast (for the balance of the year) to see your revised plan amount. The actuals could be color coded based on whether they were above or below the plan.

[Ted R.]

Thanks Josh for helping us conceptualize this strategy and the example. We've just finished out first implementation and are feeling more realistic about our expectations (and relieved we can tweak our model faster and thus learn faster from it.)

Best!

[Konstantin]

This was a very interesting read. Another topic which I've long wondered about is CAGR. In the standard 3-5 year plan, only the first and the last points are taken to calculate the CAGR. This of course ignores the middle points, which can be really out there (too low growth, negative growth). Of course, in a such a model all you need to do to make it pretty is have a high enough endpoint - and the standard CAGR looks good.

I have tried to adjust that and have come up with a CAGR model for a 3 year plan which solves the 3rd power euqation to give the "true" CAGR, which considers ALL points in the planning. Wonder why I have never seen it used before..

Way I understand it right now, it works well with a 3 year model. For more years unique solutions are not guaranteed and for two years you can have two sets of solutions which is annoying.

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