Financial Model: The Basics
In this article we provide a basic introduction to the startup financial model. The goal is to demystify one of the biggest headaches when preparing to fundraise. The key questions we will answer are what should be in your model, and why you need one. We will also provide links to some templates and tools that can help. Regardless of what investors want, there is a benefit to this exercise. It forces you to think clearly about your assumptions, pricing models, growth rates and churn. In addition, modelling shows you are targeting a big enough market, and helps plan for how much funding you really need. So, read on - you are one step closer to getting this whole thing over with.
I don’t see the point of spending all that time putting together a financial model. It’s just guesswork, and reality will be completely different.
We hear it all the time, and we can commiserate. As Mike Preuss points out, storytelling is a critical component of any company or startup, and the financial model is an extension of that story. It shows what is achievable, and what can be expected of the business. It paints a picture of the size of the market you are addressing, and tells the reader what your ambition is. In addition, it demonstrates whether or not you have realistic assumptions.
The aim isn't to be 100% right (or any percent right really). Mark Suster of Upfront Ventures makes this point in his excellent blog:
See I don’t care if your projections prove wrong over time. I care about your assumptions going in. I care about the thought that you’ve given to the customer problem. I care about how much you’ve thought about market share, competitors, adoption rates, etc
What should your startup financial model look like?
There are many templates out there (see below). If you’re not an Excel or Google Sheets wizard it can be pretty confusing. There is a lot of inconsistent advice out there too. In any case, this is how we boil down all of the things that we see and hear from investors into -- hopefully -- an uncontroversial and neutral guide.
- Your model should show monthly data for at least 3, possibly 5 years.
- It should focus on cash flows. If you have a Profit & Loss statement and Balance Sheet as well, so much the better, but for seed stage companies cash is king.
- It should show good detail on your cash inflows and costs and expenses. This is so the investor can see how you believe your revenues and costs will evolve, and what the key drivers are.
- It should be understandable. Too many models we see are internal documents - “Salary, Claire”; “Parmenters monthly fee”. Who are these people? What do they do?
- Use formulae, not hard values, so that the investor can see how you come up with each value in the spreadsheet.
- Have somebody competent review it and audit it for errors. When we are doing our models we give them to recent hires and tell them there are 2 deliberate errors in the model and they have to find them. Unfortunately this only works once.
- Ensure the model and the pitch deck are consistent. Same numbers; same category titles and names etc.
- Don't put big picture things in the model that aren't explained in the pitch deck. For example - we often come across a totally new revenue source in the financial model that isn't covered in the pitch deck.
Your model should demonstrate clearly what the key drivers of your revenues are:
- Highlight different client or customer types
- Show different revenue model types - eg subscription fees vs consulting
- Show the revenues for each relevant client/customer or revenue type separately, with the relevant drivers for the calculation, for example:
- Number of clients
- % increase in number of clients
- Revenue per client
- % increase in revenue per client
- Total revenue
Cost and Expenses build-up
Your model should break down all of the key cost items, and explain their link to the revenue line.
- For most early stage businesses personnel expense is the biggest item. Make it granular; each significant position, salary, increase in salary, other compensation
- Some businesses are driven by marketing - marketing spend may be the key driver to revenue growth, with Customer Acquisition Cost being an industry standard or observed value, and revenues being a function of CAC and marketing spend. If so, ensure that this is clearly explained
- Make sure that all relevant costs are included. Tax often gets forgotten. You may be lucky enough to have to pay it one day, and it makes a significant difference to cash flows
- On a similar note, many models maintain throughout the lifetime of the model costs which are below market. The founder paying herself £3k per month when the business is generating annual revenues of £25 million. Rent at £500 per month for the full 5 years, and so on. Many companies pay less than market rate for many services in the early years, but your model should have fully market rate costs by the end of the forecasting period.
Ultimately, the model is all about cash. So make sure that the financial statements resolve to a cash line:
- Beginning cash
- Net cash flow for the period
- Ending cash
Obviously all sources of cash should be included here - investment, including expected future rounds, grants, tax credits and so on.
What’s the investor looking for?
This isn’t just an exercise in futility; there’s a point to it. Several points in fact. The investor wants to see:
- Whether you have a good handle on the revenue drivers of your business
- Whether you can show how costs and expenses evolve over time compared to the revenues
- ie, is your business model profitable and scaleable?
- Are you realistic about your growth potential?
- Are you thorough in your presentation of the financials?
- How his or her cash is going to be used and whether more will be needed in the future (it probably will)
Most importantly, the investor wants to know whether the model demonstrates the ability for achieving around a 10x return. Yes of course it’s a bit of a game. You build your model to demonstrate that outcome, but it has to be credible, cohesive and complete in its presentation of that 10x return potential. It’s a test of the degree of ambition of you the founder, and a test of your understanding of the requirements of your audience. But most importantly the financial model is a test of understanding, method, and credibility, and as such is almost as important in creating an impression as your pitch deck.