Daniel Kahneman’s seminal work on the theories of decision-making under uncertainty won him the Nobel prize in 2002.
A direct outcome of his work was the development of base rate forecasting or reference class forecasting—an effective, increasingly adopted methodology for sustainable business and financial planning.
The idea is simple. To plan for the future, you need to evaluate past business performance. Specifically, the base rate indicates how a business has performed in the past for a metric and how it is likely to perform without intervention.
If the historical churn rate is 5%, then in the absence of any intervention, that business will continue to churn customers at that rate. To state another way, if you cease efforts to reduce the churn rate, it will regress back to the mean.
That’s the fundamental aspect of base rates—it’s hard to change them.
What happens when base rates are neglected?
A fast-growing SaaS company valued at over $500 million ignored available base rate information on historical deal closure cycles by about half the time taken—from nine months to just under five months. They overestimated their own ability to close deals twice as fast buoyed by a healthy pipeline. As a result, they were unable to meet their targets.
When we ignore base rates during planning, we tend to choose more optimistic numbers, and end up overestimating our capacity and underestimating project deadlines (see planning fallacy). This invariably results in budget overruns and missed targets.
For example, if the deal conversion rate has been 5% over the last few quarters, assuming this to be 20% for the next quarter is a huge stretch. A plan made on this assumption is likely to lead the business down a potentially expensive path.
While a 5% conversion rate can go up, without any triggers, it will likely continue to be 5% because that’s how the business functions today—irrespective of what is put in an Excel spreadsheet or any other tool.
That brings us to the first step in creating a predictable business plan.
1. Identify and measure your base rates
When you make a plan, the base rate information needs to go in as assumptions in your model, or at least they should dictate your assumptions as it helps make the plan more accurate.
Every metric can have multiple base rates, and that’s because base rates can be calculated over different periods. For example, the deal conversion rate can be averaged over the previous month, quarter, year, or longer.
Thus, it’s important to accurately measure their base rates over a suitable period after identifying your target metrics.
A good rule of thumb is to avoid going too far back or taking too short a period to calculate the base rate in a fast-growth business environment. In both cases, the model’s accuracy will suffer. One option is to use Jason Lemkins’ Last Four Months (L4M) model. At Drivetrain, we recommend four to six months for computing base rates.
2. Create a plan to achieve the new growth rate
“There ain't no such thing as a free lunch.”
Suppose you are making an assumption for your growth metrics that’s different from your base rates. In that case, it’s important to answer why and how you will achieve that new base rate and what’s giving you that confidence.
For example, if the base rate for lead to deal conversion is 10% and the assumption going into the model is 15%, clearly call out the effort and actions needed—say, hiring a sales enablement head to effect this bump.
3. Monitor and course correct
Lastly, keep a watch on those efforts. Is it having the intended impact? If not, what can you change to get the numbers back on track?
Diligent monitoring is key to sustainable and predictable growth. Since there will always be unknowns and variables involved in running a business, keep your plan flexible enough to tackle them. If you find your base rates shifting, revise your plan. That way, you can realign your strategy and tactics before it's too late.
Even if past performance is not always predictive of future performance, it is a far better indicator than making assumptions that often tend to be biased and optimistic. Base rates provide what is called the “outside” view.
Base rates have immense predictive power. Thus, improving the base rates of target metrics is a staggered, long-term process.
Setting accurate base rates and being flexible with plans are key to predictable and sustainable business planning and forecasting.
Drivetrain brings all this planning down to a hard science so that SaaS businesses achieve their targets predictably. It enables businesses to identify the right growth drivers and offers ready-to-use planning templates and systematically tracks your base rates to reduce planning times from months to just days.
Reach out to us at email@example.com to learn more.