The Definitive Guide To Financial Modelling For Startups
Financial modelling for startups serves several functions:
- Budgeting your ongoing revenue and expenses.
- Validating your business model.
- Understanding cash flow and runway, so you know when to raise money and how much to raise, borrow or generate in revenue.
- Helps you pitch investors and other stakeholders.
A financial model tells the story about your business in numbers. When you add the correct assumptions (for your business type), you are creating a powerful tool that predicts the likely future of the business and allows you to pitch a compelling growth story to investors.
When building a business, you are looking to create a sustainable future. The advice you receive early on can indicate that a financial model isn’t necessary, that it’s too technical (creating in Excel), has too many assumptions or that no one will read it. The opposite is true; investing in a financial model can predict your future finances, help you raise funding and avoid shutting down.
In this guide, we will cover these questions and tell you why a financial model is crucial. Having supported hundreds of startups with their financial modelling since launching in September 2020 with the Canaree model builder, we are interested in supporting businesses as they grow by providing this definitive guide to financial modelling.
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The crucial reasons for having a financial model:
- Validating your business: You need to build an economically viable business by quantifying and validating your business plan through a financial model to learn if and when your business will be profitable. When creating a financial model you can experiment with different scenarios to better predict your assumptions, anticipate your cash flow, profitability and timings of when to launch new features or your business if you’re just starting out.
- When fundraising, you need one to satisfy investors who will typically ask you for a financial plan when you engage with them to invest no matter which stages your company is in. Many investors will require more details and ask tricky questions when diving into your business model. Having a well thought out financial model will allow you to properly address these questions and help you accurately calculate how much funding you actually need.
- To keep you on track and to inform stakeholders you need one. How will you know if your company is performing well if you are unaware if you’re meeting any targets or creating benchmarks to compare them against? You need to update your stakeholders on how you are spending money, inform them of your runway and how much revenue you are generating. This is where forecasting helps.
How we you use a financial model?
Financial models are often used for decision-making and performing financial analysis for internal and external reasons such as:
- - Historical financial analysis
- - Projecting and budgeting the financial performance of a business
- - Growing a business organically (opening new markets)
- - Capital allocation
- - Raising capital
- - Budgeting and forecasting future finances
Financial forecasting vs financial modelling
Financial forecasting is determining the expectations of future results. Financial modelling takes the forecast and builds a predictive model that helps the company make sound business decisions. By taking both approaches, you can effectively budget, conduct investment research, finance a project and raise capital for your business.
What is financial forecasting?
Financial forecasting is vital to business planning because it uses past performance and current conditions to predict future company performance. Forecasts can help a company identify the assets or debt needed to achieve its goals and priorities.
An example of forecasting is a company’s sales. Most financial statements link to sales, and forecasting sales helps a company make other financial decisions that support achieving goals. If sales are to increase, the resulting expenses to produce the additional sales will also increase. Each forecast impacts the company’s overall financial performance. Calculating the financial implications of the forecast is where financial modelling comes into the picture.
What is financial modelling?
Financial modelling is the visual representation of a company’s financial future. Mathematical in nature linking many variables together to help a business make better decisions. The modelling process involves creating a summary of a company’s financial data compiled in a spreadsheet or with smart technology that automates the process like Canaree to build a predictive model.
Variables (e.g. profit and loss, revenue, units sold) are modified to see how changes can affect the business. Taking the example of an increase in sales, a company must forecast the impact of inventory costs, raw materials, expanded teams or other costs involved. The result could mean an increase in working capital or credit line with a bank, for example. While forecasts are incredibly useful, number-crunching will always need to process via a financial model.
Calculate the financial impact that a forecasted increase in sales has on the company’s income statement, balance sheet and cash flow.
How to structure a financial model
Building a model is often accused of being technical and challenging to create, but all you need is really to know your business and generate numbers from that. Financial projections are essential for all types of business, even if it’s not generating revenue. There are many articles about financial modelling and a variety of methods for performing this task, but generally, investors look at top-down and bottom-up approaches or a combination of the two. The key is to make it detailed enough that it tells a story about your business over time.
Top-down financial projection
A top-down analysis starts with a business assessing the market as a whole. For example, you know you need to raise X million in a Series A round 18 months from now and your data gathering on what types of revenue, margins and growth are required to hit the successful fundraising level.
How do you achieve this? First, you determine the current market size available for your business and factor in relevant sales trends. Then you estimate the percentage of the market that will buy your products or services. In the context of these trends, you want to examine your company’s strengths and weaknesses and, ideally, how to amplify your strengths and remedy those weaknesses.
Taking this approach helps you define a forecast based on the market share you would like to capture within a given timeframe based on activities and costs to get there.
Bottom-up financial projection
The bottom-up analysis, on the other hand, is based on the product or service itself. Where the projection is made based on what is required to get your offering to market (i.e. how many employees you need, how many customers you have). Also known as an operating expense plan, bottom-up forecasts examine factors such as production capacity, expenses, and the addressable market used to create an accurate sales projection.
In simple terms, top-down models start with the entire market and work down, while bottom-up forecasts begin with the individual business and expand it out. Typically start with 5-15 core assumptions about the business and most useful for a company contemplating a specific product direction, distribution strategy (i.e. considering paid advertising) or adding a partnership that could potentially impact the business.
With the bottom-up approach, you estimate revenue, costs, expenses and resources available via the company data. The pitfall of the bottom-up method is that it may fail to convince investors in your optimistic outlook of the future of the company as seen in the top-down model that can capture market share, something investors are keen to see.
It’s challenging to create a forecast reflecting a steep growth curve if every sale reflected resulted in the maximum budget for advertising, for example. With a bottom-up analysis, you can find it difficult to factor in word-or-mouth or organic growth. Therefore, it is advisable to combine the two approaches when raising investment. The whole reason why external funding is needed is to expand capacity and grow faster.
What are the key components of a financial model?
The goal of a financial model is to gain better insights into the financial side of a business for internal use or attracting external stakeholders. It should reflect your overall business strategy, business model and vision. It’s a fair assumption that your business model and financial model are two sides of the same coin. The types of data that can populate a model are numerous, depending on the type and stage of your business.
For brevity, we will focus on the top five inputs to consider.
1. Budget revenue and expenses
Revenue: use the bottom-up method for short term sales forecast (1-2 years ahead) and top-down for longer-term (3-5 years ahead) Combining the two approaches will make it possible to substantiate your short-term targets in detail while simultaneously demonstrating long- term targets generate the desired market share and the numbers ambitious investors seek out.
- - Product or services sales
- - Subscription revenues
- - Advertising revenues
- - Number of new customers, existing customers and churn
- - Marketing
- - Salaries and HR
- - Production and R&D
- - Legal & Accounting
- - Other operational expenses
When budgeting, the key factor is finding the right balance of detail. Your model should be detailed enough to be meaningful, but also logical based on unit economics. (more detail on this below)
2. Cost of goods sold (COGS))
The cost of goods sold is the total cost incurred by a business to produce goods or services sold. Other ways of expressing this include the "cost of sales" or "cost of services".
A business incurs two types of costs, direct and indirect.
Direct costs are linked back to a specific product, service or activity, such as cost of materials, labour, and commissions, etc. Indirect costs are tied to the production process and are often difficult to trace back to production. These can include "overhead costs" (i.e. rent, utilities, cleaning services, office supplies and so on). Indirect costs are tied to the production process and are often difficult to trace back to production. These can include "overhead costs" (i.e. rent, utilities, cleaning services, office supplies and so on).
When calculating COGS, you only need to take direct costs of production into account. If your company sources raw materials from an external provider, your COGS will also include the cost of conversion - the production cost necessary to convert the raw materials into finished goods - and other costs involved in bringing the stock to their current location. Not sure how to forecast COGS? Just look at the sales targets defined in your revenue forecast. You already know how many units of sales you aim to have. You then add per unit of sales the costs of raw materials and labour costs involved in producing those goods.
3. Operating expenses
Operating expenses are expenses incurred while performing business activities. Unlike the cost of goods sold, they do not include the cost of producing goods or services. They include costs related to supporting the operational side of the business, such as sales and marketing, research and development, and administrative costs.
For startups, they could include travel, legal costs, online marketing, payroll, rent, insurance, IT costs, office supplies and so on. If you want to project the future of operating costs, you could apply a certain percentage of your revenues against different expense categories. For example, many startups include 10-12% of yearly revenues budgeted against sales and marketing activities.
4. Strategic hiring plan
Recruiting for your startup is an ongoing process and requires careful planning to stay on track financially. You want your financial model to reflect the number of employees hired (contract and full-time), including their positions, salaries, benefits, payroll taxes and more. By adding this to the mix, the result will be creating a hiring plan based on your financial data like sales and revenue projected.
Team members could include:
- - Managment team
- - Sales and marketing
- - Product development
- - Customer support
- - General and administrative
To check if your recruitment forecast is realistic, divide your projected revenues in any given timeframe by the number of employees (full-time) for the year in question. This indicates how much revenue you can expect to generate per employee and can help you create a strategic hiring plan linked to your growth as a business.
5. Unit economics
At the core of any financial model is its unit economics, described as the relationship of direct costs and revenues of each unit of sales of a business.
We cover Unit Economics in greater detail here. Essentially if each sales unit generates more revenue than it generates direct costs, there will be a gross profit available to pay for the operations of your business.
They determine everything in a business! From how much revenue you can generate, what your expenses are and what resources are needed. If your customers aren’t profitable, it doesn’t matter. If you have a million of them, you will most likely fail.
Your core unit economics should contain the main customer metrics, Customer Acquisition Cost (CAC), Lifetime Value (LTV) Payback period to CAC, LTV to CAC ratio and so on.
6. Capital and financing
In this section, you want to calculate all your financing, including equity, convertible loans, grants and misc capital. Unless your business is already profitable of course.
The main reason for this is to check the impact on your funding needs when you add types of funding in each year of your model.The main goal of including these numbers to check the impact on your funding needs when you add different types of funding in the specified years of the model. By adding your financing streams, you will be able to see a financial statement often referred to as a profit and loss statement (P&L). It summarises the revenues, costs and expenses incurred during a specific time period, usually a fiscal quarter or year. It also indicates a company’s ability or inability to generate profit by increasing revenue, reducing costs of both. When this data is curated, it will include the following elements:
- Revenues impact the top line of a profit and loss (P&L) statement. In the P&L, you deduct all costs, expenses and depreciation from the revenue generated to arrive at the earnings before interest and taxes (EBIT) allows you to arrive at the net profit and informs you of your operational cash flow.
- COGS also show up in the P&L by deducting them from revenues it results in gross margin. Expressed in percentages, the higher the gross margin, the more capital a company retains on each pound/dollar of sales and can be used to pay other costs.
- The Operating expenses in a profit and loss statement help inform you about earnings before interest, taxes, depreciation and amortisation (EBITA). This is calculated by deducting operating expenses and the cost of goods sold from revenues.
- Net profit, included in a P&L statement and is synonymous with net income, is a company’s total earnings after subtracting the expenses. In this instance, the expenses subtracted will include the costs of normal business operations as well as depreciation and taxes. Often referred to as a company’s “bottom line.”
Sanity check your numbers and create scenarios
We’ve explored all the different elements of a startup and small business financial model. Are we done? Not quite yet.
As your business grows, it makes sense to spend additional time creating different versions (called scenarios) of your financial model. Entrepreneurs tend to be very ambitious and optimistic, one of the reasons they persevere where others quit before they start. With that optimism they need to be realistic about what they can achieve based on their numbers.
Unfortunately, one in six startups fails with cash flow cited as one of the driving factors. Therefore, it would be a good idea to prepare a less optimistic scenario than your original financial model. For example, what if you launch six months to a year later than expected? What if sales don’t ramp up as expected? What if your costs turn out to double compared with your projections? Answering these questions is key to anticipating the impact of cash flow, profitability and funding need in a less optimistic scenario.
Investors don’t expect your financial model to be super accurate, there’s a margin of error, but it does need to be logical. Performing a sanity check on your financial model helps you to avoid common pitfalls of startups that fail.
- Your financial model should reflect your overall business plan and strategy.
- Revenue projections should be realistic and reflect forecasted sales and market size.
- Healthy breakdown of costs that will adequately explain funding needs.
- Providing proof on numbers provided in your financial model.
- Include a hiring plan that reflects a growing business and demonstrates where resources are needed.
- Be prepared to include realistic gross, EBITDA and net margins, investors will ask about expected margins.
Investment rounds and financial modelling
The nature of most fundable startups is that they operate in the market potential of becoming a unicorn. If this is not the case, investors would not be interested as they couldn’t earn enough return on their investment to justify it.
And to reach their potential, startups need to take off like a rocket. Otherwise, why would they require investment? Every time you reach the next revenue milestone, your company graduates from Angel to Seed to Series A, from Series C to D, etc.
As your business grows, so does your revenues and funding amounts projected in your financial model. They need to be connected by expenses, budgets and appropriate valuations. If you just raised angel funding, you better double down on revenue in a year to prove growth potential. Otherwise, no investor will believe your company can generate 10x their return on investment.
Financial modelling is part art and science of budgeting and predicting your business future. It determines how much money you need to raise and how to reach profitability. It can guide you through the stages of growth and help pitch investors more effectively. If you enjoyed this article, you may want to read: Why a financial projection slide is vital to your startup pitch deck.
Even though you don’t have a crystal ball to predict the future, a financial model will help you define yours.