A Comprehensive Guide on Startup Financial Modeling
We have three straightforward questions for you:
1. Is your goal to establish a financially sustainable business?
2. Are you in search of funding opportunities?
3. Do you aim to steer clear of financial insolvency?
Chances are, you’ve answered “yes” to at least one of these questions. If you’ve ventured into entrepreneurship, all three likely resonate with you.
In addressing these concerns, having some form of a financial model becomes indispensable. Regardless of what has led you to peruse this article, it’s evident that financial modeling holds a significant place in your entrepreneurial journey; otherwise, you wouldn’t be here, would you?
Well, you’re in the right spot! With the support of the EY Finance Navigator team, who’ve assisted countless startups and scale-ups in refining their financial models over the past few years, we’ve compiled everything you need to know, including the most effective practices, in the realm of financial modeling for startups – presenting the ultimate guide to financial modeling for startups!
Please note that we won’t be providing financial modeling templates in this article. Why, you ask? Because the internet is already teeming with a plethora of templates. All you need to do is search for “financial model template,” and you’ll find an array of options.
This article serves a different purpose, one that templates can’t fulfill: it’s designed to help you grasp the various components and intricacies of a startup’s financial model, instruct you on how to populate it and guide you through data validation so that you can interpret the results on your own.
Three reasons for having a startup financial model
Before we delve into the intricacies and components of a startup’s financial model, let’s take a step back and explore why forecasting generally holds paramount significance for startups. Financial planning and budgeting are commonplace across all businesses, but startups, in particular, have unique reasons for prioritizing a financial plan:
- Foundation for Viability: A financial model is the cornerstone of establishing an economically sustainable business. It serves as a tool for quantifying and validating your business plan, assumptions, and vision. This process lets you determine whether your innovative ideas can be transformed into a consistently thriving enterprise. Additionally, crafting various scenarios gives you the foresight to adapt to unexpected challenges. For instance, what if your launch is delayed by six months? Addressing such questions within a “worst-case scenario” aids in assessing the impact on your cash flow, profitability, and funding requirements.
- Integral to Fundraising: During the fundraising journey, whether you’re engaging with angel investors, venture capitalists, banks, or subsidy providers, a financial plan is a requisite. Different financiers may demand varying levels of detail, but creating a robust model is prudent even when providing high-level data. Why? It equips you with the ability to address the intricate inquiries financiers may pose when scrutinizing your business case. Furthermore, how can you effectively secure funding if you haven’t precisely calculated your funding needs?
- Informed Decision-Making: A financial model serves as a compass for yourself and your shareholders. It provides the essential benchmarks and targets to gauge your company’s performance. Without these metrics, how can you assess your progress or communicate effectively with shareholders about resource allocation and performance in alignment with your promises? A forecast is indispensable in these scenarios.
Do these rationales resonate with your situation? If so, continue your exploration for valuable insights…
Two different approaches to financial modeling for startups
Frequently, crafting a financial model isn’t the primary challenge. The internet is brimming with countless templates, and Excel-savvy individuals are usually available to assist with the technical aspects. The REAL conundrum (and a frequent question) revolves around how you arrive at those critical numbers?
…how do you predict sales?
…what’s the size of your sector’s market?
…how much should you allocate to marketing?
And so on.
There are two predominant methods for addressing these queries: top-down forecasting and bottom-up forecasting.
1. Top-Down Forecasting
In the top-down approach, you start from a macro, outside-in perspective and progressively zoom in to a micro view. Typically, you begin with industry estimates and then narrow them down to tailor targets suitable for your specific business.
Essentially, the top-down method assists in creating a forecast based on the market share you intend to capture within a reasonable timeframe. An effective tool for top-down forecasting is the TAM SAM SOM model.
The TAM SAM SOM model segments the market size into three tiers: the global market for your product or service (TAM: Total Available Market), the portion of that market your offering addresses (the niche market), adjusted for your geographical reach (SAM: Serviceable Available Market), and the slice of SAM you can realistically secure (SOM: Serviceable Obtainable Market), given existing competition. SOM represents your sales target, representing the market share value you aim to acquire.
Once you’ve defined sales targets using the TAM SAM SOM model, the next step involves estimating all the costs necessary to produce or deliver your product or service and all the expenses required to execute sales, marketing, research and development, and general administrative tasks to sustain your company. Profitability within a reasonable timeframe is the goal. In other words, your costs and expenses should eventually align with or fall below your revenue targets, resulting in a positive EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
2. Bottom-Up Forecasting
The pitfall of the top-down approach is its potential to lead to overly optimistic forecasts, particularly in sales. Entrepreneurs often calculate SOM (equivalent to sales) by selecting a random percentage of the market without thoroughly assessing its realistic achievability.
A small market share percentage may seem inconsequential but might be overly optimistic, especially during your launch year. Hence, complementing the top-down method with the bottom-up approach can be advantageous.
The bottom-up approach relies less on external factors (the market) and leverages internal company-specific data, such as sales data or your company’s internal capacity. Unlike the top-down method, the bottom-up approach starts with a micro, inside-out perspective and then expands to a macro view. This approach projects based on the key value drivers of your business.
For instance, consider an online SaaS business where one of the primary value drivers is online marketing. One of its marketing tactics is LinkedIn advertising. The company could determine the cost per click using LinkedIn’s advertising tool, estimate the number of website visitors it will attract, predict the conversion from website visitor to lead, and project the conversion from lead to customer.
By utilizing these metrics, the company gains insights into potential sales, factoring in the budget allocated for online advertising. A bottom-up analysis prompts you to contemplate realistic targets for your company and how you’ll allocate your resources.
With the bottom-up approach, you estimate revenues, costs, expenses, and investments using the resources at hand and available company data. However, it may fall short in demonstrating the optimism necessary to convince others of your company’s potential.
If you’re a startup founder seeking funding, the bottom-up approach might not effectively convey the growth trajectory investors typically anticipate. Investors often expect startups to experience rapid growth and attain substantial market share swiftly. This is an area where the bottom-up method may not fully align.
Therefore, when crafting your startup’s forecast, it’s advisable to combine both bottom-up and top-down methods, particularly if you intend to achieve robust growth through external funding. Utilize the bottom-up approach for short-term forecasting (1-2 years ahead) and employ the top-down method for the longer term (3-5 years ahead).
This approach enables you to substantiate and defend your short-term objectives convincingly while demonstrating the desired market share and investor-appealing ambition in the long term.
Irrespective of the approach you adopt for constructing your startup’s financial model, the ability to substantiate your figures with well-founded assumptions is absolutely essential. Startups often lack historical data, making it imperative to provide the “proof” behind your numerical projections.
This practice is especially valuable when engaging with investors, as they invariably seek insight into the rationale underpinning your financial estimates. Since they are contemplating investing in your venture, you wouldn’t want to leave them with the impression that you’re peddling unfounded claims.
Assumptions encompass a broad spectrum of elements that validate your numerical assertions: market research findings, search volume data from the web, supplier contracts, pricing validation, historical sales data, conversion rates, bill of materials, website traffic metrics, and more. It’s advisable to create a “data room” (perhaps a shared Drive folder) where you systematically collect and store such evidence. By doing so, you gradually assemble a comprehensive repository that bolsters the integrity of every figure in your model. Moreover, you’ll be well-prepared in case an investor requests a due diligence process.
With this groundwork laid out, let’s delve into the key financial components that a well-structured financial model for a startup should encompass!
Three Key Outputs Found in a Startup’s Financial Model
While every sector, company, business owner, and investor possesses unique characteristics and preferences, financial models are inherently adaptable to cater to individual needs. Consequently, each financial model exhibits distinct characteristics tailored to its user.
Nonetheless, a robust financial model typically encompasses a minimum of three essential outputs: financial statements, an operational cash flow forecast, and a key performance indicator (KPI) overview.
1. Financial Statements
A well-constructed financial model includes a projection of the three fundamental financial statements: the profit and loss statement (P&L), the balance sheet (BS), and the cash flow statement (CF). These financial statements serve as universally accepted means of conveying financial information to various stakeholders, including companies, banks, investors, governments, and anyone seeking to gauge financial performance.
The profit and loss (P&L) statement offers a comprehensive summary of a company’s revenues and expenses during a specific period, enabling an assessment of its profitability.
The P&L statement provides valuable performance metrics, such as gross margin, EBITDA (earnings before interest, taxes, depreciation, and amortization), and net margin. EBITDA holds particular significance for investors, as it sheds light on a company’s operational efficiency, facilitating comparisons between different enterprises. The P&L statement aids in comparisons across time periods, budget versus actual performance, and benchmarking against other companies, thus revealing strengths and weaknesses.
In contrast, the balance sheet portrays a snapshot of a company’s assets and liabilities at a specific moment in time, typically the year-end. This snapshot distinguishes it from the P&L statement, which encompasses all revenues and costs incurred over a specific time frame.
Liabilities represent a company’s obligations and its method of financing through debt, while assets illustrate how these funds are deployed within the organization, such as capital allocation for inventory or assets like computers and buildings. The gap between assets and liabilities constitutes equity, representing the capital contributed by investors to finance assets not covered by debt (Assets = Liabilities + Equity).
As a result, the balance sheet remains in equilibrium, signifying shareholders’ equity as the net worth of the company. In essence, it signifies the amount that would be distributed to shareholders if the company’s assets were liquidated and all debts settled.
The cash flow statement is a financial document that tracks all the incoming and outgoing cash within a company during a specified timeframe. It comprises three distinct segments: operational cash flow, investment cash flow, and financial cash flow. The division into these categories offers valuable insights into the flow of money in and out of the company.
- Operational Cash Flow: This segment highlights the cash movements resulting from the core activities of the business. It captures both cash inflows and outflows associated with day-to-day operations.
- Investment Cash Flow: The investment cash flow section records changes in investments made in assets and equipment. Typically, startups will experience a cash outflow here since acquiring assets incurs costs. However, there are instances where investment cash flow can be positive, especially when a company is divesting, such as selling real estate or other assets.
- Financial Cash Flow: Financial cash flow accounts for cash changes originating from financing activities. Cash inflow occurs when capital is raised through sources like loans or equity investments. Conversely, cash outflow happens when dividends are distributed to shareholders or when interest payments are made to finance cash (e.g., to bondholders).
The cash flow statement serves as a crucial tool for management in making informed decisions about business operations. It aids in monitoring and managing company debt, identifies the company’s investment requirements, and ensures the timely settlement of expenses and debts.
2. Operational Cash Flow Overview
When it comes to fundraising efforts, financial statement forecasts are typically presented on an annual basis. Monthly breakdowns are often considered unnecessary because, especially for early-stage startups, the primary focus is on demonstrating long-term growth potential rather than offering detailed monthly operational insights.
However, for the day-to-day financial management of your company, it’s highly beneficial to incorporate a 12-month operational cash flow projection into your financial model.
Why is this important? Because it addresses questions that yearly financial statements cannot answer, particularly those related to the timing of cash inflows and outflows. This timing is crucial for anticipating financial needs, as elaborated in the ‘Working Capital’ section below.
Additionally, an operational cash flow forecast enables you to closely monitor your actual performance compared to your expected budget on a monthly basis. This proactive approach not only helps you identify opportunities to reduce costs, if necessary, but also allows you to foresee potential cash shortages months in advance.
Creating an operational cash flow forecast is a straightforward process. You simply list all the categories of cash inflows and outflows, often in a tool like Excel. Start with an initial balance (the amount of cash you currently have), and then calculate the remaining balance at the end of each month.
3. KPI Overview
A startup’s financial model not only yields financial statements and cash flow projections but also incorporates specific Key Performance Indicators (KPIs) tailored to the company and its industry. As the name suggests, KPIs are vital metrics for your business.
These indicators hold significance not just for investors but also for you as the company owner. They serve as the compass by which you navigate your company’s performance. KPIs enable you to experiment with various customer acquisition channels, business models, and cost structures while keeping you and your co-founders laser-focused on your predefined targets.
KPIs come in various forms, including those that gauge sales and profitability (e.g., revenue growth rate, gross margin, EBITDA margin, or profits), those related to cash flow and fundraising (e.g., burn rate, runway, and funding requirements breakdown), and industry-specific KPIs.
For example, Software as a Service (SaaS) companies typically estimate and closely monitor metrics like Customer Lifetime Value (LTV), Customer Acquisition Costs (CAC), LTV/CAC ratio, and churn rate, as these metrics are pivotal to their success.
However, your business or industry may prioritize different metrics. To determine the most relevant KPIs for your venture, conduct online research, consider the key drivers of your company, and identify those most pertinent to both your operational needs and the interests of potential investors. Incorporate these identified KPIs into your financial model to provide a comprehensive view of your business’s health and performance.
The Components of a Startup’s Financial Model
A startup’s financial model relies on several essential elements to generate meaningful outputs. These outputs aren’t conjured out of thin air; rather, they result from a series of intricate calculations that occur behind the scenes.
These calculations are based on data input into various sheets, supported by underlying assumptions and research conducted by the individual constructing the financial model.
This article doesn’t delve into the exhaustive details of these calculations, as that would be a monumental task. Instead, our focus is on helping you comprehend the distinct elements and intricacies of a startup’s financial model, guiding you on how to populate it and extract valuable insights from the outcomes.
For those seeking an in-depth understanding of the calculations involved, financial modeling templates are readily available for download online. Alternatively, if you prefer to avoid concerns about calculation errors altogether, you can explore our financial planning software designed specifically for startups.
Here, we’ve identified six common elements that typically serve as input sheets within a financial model. One element we haven’t included as an input sheet can be described as the financial model’s ‘settings.’
These settings define the entire model’s configuration, encompassing factors such as the forecasting period (typically 3-5 years, occasionally extending to ten years for certain industries), the chosen currency, applicable taxes, and more.
Before delving into the various inputs of a startup’s financial model, it’s vital to recognize that financial modeling isn’t an end in itself. Rather, it’s a means to an end. And that end typically revolves around gaining deeper insights into the financial aspects of building a business, whether these insights are intended for your own use or to attract potential investors.
A financial model serves as a quantitative representation of your overall business and should therefore mirror your strategy, business model, and vision. In this sense, your financial model and business model canvas are two interlinked facets of the same endeavor.
If ever uncertain about what to include in your financial model or when you need to step back from the numbers, consider using your business model canvas as a tool to aid in conceptualizing your financial plan.
The first, and often the most enjoyable, input sheet in a financial plan is the revenue forecast. Yet, projecting revenues can be challenging, especially if your startup has no prior sales history. How should you approach this task? For an in-depth exploration, we recommend referring to our previous article on crafting a robust sales forecast for your startup. However, we’ll summarize the key takeaways below.
Typically, revenue forecasting involves a combination of top-down (TAM SAM SOM model) and bottom-up methods, as discussed earlier in this article. Employ the bottom-up approach for short-term sales forecasts (1-2 years ahead) and the top-down method for longer-term projections (3-5 years ahead).
This approach allows you to substantiate your short-term targets in detail while demonstrating your long-term goals in terms of market share and the ambition sought by investors.
If estimating demand proves challenging, consider conducting keyword research. Keyword analysis tools provide insights into search volumes related to your offering, broken down by location (city, country, continent) and the number of monthly searches for specific keywords on the internet.
Tools like Ubersuggest can be particularly useful. For instance, if you sell 3D printers, you can search for “buy 3D printer” to gauge monthly search interest.
Now that you understand the forecasting approaches, here’s how you translate your forecast onto paper:
1. List all the products or services you’re selling.
2. Determine the units in which you’ll present your sales (e.g., bottles or liters for a soda producer).
3. Forecast the number of units sold per sales unit, drawing from your top-down and bottom-up analyses.
4. Establish selling prices; if you need guidance, refer to our article on new product pricing strategies.
The manner in which you construct your revenue forecast is somewhat contingent on your particular business model. The previous example pertained to a conventional business model, where a company sells products or services on a per-unit basis.
However, for a Software as a Service (SaaS) business, it might be more appropriate to formulate a revenue forecast based on factors like existing customers, new customer acquisitions, and the churn rate. If you’re looking for financial modeling templates tailored to specific companies or business models, you can readily find them online. Additionally, our startup financial planning software accommodates various business models, facilitating the development of your revenue forecast.
2. Cost of Goods Sold (COGS)
The Cost of Goods Sold (COGS) refers to the essential expenses that a company must incur to provide a service or manufacture a product. These expenditures are indispensable because, without them, the product or service would not come into existence.
COGS varies depending on the type of offering a company provides. For businesses dealing in physical products, it encompasses expenses such as the materials used in crafting the product. In the case of companies offering consulting services, it includes the personnel costs associated with the employees delivering the service.
For Software as a Service (SaaS) enterprises, COGS differs from traditional businesses because there is no conventional production or service delivery process involved. However, SaaS companies still have identifiable COGS, such as hosting expenses, customer support and onboarding costs, and online payment charges. It’s important to note that all of these costs are essential for producing the product or delivering the service.
If you’re unsure how to forecast COGS, one approach is to examine the sales targets outlined in your revenue forecast. Let’s say you’re selling a physical product. By creating revenue projections, you can determine the quantity of units you aim to sell. You can then calculate the costs of raw materials and labor required to produce each unit.
For instance, if you’re selling plastic bottles, you can determine the amount of plastic (in grams) needed per bottle and its cost per kilogram. Additionally, you’ll need to factor in the expense of the paper label per bottle and the cost of the cap. Once you have all these costs associated with producing one bottle, you can multiply them by the total number of bottles sold. Finally, include personnel costs for employees involved in the production process.
The approach to forecasting COGS also hinges on your specific business model. There are varying methods that may be more appropriate depending on the circumstances. For example, you might opt to project COGS on an aggregate level, such as a monthly basis. Alternatively, you could tie COGS to a percentage of your revenues, especially when dealing with sales commissions.
3. Operating Expenses (OPEX)
Operating expenses represent the costs incurred by a business in the course of its regular operational activities. Unlike the Cost of Goods Sold (COGS), these expenses are not directly tied to the production of goods or the delivery of services; instead, they encompass various aspects of business support and operations. This includes expenses related to functions like sales and marketing, research and development, as well as general administrative tasks.
For startups, typical operating expenses encompass a wide range of items, such as event costs, travel expenses, legal fees, online marketing, non-COGS payroll expenses, accounting, rent, utilities, insurance, prototyping, patent-related expenses, IT expenditures, office supplies, promotional materials, and more.
If you’re uncertain about the specific expenses you’ll incur over the long term, one approach is to allocate a certain percentage of your revenues to various expense categories. For example, you might set aside 10% of your annual revenues for sales and marketing activities.
The key consideration here is that your allocation of funds to operating expenses should align with your company’s strategic objectives. If your company’s growth heavily relies on online marketing, it’s expected that a significant portion of your budget will be allocated to this category.
Developing a personnel forecast is often considered one of the more straightforward tasks in financial planning. This forecast involves estimating the number of employees to be hired, along with their respective salaries, additional benefits, and payroll taxes. To simplify personnel forecasting, it can be useful to categorize your workforce into distinct groups, such as:
- Direct Labor: In this category, you account for employees exclusively engaged in the production of goods or delivery of services. Examples include engineers and technicians in companies that sell physical hardware products, junior advisors in consultancy firms, or customer onboarding staff in SaaS businesses. It’s important to note that these costs are not classified as operating expenses but are part of the Cost of Goods Sold (COGS).
- Sales and Marketing: This category covers roles like sales managers, marketing managers, copywriters, social media specialists, and more. These employees are considered part of your operating expenses.
- Research and Development: Within this group, you include employees such as R&D managers, software engineers, technicians, and related roles. These individuals also fall under your operating expenses.
- General and Administration: This category encompasses back-office staff and C-level executives, including the CEO, CFO, CMO, secretaries, bookkeepers, and others responsible for administrative functions. Their salaries and associated costs are part of your operating expenses.
To assess the realism of your personnel forecast, you can perform a simple calculation: divide your projected annual revenues by the number of employees, often referred to as ‘FTEs’ or full-time equivalents, for that particular year. This calculation reveals the expected revenue generated per employee and offers a robust basis for comparison with industry peers and top competitors.
When your revenue per employee closely aligns with that of the top twenty tech companies (as illustrated in the graph below) within just a few years after your launch, it serves as a compelling indicator that you may either have overly optimistic revenue expectations or are underinvesting in your workforce.
5. Capital Expenditures (Investments in Assets)
The fifth component in your startup’s financial model pertains to capital expenditures, which refer to the allocation of funds for acquiring or upgrading tangible assets like physical property, intellectual property, buildings, or equipment. These expenses are incurred by companies to either maintain their existing operations or expand their scope. Capital expenditures can encompass a wide range of activities, from simple repairs like fixing a roof to more substantial investments such as constructing a new factory.
The specific nature of capital expenditures varies depending on the type of business and industry. For startups, it’s common to invest in items like computers, software, office equipment, and machinery, but even purchasing a building can be considered a capital expenditure.
Many startups are motivated to classify their expenses as capital expenditures rather than operating expenses. This choice is often related to accounting practices, where payments for asset investments are spread out over several years in the profit and loss statement (see the ‘Depreciation’ section below). Consequently, these expenses don’t have an immediate and noticeable impact on profits. However, it’s crucial to note that the criteria for categorizing expenses as assets are stringent.
The final potential component of a startup’s financial model involves a financing module. Within this section, you can incorporate various sources of funding such as equity, loans, or subsidies. The primary purpose here is to assess how different forms of financing, introduced at various points in the model’s timeline, affect your overall funding requirements.
In instances where your model includes the option to input loans, it must also factor in the repayment of the loan principal and interest payments, as these aspects have a significant impact on cash flows.
The six input sheets mentioned earlier are all interconnected with the outcomes of the financial model, particularly when it comes to the financial statements. Here are the specific connections for the financial statements:
- Revenue: Revenue has a direct impact on the top line of the profit and loss statement (P&L). In the P&L, you subtract all costs, expenses, and depreciation from the revenue to calculate EBIT (earnings before interest and taxes). EBIT, in turn, serves as a crucial input for the operational cash flow section of the cash flow statement. After deducting interest and taxes (explained in the ‘Taxes’ section below) from EBIT, you arrive at the net profit. Additionally, revenue affects the balance sheet by defining the accounts receivable position.
- Cost of Goods Sold: The cost of goods sold is another factor that appears in the profit and loss statement. Subtracting it from the revenue yields the gross margin. This gross margin can also be expressed as a percentage, where a higher percentage indicates more revenue available to cover non-production-related costs. The cost of goods sold also impacts the balance sheet by defining accounts payable and inventory.
- Operating Expenses: Operating expenses are also featured in the profit and loss statement. By deducting both operating expenses and the cost of goods sold from revenue, you calculate EBITDA (earnings before interest, taxes, depreciation, and amortization).
- Personnel: Personnel expenses can appear as a separate line item in the profit and loss statement or be included in either the cost of goods sold or operating expenses. Personnel directly involved in delivering services or producing goods fall under the cost of goods sold category, while all other personnel expenses are part of the operating expenses.
- Investments in Assets (Capital Expenditures): Investments in assets do not show up as costs or expenses in the profit and loss statement because, from an accounting perspective, they are considered investments and can be capitalized. This means a company can leverage its value over several years. Consequently, they are reflected as assets on the balance sheet. Their value depreciates (reduces in value) over their useful life, which is recorded as depreciation in the profit and loss statement. Despite not being considered costs or expenses, investments do result in cash outflows, and thus, they are also reported in the cash flow statement as investment cash flow.
- Financing: Financing has a twofold impact on the financial statements. Firstly, new financing and changes in debt are recorded in the cash flow statement under financing cash flow. Secondly, the profit and loss statement reflects interest payments on debts.
Furthermore, it’s important to note that the financial statements themselves are interconnected, and creating a more complex model, especially one involving supporting schemes, as discussed in the following section, may benefit from the guidance of an experienced individual if you lack expertise in this area.
Other supporting elements of a startup’s financial model
In a startup’s financial model, there are additional factors to consider beyond the ones previously mentioned. As you may have observed, some of the elements discussed earlier involve adjustments to the numbers before arriving at the accurate information presented in the financial statements. Supporting components, such as working capital, depreciation, and taxes, may be necessary.
Furthermore, when constructing a financial model for a startup, you inherently organize a wealth of data that can also serve other purposes, such as company valuation. Consequently, below, we outline four elements that provide support to a startup’s financial model:
1. Working Capital
Working capital represents the capital required to maintain daily operations. From a technical standpoint, it is a comparison between the value of your current assets and current liabilities. In simpler terms, the value of assets can be converted to cash in the short term (within a year) versus the value of obligations due in the short term (also within a year). Current assets encompass items like cash, accounts receivable, and inventory, while current liabilities include items like accounts payable.
Working capital holds immense significance for startups as it measures a company’s efficiency and short-term financial health. It can significantly impact cash flow, so if a company’s current assets fail to exceed its current liabilities, it might encounter difficulties in repaying creditors in the short run, potentially leading to bankruptcy.
Payment terms can influence working capital. Thus, when managing your company, it’s crucial to focus on revenue targets and cash flows. Forecasting cash flow provides insight into the timing of incoming and outgoing cash flows, a topic explored in the section titled ‘Operational Cash Flow Overview.’
Why is this essential? If you concentrate solely on costs and revenues without considering the timing of payments, you could encounter substantial issues. For example, imagine a large corporation placing an order for one hundred 3D printers from a startup specializing in a new type of 3D printer. The client expects delivery within a month, but due to extended payment terms, it might take up to 90 days for the startup to receive payment for the order.
Consequently, the 3D printer startup must fund the raw materials and production process independently. After all, they have to deliver within 30 days but won’t receive payment until 90 days later. If the startup lacks the funds needed for production, the order could be canceled, leaving both parties dissatisfied. If this occurs repeatedly, it could lead to the startup’s bankruptcy, even with a steady stream of orders.
Working capital is calculated based on the number of days your sales and payables remain outstanding and the number of days you hold inventory before selling it. It is reflected in the balance sheet. Therefore, a financial model may require a separate component that computes working capital based on revenues, cost of goods sold, and outstanding days. As illustrated below, consider the example of calculating accounts receivable, where year-one revenues total €100,000, and outgoing invoices have a 15-day payment term, resulting in an accounts receivable balance of €4,110 at year-end.
Depreciation represents the decline in the value of a company’s assets. It is determined based on the asset’s initial value and its expected useful lifespan. Depreciation is a component of the profit and loss statement and has an impact on the asset values shown in your balance sheet.
To illustrate, suppose you intend to purchase computers for your company at a cost of €20,000; these computers are expected to remain in use for four years. In this scenario, you would spread the entire €20,000 investment over a span of four years. This means you will allocate €5,000 as depreciation expense each year for the next four years, assuming the computers have no residual value afterward.
In a financial model, it is necessary to include a separate mechanism that computes depreciation based on investments and their respective anticipated useful lifespans.
Every company, upon its incorporation and registration with the Chamber of Commerce, is obligated to pay annual taxes on its financial earnings—specifically, the corporate income tax.
Taxes are subtracted from your financial results in the profit and loss statement. For a comprehensive list of corporate income tax rates by country, you can refer to this resource.
If you intend to incorporate tax carryforwards into your financial model, you’ll likely need a distinct tax framework as a component of your model. The concept of tax carryforwards operates as follows: As an entrepreneur, it’s common to experience negative financial results during the initial years of business operations.
Negative results essentially indicate that your expenses surpass your revenues, resulting in an operating loss. When you incur a loss, there is no taxable income for the tax authorities to assess.
This loss can be utilized in subsequent tax reporting periods to offset taxable income (a concept known as ‘carrying it forward’), thereby reducing the amount of tax you are liable to pay in that specific tax reporting period.
Many startups develop a financial model with the primary aim of securing funding. Part of this fundraising process involves negotiating with potential investors to determine the value of the company they are considering investing in. The good news is that when you have constructed a comprehensive financial model for your company, you possess all the necessary components to conduct a valuation of your company as well, often through the use of the discounted cash flow (DCF) method.
The primary advantage of the discounted cash flow method lies in its ability to value a company based on its anticipated future performance. This is particularly advantageous for startups that may not have a historical performance track record but anticipate substantial future earnings. During the (pre-)seed stage, it’s not uncommon for startups to generate no revenue at all while engaging in discussions with investors regarding ownership stakes and the associated company valuation. In such cases, the discounted cash flow method is highly suitable because it emphasizes future potential more than current performance.
Nevertheless, there are notable drawbacks to using the DCF method for valuing startups. Essentially, the DCF method is a mathematical formula, making the quality of the valuation highly sensitive to the input variables used in the calculations. Additionally, it heavily relies on your ability to precisely forecast your company’s future performance since future earnings serve as the fundamental basis for the valuation.
While an in-depth exploration of discounted cash flow valuation is beyond the scope of this article, the key steps involved in performing a DCF valuation are outlined below. However, we have also prepared an in-depth guide to startup valuation:
- Step 1: Create financial projections for your company (check!).
- Step 2: Determine the projected free cash flows.
- Step 3: Calculate the discount factor.
- Step 4: Compute the net present value of your free cash flows and terminal value using the discount factor.
- Step 5: Summarize the results from step 4.
Depending on your specific goals and the level of intricacy required in your financial model, you have the flexibility to determine whether it’s necessary to incorporate supplementary components like working capital, depreciation, and tax carryforwards.
There are readily available financial model templates online that include these elements. If you prefer to bypass the intricacies of managing these components entirely, our startup-focused financial planning software can handle all the necessary calculations on your behalf.
Scenarios and sanity checks
Now that we’ve covered various components of a startup’s financial model, are we finished? Not quite! For seasoned professionals, there are additional steps to consider.
Firstly, it may be beneficial to dedicate some time to crafting different iterations, known as “scenarios,” for your financial model. Entrepreneurs tend to be optimistic individuals, a valuable trait for maintaining motivation and resilience in the face of challenges.
However, the reality for entrepreneurs often falls short of initial expectations, particularly from a financial standpoint (but don’t lose heart). In addition to your default financial plan, often referred to as your “base case scenario,” it’s prudent to prepare a scenario that’s less optimistic, your “worst case scenario.”
What if your launch is delayed by six months? What if sales don’t pick up as projected? What if your expenses turn out to be double what you initially anticipated? Addressing such questions helps you anticipate how your cash flow, profitability, and funding requirements would be affected in a less optimistic scenario.
Don’t forget to create a “best-case” scenario as well. Why? It enables you to provide potential investors with a glimpse of your company’s upside potential, and, most importantly, it’s enjoyable to see the financial impact of aiming for the stars!
Secondly, it’s wise to conduct a sanity check on your financial model to steer clear of common pitfalls in startup financial modeling. Here are ten common errors to watch out for:
1. Lack of alignment between the financial model and the business strategy.
2. Overly optimistic or excessively pessimistic revenue projections (refer to the “Revenues” section for guidance on sales forecasting).
3. Inadequately explained funding requirements; ensure you provide a breakdown of costs.
4. Unclear definition of underlying assumptions; be prepared to offer clarification or evidence for your figures.
5. Underestimating the number (and costs) of employees required for building a rapidly growing company.
6. Revenue projections not in sync with the market size (revenues cannot exceed the market’s size by definition).
7. Omission of operational expenses that should align with your strategic objectives.
8. Operational expenses that don’t correspond with forecasted revenues should resonate with revenue figures.
9. Lack of a realistic view of gross, EBITDA, and net margins; always be ready to address questions about your current and expected margins when speaking to investors.
10. Neglecting the importance of working capital; don’t underestimate the impact of payment terms on your funding needs.
Fundraising Strategies for Startups
Wondering how to secure funding for your startup? Many startups develop financial models to raise external capital. Whether you’re seeking a bank loan, pitching your firm’s potential to an investor, or applying for grants or subsidies, you’ll typically need to present a comprehensive financial plan to your prospective funding source.
There are two primary avenues for raising capital for your startup, each with its own distinct characteristics:
1. Debt Financing: Debt financing involves obtaining a loan from a bank, a business entity, or an individual. This arrangement entails agreeing upon specific terms for repayment and interest. For startups, securing a loan from a bank can be challenging, as they often require minimum revenue thresholds and collateral.
Advantages of debt financing include:
- Retaining control of your company remains in the hands of you and your existing shareholders.
- Interest paid on debt is typically tax-deductible.
- Debt can impose discipline on a management team, as limited cash flows encourage efficiency and value creation.
2. Equity Financing: Equity financing involves raising funds from angel investors or venture capitalists (VCs) in exchange for ownership shares in your startup. For startups, equity financing is often more accessible than debt financing, as banks tend to be risk-averse.
Key points about equity financing:
- Equity investors take on higher risk by investing capital in exchange for shares, which means they could potentially lose their entire investment.
- When an equity investor invests in your company, they become shareholders, which means you may relinquish some control over the firm.
- Sharing profits with new shareholders becomes a requirement, and they may seek active involvement in managing your company.
In your fundraising journey, understanding the nuances of debt and equity financing can help you choose the most suitable approach for your startup’s unique needs and circumstances.
Integrate Your Cap Table
Equally vital in showcasing a deep comprehension of your startup’s financial and ownership structures is the inclusion of the capitalization table (commonly referred to as the “cap table”) within your financial model presentation. This cap table functions as a momentary snapshot of your startup’s ownership landscape, offering detailed insights into the following components:
1. Founder Equity: Each founder’s ownership stakes, reflecting their respective roles and contributions to the startup.
2. Investor Equity: The shares owned by angel investors, venture capitalists, and other financial backers, including details about their specific investment rounds.
3. Employee Equity: This encompasses stock options and grants allocated to employees as a part of their compensation packages.
4. Convertible Securities: Any convertible notes or SAFE (Simple Agreement for Future Equity) agreements specifying the conversion terms and potential dilution impacts.
5. Dilution Scenarios: Anticipated outcomes of future fundraising rounds, demonstrating your startup’s growth potential and the resultant effects on existing stakeholders.
Maintaining consistency between your financial model and the cap table is imperative as it furnishes investors with a coherent and precise depiction of your startup’s financial and ownership dynamics.
Format Your Financial Model for Clarity and Impact
Now that you clearly understand what components to include, it’s time to roll up your sleeves and start constructing your financial model. While thoroughness is crucial, don’t underestimate the significance of smart design. A well-designed financial model should be as user-friendly as a meticulously organized filing cabinet. Here’s a step-by-step guide on how to achieve this:
1. Organize with Tabs: Begin by allocating each major component of your financial data to its dedicated tab. The essential tabs typically encompass assumptions, income statements, balance sheets, and cash flow statements. Additionally, you may need tabs for scenario planning and your cap table.
2. Declutter Effectively: Avoid creating overwhelming tabs for every conceivable view or analysis. Instead, employ a single tab for each statement or topic and adjust variables to switch between relevant perspectives.
3. Enhance Clarity: Differentiate your content with clear headings and subheadings that partition sections. Use bold text for headings, distinct font colors for assumptions, inputs, and outputs, and italics for comments or notes. If necessary, employ lines and background colors further to distinguish tables, dashboards, and other data chunks.
4. Maintain Consistency: Consistency is key. Ensure that your formatting and styling remain uniform throughout the model. This means all headers should share the same appearance, subheadings should be consistent, and inputs and outputs should exhibit uniform formatting. This consistency simplifies comprehension of hierarchies and equivalencies within your model.
5. Leverage Visual Aids: Supplement your model with visually engaging aids such as charts, graphs, or tables that encapsulate critical aspects of your financial data. These visualizations facilitate rapid comprehension for investors and enhance the overall appeal of your presentation.
While the presentation may appear superficial in comparison to your core idea, its impact cannot be overstated. Let’s consider a real-life example: a SaaS company I once assisted.
The company had an excellent product—a financial management and payments tool aimed at small businesses—and an impressive pitch deck.
However, its financial model resembled a disorganized kitchen where ingredients blended with the cooked food. Investors informed the founders that the model obscured the company’s financial potential.
Recognizing the need to streamline the financial model, I applied consistent formatting to distinguish inputs from outputs and enhanced the tab structure for easier navigation. Instantly, the founders found it much simpler to manage their numbers, and investors gained a clearer understanding of the company’s potential. Consequently, the SaaS startup successfully secured the funding it required.
Create a Sense of Urgency
A robust financial model serves as a powerful tool to underscore the unique growth prospects and prevailing market trends that demand swift action from investors. You can convey a sense of urgency by emphasizing several crucial factors:
1. Time-Sensitive Opportunities: Take, for instance, an innovative company specializing in groundbreaking AI healthcare solutions. Utilizing its financial model, it can illuminate the potential for substantial revenue gains stemming from a new government telehealth initiative with a limited application window.
2. Consequences of Inaction: Consider a tech firm that has developed a cutting-edge IoT device for smart homes, facing competition on the horizon. Investors perusing the financial model would discern that delays in securing funding could swiftly erode the company’s anticipated market share.
3. Speed to Market: An agile food tech venture with a lean business model and established partnerships can leverage its financial model to showcase how swiftly it could generate revenue post-funding.
4. Early-Mover Advantage: In the case of a fintech startup pioneering its niche, the financial model becomes a tool to illustrate the potential for augmented market share and brand recognition, all attainable with investor support.
5. Scalability and Growth Potential: Picture a SaaS firm armed with an impressive growth strategy. Its financial model can accentuate the scalable business model, offering insights into how monthly recurring revenue could skyrocket with increased investment.
Highlighting these time-sensitive opportunities not only persuades investors of the imperative need for prompt action but also underscores the potential for bolstered market positioning and enhanced returns. This approach proves especially valuable today, as capital availability is not as abundant as it once was, and investors exercise increasing caution.
Be Prepared to Answer Questions and Defend Your Assumptions
Investors, especially those considering early-stage companies, prioritize two key factors: the reasonableness of the financial numbers presented and the founder’s deep understanding of their business operations. To effectively address investor inquiries and instill confidence, you must comprehensively grasp every facet of your financial model.
This entails explaining and defending your assumptions, calculations, and financial projections in meticulous detail. Here’s how to prepare for this essential task:
1. Comprehend Your Assumptions: While it may seem evident, you need to be capable of elucidating to investors the origins of your assumptions. For instance, you should be able to trace how industry research findings have informed your assumptions, allowing you to anticipate trends or cycles that your business can expect to replicate.
2. Articulate Your Methodology: Be prepared to expound on how you arrived at your numerical figures. Demonstrating transparency and a willingness to share your process goes a long way in reassuring investors and establishing credibility.
3. Conduct Thorough Research: Recognize that your investors likely possess a wealth of industry knowledge. Consequently, it’s crucial to substantiate your assumptions with reliable sources pertinent to your field, thereby showcasing that your projections are grounded in information investors trust.
4. Anticipate Common Questions: Foresee probable inquiries about your financial model and rehearse your responses. For instance, if your startup is in the SaaS realm, readiness to address questions concerning churn rate management, customer support scalability plans, and other pertinent matters is vital.
Time and time again, I’ve witnessed the transformative impact of a simple model refinement on startups striving to captivate investors. A well-structured financial model ensures that investors swiftly glean key insights and recognize your startup’s potential. Conversely, an inadequately organized model can breed confusion, undermining the narrative you aim to convey.
Furthermore, a well-organized model tailored to your specific business facilitates your own comprehension and usage as the founder. Your financial model serves as the bedrock upon which you’ll construct your company. It becomes the tool for making nearly every decision affecting your company’s future: monitoring progress, testing ideas, allocating resources, seeking funding, evaluating risks, and projecting growth. Ponder the potential harm in making a decision based on vague, inaccurate, or incomplete data simply because your model was convoluted.
Not every founder is a finance expert, and you don’t need to be one. With expert design and regular maintenance, your startup’s financial model can simplify the management of your company and increase the likelihood of securing the investment required for growth and enduring success.
Engaging in financial modeling is crucial for startups, driven by various compelling reasons. Financial modeling is a foundational tool for establishing an economically viable business, enhancing preparedness for the future, communicating your company’s performance to potential stakeholders and investors, and setting achievable targets for your organization.
Two primary approaches to financial modeling are commonly employed: the top-down method, which leverages market data to construct forecasts for your company, and the bottom-up approach, which utilizes internal company-specific data such as sales figures and internal capacity data.
A recommended strategy often involves combining both approaches, enabling you to substantiate short-term goals with granular precision while demonstrating your long-term market aspirations, aligning with the expectations of potential investors. Regardless of the approach taken, the success of a forecast hinges on the accuracy of its underlying assumptions.
Typically, a startup’s financial model generates outputs that include a three-to-five (or sometimes 10) year financial statement forecast on an annual basis, encompassing the profit and loss statement, balance sheet, and cash flow statement. Additionally, it provides an operational cash flow projection for the upcoming 12 months and offers an overview of company-specific or sector-specific key performance indicators (KPIs).
These outputs result from calculations occurring within the financial model, driven by data entered into various input pages, including forecasts for revenue, cost of goods sold, operating expenses, personnel, capital expenditures, and financing.
Certain outputs necessitate supplementary calculations and schemes, encompassing factors like working capital, depreciation, and taxes. With the typical data contained within a financial model, it’s also possible to conduct a valuation of your startup using the discounted cash flow method.
Creating multiple scenarios within your financial model, including worst-case, base-case, and best-case scenarios, and conducting thorough sanity checks are valuable steps to approach a more realistic representation. This approach prevents the presentation of overly optimistic or unattractive projections.
Possessing a well-constructed financial model is instrumental in the fundraising process, as external investors often demand a forecast before committing their capital. This requirement aligns with the logical expectation that investors want to understand the financial outlook of the company they’re considering for investment.
Various sources of funding are available to startups, with debt and equity financing being the primary options. However, the landscape has evolved to include alternative sources such as convertible notes, crowdfunding, initial coin offerings (ICOs), and government subsidies and grants.
Congratulations on making it to the end of this article! Armed with the information we’ve shared, you’re well-prepared to embark on financial forecasting, perhaps even constructing your own financial model and deciphering the metrics and data it presents.