I don’t know how many times I’ve heard entrepreneurs say this or how many times I’ve read it in a business plan. It seems simple, right? How could the business not get such a small percentage of the market? And given that the market it huge, they’ll be doing 8 figures by their third year. Unfortunately, this weak reasoning often lulls entrepreneurs into a false sense of security. No one gives you market share for just showing up.
The market you are entering is huge. That’s great. It means that should you become successful and be able to gain market share, the rewards will be big but it’s nothing to base your financial projections on. If you load up on debt based on these mistaken projections, you will learn the impact of negative cash flow in a hurry.
I remember a restaurant that based their projections on an assumption that they could get a certain level of gross revenue. The problem was that when I took into account the seating capacity of the restaurant, the hours it was open, and the expected table turn over rate the average spend per customer would have to be $100 to achieve their revenue projection. I don’t know about you, but I frequently spend less that $100 when going to a casual dining restaurant. Clearly their gross revenue assumption was unreasonable. The restaurant in question closed down after 4 months of operation. The owners weren’t willing or able to fund the monthly losses.
A much better way to have done the revenue projection would have been to work it from the bottom up. If they would have made an estimate of the average number of customers through their establishment in a day and the average amount each customer would have spent, they could then have calculated the gross revenue for the business based on these numbers. After deducting the direct cost of goods sold (such as food) and the overhead costs (like rent) they could have determined whether or not this combination of the number of customers and the average spend per customer would have given them the financial return they wanted. If not, they could change either variable to see what it would take to break even.
This method of calculating financial projections has an advantage in that it is easier to determine if the revenue number is reasonable. Going back to my example, the prospective restauranteurs would have been able to tell very easily that their gross revenue number was not reasonable because it was not likely that the average customer would spend that much money per visit. They would have then known to rework their cost structure so that the restaurant could have turned a profit at a more reasonable level of customer spending. On the other hand, they may have decided to give up on the project, which would have been a better decision that would have saved their investment capital. There is a lot of value in learning that you shouldn’t make an investment.
It’s a good idea to research the size of the potential market for your product. It lets you know what a major success could look like. It also lets investors know the size of their opportunity. What it doesn’t do is let you know how much market share you’ll get. Work from your business’s fundamentals and build up. While it won’t give you a perfect prediction of the future, it will allow you to make a better judgement of what is or isn’t reasonable.