Let’s take a closer look at all the inputs needed for a financial model. Essentially, we need to think about our specific business model and what expenses we will incur and how we can make money from our product or service.
Fixed vs. Variable Drivers of your Assumptions
Some expenses like rent will be fixed, while others like transaction fees will be variable depending on business activity. That means when you start building your revenue model, your projections will consist of a combination of many fixed and variable line items. And for each of these so-called cost or revenue “drivers”, there may be an adjustment based on inflation or business activity over the various periods you want to project.
For example, in a commission driven business, you might want to either increase your commission percentages over time to reflect your growing market force or decrease it as you predict new competitors entering the market.
Likewise, with rental expense you might assume that inflation will drive up your monthly office rent by either a fixed amount or an inflation-based percentage.
All in all, your model should be comprehensive and flexible enough to include fixed and variable assumptions for all major revenue and expense categories and account for assumption changes for every year that you want to model. All such drivers need to feed into the results of your model dynamically with formulas, otherwise it will be nearly impossible to update in the future. And you might even want to consider storing all your assumptions cleanly in a separate tab of your Excel workbook, for easier editing and so that investors can easily understand your thinking when they review your financial model.
Everybody uses Templates, its OK!
While you can build a model from scratch, the entire process is kind of standard, which means you should probably consider using either our or somebody else’s template begin with. Once you are done with “the Basics” you will know how and where to tweak the details. Let’s start by taking a closer look at unit economics first.
Research is one of those areas where different people need different advice as some entrepreneurs go totally overboard on this, while others act like they know everything and need to become more diligent. So, the trick is to find the right balance and here are some examples on how to evaluate your efforts:
Finding the Right Balance in Research
Essentially, you will want to center your research around the areas that really matter. And by matter, we mean have the most significant impact on your financial model’s outcomes. That includes everything that relates to your revenue streams, namely pricing information, market sizing, margins and repeat purchase rates. The better your assumptions in this area, the more likely your unit economics will be close to reality.
When it comes to expenses you should factor-in, whether the respective expense group is really important to you. For example, a startup with a large support department should take a look at a couple of salary reports before making too vague assumptions in regard of salaries. However, you also don’t want to overdo it. As long as you get the functions and number of employees roughly right, you will likely be fine. Instead of getting into too much detail on all things tax and social security related, it’s probably best to just add a buffer of 10-30% and be done with it.
This leads to the topic of taxes and exchange rate fluctuations. If you are planning your early stage startup and you are only operating in one country it’s probably fairly easy to get the tax rates exactly right – especially, if employee related items are not too complicated. But if you are sitting in Europe or Asia and are planning to go international rather quickly, you might just solve this issue initially by adding another buffer in your corporate income tax or simply increasing for example salaries by 10-30% and then figure out the details once you are really going into the respective market.
Dig Deeper in these Areas of Operational Expenses
When it comes to regular operational expenses a couple of areas, which you might want to consider doing research on, are:
- Marketing expense: Especially, if you already know which marketing channels you will use, you might as well get some decent estimates. Google Adwords for example lets you estimate any kind of search keyword you would like to advertise for and you can use that to get user acquisition cost ranges that can go a long way in making your unit economics more precise. For example advertising for “insurance” related search terms will be more expensive by multiples than some esoteric search term on camping gear.
- Office rent: This can vary greatly between countries and between cities or regions within a country. Co-working spaces or serviced office providers are an easy way to get a price-per-employee, which will surely be on the upper-end of the spectrum and provide ample buffer for renting your own space including buying furniture later on.
- General administrative fees: While you can solve a lot of this with a flat rate buffer or a percentage-of-revenue formula, you should look out for major accounting and legal costs. Especially, if you are seeking seed or angel funding, incorporation, auditing and legal bills can be quite substantial and easily amount to 10,000-20,000 USD even on the first small investment round. In terms of legal bills, you might want to consider trademark registration, shareholder agreement development as well as writing of significant commercial agreements. By the way, there are more and more online legal providers, which can help you avoid paying too much for standard contracts, especially the less important ones that you will likely never bother to go to court over in the early days, anyways. They provide databases of standard contract templates, which are customized through the filling out of input fields and by asking a set of standardized questions during contract creation.
So again, doing research is all about balance. At first glance, you might think that our approach is a bit superficial, but once you really start listing items in excel, things will look very detailed very quickly. Nobody will give you “good grades” for your excessive efforts here. Most important in regards of research is to ensure you are budgeting for a long enough runway, all while showing an impressive enough business potential that can actually enable you to raise the necessary funds.
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