Understanding What a Financial Model Is: For Startups
For startups, a financial model is a finance tool that should be the numerical representation of the startup’s strategy and vision. It communicates and forecasts the company’s revenues, customers, KPIs, expenses, employee headcount and cash position.
More sophisticated companies will use the financial model as a budget, informing the different divisions within the organization of their projected hiring, major expenses and financial goals. For early-stage businesses, or simple ‘ideas,’ the financial model is a business plan that outlines the near-term expenses and goals for the company, and the longer-term illustrates the startup’s growth potential. Companies raising venture capital funding will use the projections as a tool to communicate with the VCs, and it will often be an important part of finance due diligence.
What Goes into a Startup Model Template?
Most projections that investors and experienced founders are expecting to see are pretty much the same template – revenue and expense projections, and a net cash position. Some templates have the three most important financial statements (the income statement, cash flow statement and balance sheet), but many templates simplify to just the income statement and a projected cash position. We tend to recommend that founders use a template without the balance sheet and cash flow statement unless they are working with a professional like us.
This is because the balance sheet can be tricky to model correctly – an unbalanced balance sheet is embarrassing and can cause investors to lose faith in the modelling exercise. Since most early-stage companies don’t have complicated working capital, CAPEX or loans, the balance sheet adds less to the analysis than you’d think. Thus, we recommend that founders DIY their projections using a template that doesn’t bother with the balance sheet and cash flow statement. Although, when we produce projections our templates and outputs always have these statements – but again, we do this every day, so it doesn’t take us meaningfully longer to get them right.
Forecasting Best Practices for Your Startup
Let’s talk about forecasting best practices, that’s building a three-year model that’s dynamic.
You want your model to easily change assumptions for each year, and you want to include a waterfall throughout the entire sales funnel, that’s going to include conversion rates and unit economics.
This is a best practice that the best CEOs do because it provides an understanding of the resources and effort required to close a sale. You also want to remember to include delays due to sales cycle and customer collections. This is going to affect your cash flows.
Next, you want to stress test your model, conversion rates, and growth rates and see what the impacts are. When these start to go sideways, you’re going to be prepared. If not, it can kill your cash. Next, your model should include a balance sheet, income statement, and cash flows. Finally, be honest with yourself in building your model.
How to Create a Financial Model
We’ve outlined the steps to create a financial model for your startup;
- Determine the goal of the model.
- Understand the goal of the model so that you can decide how complicated to make the project. In general, if you are market sizing or doing back-of-the-envelope estimates, less complicated is better. The next level of complication is if you are raising capital – too detailed, and your conversations with investors will get bogged down in minutiae. But have enough detail to show that you understand the market. Finally, for a detailed cash flow model for an operating business, it is typical to have a very detailed analysis.
- Determine the KPIs for your company.
- Understanding – and organizing – your KPIs helps you prepare to organize your key assumptions and outputs. Ideally, these KPIs are numerical factors and assumptions that you will be able to track – KPIs in a model a useless if you can’t track how you perform against them! Use industry-standard KPIs as a starting point.
- Get a financial model template. You can get this from the GFA E-store. Check here: e-store – GetFundedAfrica
- Existing templates almost ALWAYS make sense. Don’t start from anything; building a working piece of Excel is time-consuming and a waste of time. Use one of the many free templates – like the ones on this page.
- Merge actual results into the template.
- Don’t forget your actual financial results. If you have an operating business, merge your actual results into your projections. It’s best to start with reality, so you can level set. Strange ‘kinks’ in the model where actual results meet projections are a sign that there is something off with your projections.
- Start forecasting revenue.
- Work your way down the income statement, starting with revenue. When you think about how much revenue you’ll have, make sure you understand what’s driving that revenue. Is there a particular number of customers or salespeople or marketing spend/activities that will cause that revenue growth? You’ll also want to think about your cost of goods sold as you project your revenue. Note that this does NOT make sense if you are projecting a hardware or biotech company with a long time to revenue. Instead, for those, map out the effort you’ll need to reach critical product development milestones.
- Project headcount needs.
- For most startups, headcount is the biggest expense (at least until marketing kicks in!) How many people will you need to achieve your goals, and how much will each cost? Don’t forget recruiting costs; even if you have a deep network, you will likely need to hire in the out years.
- Estimate other expenses.
- You can use examples from other successful companies to see how they’ve scaled their expenses. Remember to add in additional expenses as the company grows – this should also apply to your headcount expenses. Very few companies have over a 50% pre-tax profit margin, so make sure you are adding in expenses!
- Model working capital.
- Working capital can be a surprisingly large driver of your model’s cash position. Read our section below. Basically, understand when your clients will pay you, and when you’ll need to pay big vendors.
- Review your projections.
- Do a sanity check! Startup financial projections. Take a look at the summary. Does it make sense? Is the model telling the story that you envisioned? A sanity check is always a good idea.
At GetFundedAfrica, we are here to serve you better. If you do not know where to get started with designing your template visit https://getfundedafrica.com/register/ to register. This gives you access to our resources tailored to suit your needs.