The Financial Model serves two functions for a startup: 1) budget your revenues and expenses , 3) validate your business model and 2) to pitch your business to investors. By picking the right assumptions and building on-top of the right unit economics logic, a financial model can be a very powerful tool to predict the likely future and pitch a compelling growth story to investors.
Beginning the journey of developing your own startup is a fascinating time, offering a steep learning curve. But it also is a time where you are bombarded with contradicting advice. All too often you will hear plain wrong generalizations by people who have never started a company themselves or became successful under circumstances that were different from yours.
One such area of misinformation by non-experts is the financial model. All too often you will hear to not bother with a financial model as its “too technical”, “has too many assumptions” and “nobody will read it”. While this applies to any calculated prediction, you can get a lot of value from a Financial Model. The key is to find the right balance of detail, base everything on a sound logic (unit economics) and constantly test your assumptions. If you do that your model helps you to better understand your business and become significantly more credible to investors.
Functions of a Financial Model
There are three main functions of a Financial Model:
- Budget revenues and expenses
- Validate your business model
- Pitch your startup
The latter part then allows you to shop around for investors to help realize your predictions or to sell the business. For both decisions you need to know how much your equity is worth. Additionally, building a credible and easy to understand financial model will greatly improve your chances of convincing an investor that your price is actually correct.
To achieve all this, you essentially need to take the time and think about how your business will make money, and what resources it will need, not only in terms of cash, but also employees, supplier relationships, key business assets, and so-on.
1.) Budget Revenues and Expenses with a Financial Model
At the core of a Financial Model are the revenue and expense predictions. These are planned for 3-5 years on a monthly basis. By going this granular, the Financial Model is the core of your budgeting efforts for any department. It will include all the basic revenue and cost centers.
- Product Sales
- Subscription Revenues
- Trademark and IP Licensing Income
- Advertising Revenues
- Salaries and HR
- Production and R&D
- Legal & Accounting
- Other Operational Expenses
The key with budgeting is to find the right balance of detail. You need to be detailed enough that your model is meaningful, but you also need to keep it understandable. On top it needs to be inherently logic by being based on a sound unit economics logic. More on unit economics below.
2.) Validating your Startup with a Financial Model
A good financial model is a very powerful tool to consistently test a startup’s key underlying assumption and hence prove whether a business is working or not. This is critical information in many ways:
- You will know whether your business model can actually generate profitable unit economics
- You will know what resources you’ll need to achieve your growth
- You will know how much money you need to raise
Note that none of this iterative feedback will be provided by a business plan or by writing a pitch deck. Even though some investors may never read your financial model, it will help you in understanding your own company better.
3.) Pitching with a Financial Model
One of the main complaints about Financial Models is their complexity. This supposedly leads to inaccurate predictions and boring your audience every time you propose showing your financial model.
As famous NYU Professor Aswath Damadoran has coined, there are essentially two sides to valuation and startup pitching:
- The numbers
- The story
Those of us who are story tellers, tend to describe and perceive the world as…well…a story. Something that you and me can relate to, a story from child hood, something reflecting on culture. And those of us who are the analytical kind need to prove everything with numbers and abstract universal rules.
The most effective pitch however is a combination of the two domains: Credible numbers + a captivating story. No matter how hypothetical predictions are, there is some truth to it. If you have some tested advertising metrics and some revenues you can start building your actual unit economics. And having a very positive LTV:CAC ratio based on a small sample group of customers will certainly be better than just a story alone.
Building a Startup Financial Model
Building a Financial Model can be a very daunting task. Its quite a complex thing technically and you can easily go in the wrong direction detail and logic wise. So you should start with the end in mind. To achieve that you need to answer the following questions for your yourself:
- Who is the audience of your model? (experienced VC, wealthy Angel with no startup experience, strategic investor, management,…)
- Is this an internal planning document or are you pitching a deal?
- If you are pitching a deal, what type of deal is it? (Investment, Merger or Exit)
- If it is an investment round, what round are you pitching? (Seed, Angel, VC,…)
- What assumptions do you want to prove? (Detail level of unit economics and revenue streams,…)
The overarching theme here is detail level. If you just need to raise US$50k from a former colleague a basic budget will likely do. If you want to raise an Angel round you should have a decent revenue model in place. And if its time for VC money you will need to show exactly what you use your money for, how cash flows plan out and you will need to have a good idea of your valuation.
Once you are clear on what the end product should address, its time to start building your model. The key to building a meaningful model is to get the assumptions and the underlying logic right. And start of all of this are Unit Economics.
1.) Unit Economics – The Core of a Startup Financial Model
At the core of any financial model have to sit the so-called unit economics. Unit Economics describe the relationship of direct costs and revenues of each unit of sales of a business. We cover Unit Economics in much greater detail here, but the essence goes as follows: If each sales unit generates more revenues than it generates direct costs, there will be gross profit available to pay for the operations of your business.
So naturally they determine everything in a business! From how much revenue you might be able to generate, what your expenses are and what resources you need. If your customers are not profitable it doesn’t matter if you a have a million of them, you will always fail.
Your core unit economics should contain all main customer metrics, Life Time Value, Customer Acquisition Cost etc. If your business allows for that distinction also list out users separately as fine tuning conversion will be core to your marketing team. Again, we got a complete section on unit economics here.
2.) The Difference of Startup and Investment Banking Financial Models
Most people building Financial Models have learnt their craft at Investment Banks or in courses designed for Investment Banking hopefuls. The Investment Banking approach to Financial Modelling however has two major short falls when you apply it to startups. They are focused on large, established companies and the models themselves are too detailed in the wrong areas. That means they can be too detailed for most startup investors while still lacking assumptions based on unit economics.
a) Focused on Large Enterprises
Typically Investment Bankers only enter the scene during late stage financings or when a company is getting listed on a stock exchange. That means they generally deal with companies that have at least a couple years, if not decades, of financial history. To cater for the complexity of deals of that size, financial models will cover all cash flow sub-tabs such as depreciation, working capital, equity financings and even interest expenses for borrowing. And of course they will feature the full three-statement output (Balance Sheet, Income Statement, Cash Flow Statement). While a VC won’t outright reject your startup, if you base your financial model on your old investment banker’s template, you will surely end up including too much detail in the wrong areas.
b) Rarely Cover Unit Economics
Talking about too much detail in the wrong areas, Investment Banking Financial Models will boast surprisingly superficial revenue and expense assumptions. The common approach is to extrapolate the past years by some percentage or step function. Everything centers around a base case of a few percent growth and if there are plans to enter a new market you add a few percent and if you worry about the economy you deduct a few. If you are diligent you might validate your results with a top down analysis. I.e. make sure you don’t predict more than 7 billion customers. That’s about it when it comes to assumptions.
This approach might work really well, if you are dealing with a mature company operating in an established market. But for a startup operating in a new niche, possibly without any historicals that just doesn’t work. Think about it: Can you justify growing your US$10k monthly revenue by an arbitrary 50% every quarter just cause that’s what you think your need to get VC funding?
Getting your revenue and expense assumptions right is absolutely critical! That’s why it is so important to base everything on sound unit economics and have defensible price and expense assumptions. And as the company grows, these assumptions need to be continuously tested and updated.
3.) Investment Rounds and Financial Modelling
The nature of most fundable startups is that they operate in a very large billion dollar market. If they wouldn’t, investors wouldn’t be interested as they couldn’t earn large enough returns to justify their investment. And to reach their potential, they usually need to take off like a rocket otherwise for which they need enough investment. Its a chicken and egg problem. Everytime you reach the next revenue milestone your company graduates from Angel A to Series A, from Series C to D etc.
That means revenues and funding amounts projected in your financial model need to be connected by expense budgets and appropriate valuations. It all needs to be connected. If you just raised Angel A, you better double your revenues in a year and prove there is growth potential. Otherwise no VC will believe your company can generate them 10x return on their (more expensive) investment.
Financial modeling is the art and science of budgeting and predicting your business future. This will determine how much money you can raise and how to reach profitability. It will help you grow your business and pitch more effectively even if not every investor will read it in detail.
Even though you can’t predict the future, a financial model will help you define yours.
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