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Financial Models for Startups

December 18, 2013

On the short list of items one must put together when pitching a startup is the financial model – the Excel workbook which contains formulas and variables predicting revenues and expenses and, ostensibly, a business model that could produce a big exit for the founders/shareholders.

There are two guarantees with just about every startup financial model: 1) if you do a line graph of the revenue, it will look like a hockey stick; and 2) the model is totally made up and will most likely bear no resemblance to real life.

Startup Financial Model

Yep, I just shared the not-so-secret rule of startup life: your financial model is going to be total bunk. My friends in later stage private equity or the hedge fund world are always amazed when I tell them how it’s standard practice for us to discount companies’ plans by 50% or more when doing underwriting of venture debt deals (and that’s for later stage companies!). For early stage companies, it’s even more of a crapshoot.

Despite the fact that the model probably won’t play out as planned, it’s an absolute necessity when planning the business and is one of the most important factors investors look at when considering an investment. Here are a few things to remember when putting together the model:

It’s all about the logic – With a startup financial model the numbers are only partially important. Sure, investors want to invest in “good teams in large markets,” and the model has to show that the market is big enough to entice a venture investment. But, because most startups don’t play out as planned and the degree of variability between the actual numbers in the model and reality is so large, the more important factor is the underlying logic behind the numbers. Investors are more interested in understanding the “how” behind the numbers than the exact numbers themselves.

This can be instructive for entrepreneurs in a couple of ways. First, it’s tempting to show scenarios in your model that lead to desired outcomes. For instance, you may want to show you can get to cash flow breakeven off a single round of investment, so you tweak the variables to make this happen. Or, you want to get to a specific milestone and/or run rate prior to a certain date to lead to a desired valuation for the next round. This type of thinking is a death knell because it takes the focus off of the logical path of building a business – how you are actually going to make things happen – and puts too much focus on the end game (the “what”). The better approach is to think holistically first about how your business will grow, and then build the model that very rationally shows how this translates into numbers, step by step. When an outsider (i.e. investor or advisor) asks questions about the model and why certain scaling assumptions are used for revenues, expenses or fundraising, it should be very easy to explain the logic. This is paradoxical, of course, because I’ve just spent the better part of the last 500 words explaining how unlikely it is you will be able to predict the future. However, strong logic gives confidence to investors on their bet in the team and also provides a framework for adjusting to the inevitable changes over time. You may not be able to predict the future but you at least need to show that you can provide logical paths to outcomes.

Practically speaking, this means that a model that uses a “top down” approach of “we will gain 1% of a certain market in a certain amount of time” is not good enough. And, even when using “bottom up” approaches, one must dig deep to provide proper logic. For example, maybe there’s an assumption of growth in number of users or number of customers and, for the purposes of the model, this is shown using a growth rate percentage per month or per quarter. It’s fine to model the number like this provided there is a logic behind why that growth rate makes sense and how the execution of that growth will happen (X number of sales reps at a certain customer acquisition per rep, etc.).

One execution tip as you make sure the logic in the model is clear – take the numbers and various variables in your model and map them in a flow chart or with words on a white board or PowerPoint slide. This allows you to show that you know the important levers and how you’re thinking through the business model. It can sometimes be useful to share this “model map” with investors when you get to a stage of diligence when they’re trying to make sense of your model and will definitely help in translation and your overall pitch.

Make sure you’re sensitive – As noted above, most people involved in startups will be comfortable with financial plans which could have a high degree of variability. In light of this, it doesn’t make much sense to only build a model which shows a best case scenario without quantifiable and easy-to-tweak ways to sensitize the model. Once you’ve figured out the major drivers of the business and growth, ensure that your model allows for you to easily sensitize the growth assumptions for revenue, expenses, headcount, and fundraising. This helps you run multiple scenarios for business planning (i.e. raise more $$ and go high growth vs. bootstrap and grow organically). Make the sensitivity easy to run and go ahead and create multiple versions of the model. If your model is not easy to sensitize, it’s an indication that it’s either over-engineered or the levers are not mapped in a way to properly think through the business.

Burn Baby Burn – In most cases, the calculations for cash burn and months of runway are the most important in any early stage financial model. The overview of cash remaining and monthly cash consumption needs to be easily identifiable and understandable. While it’s important to think through how you will scale on both the revenue and expense side, it is more important to know exactly how cash will flow. Remember that revenue and cash flow are often not correlated on a 1:1 scale and, even when they are, it is crucial to understand the working capital and cash flow considerations of your business. Forecasting burn is easy when you’re pre-revenue as you just need to figure out the expense side and do some simple math. But, when you start generating revenue and have to think through invoicing, A/R, inventory and other variables that impact cash flow, things can get a little cloudier. It’s all about the cash with early stage startups – so, at a minimum, when building your model have a rock solid understanding of how much runway you have, as this will impact all kinds of business and strategic decisions.

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