Financial modelling has become a critical competency for startup teams
Many moons ago, when companies primarily sold physical products through physical channels, financial models were pretty straightforward. A basic P&L, Cash Flow and Balance Sheet template met most needs. Now, with the plethora of more complex, internet-enabled business models and greater levels of investor scrutiny, financial modelling has become a critical competency. The adoption of best practice is vital, so where to begin?
What is a Financial Model?
First, let’s make sure we’re all on the same page.
A financial model is essentially the numeric version of the business plan. It reflects the key economic assumptions about the future of the Company. It takes these assumptions and provides a financial outlook, usually over a 5-year period.
The core of the model is similar to a set of consolidated financial statements, but unlike historical accounts it is almost entirely forward looking. It is essentially a forecast that will evolve over time as reality replaces assumptions.
It is usually constructed in excel and has a linked Profit & Loss, Cash Flow and Balance sheet together with an Input sheet (so the key economic assumptions can be easily entered and varied), and an Output sheet (providing a dashboard of all the important metrics or KPIs). The primary statements are all formula driven, so by changing a value in the Input sheet you see the immediate impact in the Output.
For the prospective investor it quickly provides insight into a range of important factors such as growth rate, revenue and profitability potential, cash required through profitability, and many others KPIs related to your specific business model.
Amongst other things this helps investors determine the potential future value of the business, which of course is one of the biggest factors in their decision making.
For more on the investor perspective this article by Impression Ventures is a good read.
However, it is not just an essential document for investors - it has an even greater purpose.
It is a planning tool that enables the CEO and senior management to regularly evaluate business scenarios and make informed decisions about potential future performance and funding needs, based on a set of relevant metrics.
This last paragraph took me a while to construct because I wanted to be very precise about this ‘greater purpose’. The phrases in italics are of the essence and serve to highlight what a financial model should enable.
There are 3 big components here:
1. A planning tool for the CEO and senior management…
If you’re a founder and you’ve been reading this thinking that the financial model is something that you only need to dust off when preparing for funding, you are truly missing something.
For those in this position, it may be because the design of your current model does not lend itself to being used as a management tool. In addition, if it’s not easy to use and is not being updated regularly by the team it will lack relevance and be of little value.
Perhaps instead you are relying on a short-term cash flow analysis to guide your immediate decisions? This may feel like you are travelling with purpose, but you really can’t know where you are headed longer term. You need to be watching the satnav as well as the fuel gauge.
The most effective models are where the CEO and management team have specified:
What key business assumptions need to be incorporated in the model in the first place (the inputs tab)
What KPIs or metrics must be extracted from them, and
How these should be presented (tables, graphs, etc) in the outputs tab.
These insights are also what investors will be most interested in. Remember it will be you who will be explaining all this to them, not the finance person who actually built the model.
The primary users must therefore feel intimate with the model and, in particular, understand what factors influence the key metrics.
2. …to regularly evaluate business scenarios and make informed decisions about potential future performance and funding needs…
In the formative stages of developing the business, much will be changing. You may be striving to confirm Product/Market fit and important new customer data will be arriving regularly.
You will be cautiously committing cash to this effort and know that at some point you will need to raise further capital.
This is a crucial decision point and of course there will be many others like this as you progress.
The financial model is now the essential tool in helping you evaluate these scenarios. If you don’t have a fully functioning model at this stage, you are going to struggle. It will be almost impossible to run any meaningful sensitivity analysis. i.e. as you receive market feedback you will want to easily vary key inputs such as pricing, product volumes, deal timing, materials costs, and so on, so you can evaluate the likely cash impact.
A fully functioning model should be updated every month with actuals. In addition, you will be regularly ensuring that your bottom up customer revenue pipeline has sufficient coverage to give you confidence in your revenue outlook over the next 12-18 months. This is hard at Seed stage but will become easier as you begin early scaling.
Remember, this is a model and should not contain detailed customer level data. You should have this in a separate revenue pipeline document.
Similarly, your most accurate cash flow outlook will be your separate (and very detailed) short-term cash flow forecast, but the model should be close.
The model will then take this cash flow forward over several years and identify the key milestones for future funding as well as the use of funds.
3. …based on a set of relevant metrics
In the internet era, business models such as SaaS, Subscription, Transactional, Marketplace, eCommerce, Advertising and others, enable user engagement and revenues to be generated at a much earlier stage than ever before.
A raft of new metrics like MRR, Churn, CAC, Retention, MAU and many others must now be measured. Investors will drill into these with vigour when evaluating any business, right from Seed stage.
Setting and tracking such key performance indicators (KPI’s) is now an essential part of business planning and a critical competency for any startup team. The financial model is the natural home for bringing this together. The outputs tab is the ideal place to monitor overall progress.
The metrics you track will of course vary depending on your business model. Anu Hariharan of Y Combinator has produced a useful video tutorial on business model metrics, which can be found on YouTube.
A quick reference table below captures the essential metrics that Y Combinator evaluate, by business model:
Note that these are not necessarily definitive across all investors, so you should add in others that you think are important to track for your specific business.
The combination of a wider array of internet-enabled business models and greater levels of investor scrutiny mean that financial modelling has become a critical competency for startup teams.
A properly constructed financial model is essential for raising institutional investment. It quickly provides insight into a range of important investment factors, including key metrics that will be specific to your business model. This also helps investors determine the potential future value of your business.
A financial model is also an essential planning tool that enables the CEO and senior management to regularly evaluate business scenarios and make informed decisions about potential future performance and funding needs.
Good models typically provide a 5-year financial outlook and are regularly updated to stay in lock step with the business plan. The model does not replace the short-term cash flow forecast and revenue pipeline, which should run in parallel.
Founders must be intimate with the model and understand what factors influence the key metrics. Remember, it will be you who will be explaining these metrics to investors, not the finance person who actually built the model.
About the author: John Hall is CEO and co-founder of Duet Partners. His 30-year tech career began with major US semiconductor and software companies, and was based in Silicon Valley during the '90's. Before Duet he was CEO of a VC-backed consumer electronics company, sold in 2009 following several rounds of capital raising. In the past 10 years since starting Duet he has advised dozens of founders on the startup to scaleup journey and is a retained Board advisor to a number of UK technology companies.