Every company has to build a financial model.
They’re absolutely essential for raising capital, conducting financial planning & analysis (FP&A in industry-speak), and eventually valuation for the business. Modeling and forecasting can be intimidating for founders who lack that sort of technical expertise, especially if hiring a CFO or finance team seems like a concern for the more distant future. The good news is that early-stage models aren’t nearly as technical or daunting as you might fear; unfortunately, this means that there is some bad news as well. There’s a decent chance your whole approach is wrong. The vast majority of non-financial founders who cavalierly minimize the challenge of modeling fail to think about their forecasts the right way. You can Google different templates and structure guides, research the various line items and benchmarks, and toss in industry average metrics in your assumptions to arrive at a pretty respectable and defensible place. But that doesn’t help you interpret what the model is saying, so you’re failing to realize its full power. This can have dire consequences for investor discussions and overall strategic planning. Luckily there are some excellent guides available to help marry the technical, the mundane, and the narrative elements of a good model. Too often I have early-stage clients who have done some Googling, cobbled together a few spreadsheets with financial statement outputs, and spit out a static set of financial projections that fit a reputable template. I never want to disparage this work and initiative, and sometimes it’s even sufficient for their current needs. Unfortunately, they often have themselves outpacing Facebook in early user growth rate, and running smoothly to 70% pre-tax margins within 5 years. Sometimes they’ll point out that these estimates are conservative since they are required to gain a mere 3% share of the total addressable market to reach those figures. Avoid a top-down approach. Each of those forecast elements drives me up a frustrated wall for different reasons, but the common thread among them is top-down thinking. Implicit in this optimistic methodology is the recognition of other startups, with different products and different teams, who were successful, who you plan to mimic and surpass. Missing from this methodology is evidence that you’ve thought extensively about how you’ll acquire customers/users/clients, how your team will grow as your revenues do, how you might have to pivot and adjust future product rollouts, and how all the pieces of your business interact in a dynamic environment while you scale. Top-down thinking is often poisoned by hubris and lack of foresight; if were a prospective investor, I’d be concerned that such a founder is unwilling or unprepared to learn the lessons that will surely be coming their way. As a founder, you are already on your heels by failing to anticipate the practical progression of your business. In contrast, I would be more confident that a bottom-up thinker is proactive about recognizing problems or challenges, and solving them before they evolve into crises. For very early-stage companies, the dirty secret is that investors can confidently assume that your financial statement forecasts for out-years are simply incorrect, so they don’t even truly care what those numbers exactly are (at least sort of, we will delve into this later). What’s really important is understanding your inputs and assumptions, and having an exceptionally strong grasp on how the financial mechanics of your business model will mingle. When I open new client engagements, I usually pose a series of questions that the model will be designed to answer. Sometimes, the client can easily discuss the topics and provide answers, but sometimes this is an illuminating conversation where we discover blank spaces that require filling. What Should a Good Model Tell Us? Founders need to have a good idea of the bare minimum fixed costs required to get moving. Think about which team members you’ll need to hire and when, outsourced development costs, rent, and how that will rise with headcount, office expenses, insurance to protect from lawsuits, etc). This is a major factor in determining cash burn, a term that is always discussed during investor pitching. Beyond that bare minimum, how do think about your eventual break-even? What is the relationship between rising sales and the required expansion of corporate infrastructure to support a larger team and more customers? What’s the average revenue per employee for similar companies? Can you demonstrate that the market is large enough to support a company of your targeted scale? How much cash will you now through before you can finance your operations with internal flows? Go-to-market strategy, brand building, and customer acquisition are vitally important. If you are selling a product, will you utilize e-commerce or retail channels? Are you direct to consumer? What are the expense ramifications of each, and what is the cash flow cycle like (eg how long does it take you to collect cash from the time you start spending on inventory and sales)? If you are SaaS or mobile, how will you acquire users, how much will that cost on average, and how long will they stay around or how frequently will they return? Simply telling me that you expect to gain a 3% market share is borderline useless if you are early-stage, in my opinion. Sure, you’ve shown that the market is large enough to sustain a company of your targeted scale, but it seems that you don’t actually know how you’re taking over that slice of the pie. You have to forcibly convert new customers and hope that some viral element draws even more through your funnel — I want to know that you’re prepared to address the controllable aspects of this challenge. Once you’ve converted a user/subscriber/customer/client, how much revenue and direct profit will each one generate on average? Does revenue recur from each user, or is it a one-off sale? Do customers return, and if so how many of them and how often? If you add up every dollar you make from your average customer or user, how does that compare to the cost to acquire them? These are the unit economics that are often discussed. Early on, are you thinking about discrete expenses that you can control, or are you simply expecting sales and marketing expenses to be a certain percentage of top line? What about general and administrative expenses? Setting expenses as a percentage of sales is t accepted methodology for much of corporate finance, equity research, enterprise consulting, and private equity. That’s not wrong per se, but it’s much more effective with more complicated, diversified, and mature companies. Young startups’ fortunes are much more connected to the ramifications of every little decision. Expenses can decouple from sales, especially month-to-month and week-to-week, and this is a huge deal for capital-starved growth companies on a shoestring budget. As an aside, even funded startups should cherish every dollar as an opportunity to exceed growth goals and ensure survival. Every dollar spent carries opportunity cost, so ROI should be on your mind at all times. The timing of cash flows is hugely important during your leanest phases. Do you expect seasonality in revenues? Do you have to build inventory or span a large lag time between the rendering of services and collection of revenue? Sit on the investor’s side of the table if you want to craft a compelling pitch. How and when can investors expect their capital to be returned? Their goal is generally to notch a successful exit and move onto the next. You have to be optimistic and aggressive in forecasting, otherwise, it won’t be an attractive story. But just submitting a P&L that says you’ll have $60m in sales and $20m in net profits by year five because you heard that’s what investors like to see, is analogous to copying off the smart person next to you in class without showing your work. Understanding your assumptions, the key performance metrics you’ll need to track, and how the business needs to come together to reach your aggressive P&L forecasts will allow you to have more confident and productive conversations with investors (and eventually board members), and it will help you anticipate or even partially solve the strategic problems your team is going to face along the way. Do you want to submit a context-free set of numbers just like the other several dozen (or hundreds) that have pitched your target angels and VCs? Or would you prefer to make it clear to observers that you’re moving at a different speed from all the pretenders? Using this guide and other resources available to entrepreneurs can be extremely helpful. Some startup teams have fantastic financial and business minds who can handle these questions, and a lot of them get by on the ingenuity and hard work of their early team. For many who don’t have the ability, confidence, or time to spend on this aspect of business planning and capital raising, it can be transformative to contact a professional to provide guidance and coaching. https://medium.com/siliconcfo/how-to-think-about-financial-modeling-like-a-pro-2f84015fad5a |
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