15 Essential Terms To Know About Startup Financial Modeling
By @Lior_Ronen | Founder, Finro Financial Consulting
Every startup reaches the point that it needs to share its financial model with a potential investor.
The startup founders need to show an Excel spreadsheet or Google Sheet, where they translate their business idea into a business model and into financial projections.
Sounds simple, right?
Well, in its raw form, it is simple - make sure you include these 5 must-haves, and you're all set.
But showing the information doesn't cut it in most cases. You also need help investors knowing the ins and outs of the business.
The best way to do it?
Speak in the industry language, use the right terms, and provide insights that help investors understand your business.
Make your startup financial model accessible, straightforward, and easy to follow, which could drive positive reactions.
So without any further ado, here are the top 15 financial forecasting terms you need to know and include in your startup financial forecast.
1. Revenue model: this is the general framework you use to generate revenues. For example, a SaaS business (software-as-a-service) will generate revenues in a subscription model, while an e-commerce business will generate revenues from selling products online.
A good financial model will outline the revenue model and break down the different product lines and revenue streams that build up the overall revenues.
So, it's not enough to show how you generate revenues from selling monthly subscriptions. It would be best to show how many of these subscriptions are premium vs. free, located in the US, EU, or Africa, how many new users join compared to users who leave every month.
Remember that every business's revenue includes two components: quantity (products sold, users, etc.) and pricing (product price, monthly license price, etc.). So make sure to include both of these items. See #2 and #3 below for more.
2. Monthly Recurring Revenues (MRR): MRR is a term used with SaaS or subscription-based businesses. MRR reflects the amount of predictable monthly revenue that a company expects to generate.
MRR takes into account the number of subscriptions it has and the price each subscriber pay (hence, the recurring part).
MRR calculation is relatively simple. You multiply the Average Revenue Per User (ARPU) per month and multiply it by the number of average users per month. That'sThat's it.
3. Conversion Rates: most startups that operate in a subscription-based business model have a free plan and a few premium tiers.
To capture the user base correctly, you need to capture all the relevant conversion rates that include: the number of clicks on your ad, the number of visits to your website, the number of users that convert from free to paid plans, and the number of users that convert from a low tier premium plan to a higher tier.
4. Pricing: this is how you price every plan or product in your business, sell-up opportunities, discounts, and how these prices will fluctuate every year.
In some industries, discounts are standard, but in other industries, free subscriptions are standard. Make sure to research that before.
A good pricing model will include a walk from the initial price to the price the end-user pays for every product, flavor, plan for every year.
5. User Base: In many tech startups, this is the most crucial financial model element. Building a detailed pricing model is nice, but without paying customers, there is no business.
Typically, the business's growth rate is determined by the pace the business grows, the total number of users, or the number of customers.
A good user base section includes a breakdown of the new customers, total customers, and churn rate per product.
6. Cost of Revenues: These are the expenses that directly help you to bring your product to the client and allow your client to use it (also known as COGS in some cases).
Ok, but what's included in that definition?
Cost of revenues varies between cases, so let's use SaaS as a benchmark to items you should expect to see in a startup's cost of revenues.
We usually include these expenses in SaaS companies' cost of revenues when building financial projections or analyzing financial statements:
+ Customer support expenses
+ Hosting expenses
+ Processing fees
+ Any other expense directly related to post-sales support
7. Gross Margin: this is a profitability measure that calculates how many cents a company keeps of every dollar of sales after paying the cost of revenues. Businesses with high costs to produce and distribute their products, like hardware companies, will have low gross margins than software businesses with low costs of bringing their product to clients.
As a general rule of thumb, we expect a gross margin of 80% to 90% for software companies and 40% to 60% gross margins for hardware companies.
8. Operating Expenses (OpEx): OpEx is the operational costs that keep the business going.
What's in there?
The short answer is all expenses except for the cost of revenues.
The long answer is every operational expense needed to run the business like sales, marketing, product development, research, general, and administration.
EXCEPT,
Cost of revenues expenses and substantial, long-term purchases will contribute to the company over the long haul, captured after the capital expenditures (CapEx) in the cash flow statement.
9. Headcount: this is one of the most critical aspects of the startup financial model and a crucial business execution element. The startup's headcount not only determines the company's payroll and impacts the cash flow; it also determines whether a startup could meet its milestones or not.
Poor headcount planning leads to a lower level of resources needed to accomplish a task that could lead to delays in execution or rushed hiring that could bring the wrong type of employees to your company.
More about headcount planning and payroll forecast is available here.
10. Depreciation: Early-stage startups and founders who are just getting started should not waste their time building balance sheet projections.
Unless:
A specific asset or liability has a significant impact on bringing the product to the market, such as hardware companies, for example, or particular cases of Fintech businesses.
12. KPI Metrics: this is a group of financial and operational ratios that measure and summarize the business and financial performance. Many of the terms mentioned in this post could be included in the company's KPI metrics, such as MRR, conversion rate, gross margin, burn rate, CAC, and LTV.
You should also add the KPI to the financial summary section on your pitch deck and business plan to provide a snapshot of key metrics.
13. Burn Rate: Burn rate shows the speed at which the startup spends its cash. It is crucial when fundraising and can show whether the startup is efficient or lavish and whether it spends its money wisely.
This is a cash flow measurement, which means you need to include all the outgoing cash in the burn rate, not only the spending captured under the income statement but also items captured under the cash flow statement.
14. Customer Acquisition Costs (CAC): This is a critical metric that is important not only for the venture capitalists when fundraising but also for the CFOs or startup leaders. It measures how much it costs for a startup to acquire a single client.
To calculate the CAC, you divide the annual or monthly sales and marketing spending (including both payroll and non-payroll expenses) by the number of new clients you added in that specific period.
15. Lifetime Value (LTV): The LTV is the valuation of the client relationship to the business.
There are many different methods to calculate LTV with a different use case for every method. This HubSpot blog gives an excellent overview and calculator for the topic.
For Conclusion
This post covered the top 15 most common startup financial modeling terms you need to know.
You might hear other terms from venture capital funds as budgeting terms that I haven't covered here; however, this is a great starting point for understanding startup financial modeling.
But what do you think?
Is there a fundamental term that I didn't cover here?
Or maybe one that I used, but it is not that important.
Either way, leave a comment below to let me know.
