How investors and entrepreneurs can successfully play the forecasting game

Entrepreneurs are not the naïve dreamers that investors assume them to be, according to new research which has important implications for both entrepreneurs and venture capitalists

Guy Kawasaki is a successful Silicon Valley venture capitalist and co-founder of Garage Technology Ventures, a seed and early-stage venture capital fund which invests in start-ups and entrepreneurs looking to transform big ideas into game-changing companies. It has picked and backed many successful start-ups including music and podcast streaming giant Pandora Media.

Kawasaki (also the former Chief Evangelist for Apple and now Chief Evangelist for Sydney-based high-profile start-up Canva – in addition to being an Adjunct Professor at UNSW Sydney and Executive Fellow at Haas School of Business) is unapologetically blunt about entrepreneurs pitching for capital. One of his more famous quotes is: “An entrepreneur’s projections are never conservative. If they were, they would be $0. I have never seen an entrepreneur achieve even her most conservative projections … As a rule of thumb, when I see a projection, I add one year to delivery time and multiply by .1.”

But how accurate is this rule of thumb in practice for both investors looking to accurately assess a start-up’s financial potential, and entrepreneurs who want to develop realistically optimistic valuations for such investors?

Frederik Anseel, Associate Dean of Research and Professor of Management at UNSW Business School, together with Veroniek Collewaert, Professor of Entrepreneurship at the Vlerick Business School & KU Leuven, and Tom Vanacker, Associate Professor at Ghent University and Research Professor in Entrepreneurship at University of Exeter Business, set up a series of studies and conducted interviews with investors and entrepreneurs to understand this phenomenon better. This culminated in their new research paper, The sandwich game: founder-CEOs and forecasting as impression management.

“We discovered that both founders and non-founders have to find a way to navigate the often-conflicting expectations from investors. Investors like ambitious goals – it’s a testament to the drive of the entrepreneur(s) concerned and holds the promise of a lucrative financial return on investment,” says Prof. Anseel.

“As one investor we talked to formulated it: ‘We typically want to see more than 50 per cent annual growth…at the end of the day, you need to have them run fast. The more ambitious they are, the more I like it.’ This encourages entrepreneurs to present extremely ambitious forecasts,” says Prof. Anseel. “But entrepreneurs can also take it too far. Investors also value accuracy and credibility. There is a fine line between presenting oneself favourably and outright lying. Entrepreneurs need to be careful that their forecasts are still credible and sufficiently accurate.”

Founder CEO vs non-founder CEO forecasts

The research examined how tactical (and thus, rational) entrepreneurs are when presenting forecasts to investors. Forecasts are not simply the result of a financial accounting estimate. They involve subjective judgment which allows entrepreneurs to present themselves less or more favourably to investors. By tactically biasing forecasts, entrepreneurs try to navigate the conflicting expectations investors hold for them.

More specifically, the research (comprising a mixed-method study of exploratory interviews, two field studies and a causal chain scenario experiment) examined differences between forecasts presented by founder-CEOs versus non-founder-CEOs. The lead author for the study, Prof. Collewaert, explains that most people expect that founders would provide the most optimistic forecasts about the financial prospects of their business. “After all, having founded the venture themselves, they should have high hopes; it is their baby, their life work and thus, they’ll likely have the most optimistic expectations,” she says.

“But contrary to this common view (some of our reviewers actually had the same view), we actually found that founders provide less optimistic forecasts to investors than non-founders (thus, CEOs that were appointed to lead a new venture). Mind you, we found that both founders and non-founders are tempted to paint the most rosy picture possible to keep investors on board.”

In the financial forecasts entrepreneurs provided to their investors, the study found that, on average, they overshot realised revenues in the next year by about 22 per cent. In particular, founder-CEOs overshot realised revenues by about 15 per cent, while non-founder-CEOs do so by 27 per cent.

“One of the entrepreneurs interviewed called this ‘the sandwich game’ and founder-CEOs and non-founder-CEOs play this game differently,” says Prof. Anseel, who explains non-founder-CEOs have shorter-term career horizons in a venture, so they tend to care less about what intentional overshooting may do to relationships with investors. “The costs of being wrong are less important to them.”

For founders, however, it’s a different deal. “For them, this venture is their life’s work. So, they navigate more carefully, trying to be positive enough to keep investors on board, but without going overboard. Thus, founders are not naïve dreamers but carefully weigh the pros and cons of providing an inflated forecast,” he says.

Importantly, the study focused on entrepreneurs who were not seeking funding for the very first time. “What we studied is ongoing investment relationships, where a venture capitalist or group of investors has already invested in a venture and is now monitoring their investment on the basis of yearly forecasts,” says Prof. Collewaert. “Of course, often an entrepreneur will hope that, on the basis of promising performance, investors will further continue and grow their investment.”

Walking the line: implications for entrepreneurs

It is good for entrepreneurs to be aware of their overoptimism (to the extent they aren’t already) – but the research shows they are not overoptimistic dreamers that investors sometimes assume them to be, says Prof. Collewaert. While it might be tempting to label entrepreneurs as liars or frauds based on the research, she explains that this is simply not the case.

“We need to be aware that when making forecasts, entrepreneurs naturally have some degrees of freedom and face a lot of uncertainty,” she says. “There is nothing wrong with some subjective judgment and entrepreneurs are often best placed to make those calls. The question is: where does subjective judgment stop and where does tactical impression management begin?”

Prof. Anseel adds that entrepreneurs may naturally ponder and ruminate how they will be seen by investors and what the implications for their venture could be. But it could be that “it does not matter that much in the long-run,” he says. “We found that investors are actually pretty good in tracking and monitoring forecasts in their investment decision-making. Entrepreneurs who provided overly optimistic forecasts to investors got penalised in the form of a risk downgrade.”

As such, Prof. Anseel says over-optimistic entrepreneurs don’t get away with their risky projections and are flagged on the investor’s radar. “Moreover, despite entrepreneurs often hoping for this, we found that overly optimistic forecasts did not help in securing a next round of financing. So, in the end, our advice is – try to make the forecast as accurate as possible, as tactical game-playing gets picked up anyway,” he says.

How investors can accurately assess value

There are also a number of significant implications in the research for investors. Importantly, investors should pay attention to how they communicate with entrepreneurs and how they interpret entrepreneurial forecasts, says study co-author Prof. Tom Vanacker.

“Forecasts are not simply the result of a financial modelling estimate,” he explains. “They involve subjective judgment and entrepreneurs will use them to present themselves less or more favourably to investors.” By tactically biasing forecasts, Prof. Vanacker says entrepreneurs try to navigate the conflicting expectations investors hold for them.

“For example, during our interviews, some investors highlighted they do not like to see the typical hockey stick growth forecasts. but then they also suggest they want to see high-growth ambitions. “By doing so, they might create a situation in which entrepreneurs in their portfolio companies feel sandwiched between providing their best estimates versus more positively biased forecasts,” he says.

“We see that investors are often convinced that entrepreneurs are irrational optimists and use their own rule-of-thumb in terms of what discount to apply to financial forecasts. The average investor knee-jerk reaction to our study could very well be: ‘Ah, nothing new there, could have guessed this beforehand.’ But, there are two key things investors should take away from our study.

“First, a 0.1 multiplicator, as suggested by Guy Kawasaki, seems a vast exaggeration of the average optimism we observe; a 20 per cent discount seems more in line with reality. Second, investors may also want to differentiate between founders and non-founders, because especially non-founders are more prone to over-optimistic forecasts. This observation runs counter to the intuition of many investors.”

For more information read The sandwich game: founder-CEOs and forecasting as impression management or contact Frederik Anseel, Associate Dean of Research and Professor of Management at UNSW Business School.