[credit provider=”Esther Dyson” url=”http://www.flickr.com/photos/edyson/13434169/”]
Entrepreneurs may be paranoid by nature, but their financial projections are known for being impossibly optimistic. Now two researchers have got a bit of a handle on exactly how pie-in-the-sky entrepreneurs’ projections tend to be.The researchers found that an entrepreneur’s mindset can often be summed up this way: “The first year will be a nightmare. After that it will be easy.” Too bad it doesn’t actually work out that way.
Christopher Mokwa and Soenke Sievers, both from the University of Cologne, have examined records of 176 German startups, backed by 339 different venture capital firms, to try figure out exactly how overly optimistic startup founders really are.
They also tried to determine if milestone payments-making the next round of funding conditional on certain accomplishments, such as reaching a certain level of revenue, signing big customers, or reaching a certain phase in project development-would lead to more realistic projections. Here’s what they found:
- Entrepreneurs are way too optimistic. Overall, management projections for expenses, revenues and profits are significantly inflated across a one-to-five-year time horizon.
- Revenue projections are the worst. On average, entrepreneurs think their revenues will be 388 per cent higher than they turn out to be.
- Entrepreneurs don’t need as much money to run a company as they think they do. Entrepreneurs over-estimate their expenses by 211 per cent, on average
- Profits are the most accurate projection, but still are way off. On average, profits are overstated by 136 per cent.
- The first year goes better than entrepreneurs expect. The one-year profit forecast is the only one that was routinely too low.
- Most companies expect to break even after being in business for three years.
- Milestone payments do make a company’s forecasts somewhat more accurate. They bring the errors in revenue forecasts down by 58 percentage points and the error in profits down by 122 percentage points.
Are these entrepreneurs just fooling themselves? Or does their optimism serve a purpose?