Top 5 Startup Financial Model Must-Haves
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
A startup financial model addresses a specific need when fundraising for a startup.
The financial model illustrates the company's projected growth and its resources to achieve its goals and materialize its growth.
The financial model is used as a means to showcase all the essential business elements to potential investors.
Here's the deal:
Since investors don't know the ins and outs of your business as you do, you should help them understand it as well.
The question is, how?
Building a clear financial model that is easy to follow will help you accomplish that. In the model, you need to speak the language investors understand and expect to see. It needs to include relevant information that showcases your business potential clearly and quickly.
In this post, I'll introduce three types of financial models investors typically see. I'll point out which one you should strive for and the must-have elements to include in your financial model to get you there.
We encounter three financial models when reviewing clients' previous models or when performing due diligence for an investor.
Type 1: Poor
These are usually canned, generally-purpose, one-size-fits-all financial models built for one industry and forced onto another sector.
These templates try to fit as many niches as possible and use general terms, common business approaches, and put their entire weight on elements that might not be relevant for the business who uses them.
These models require many adjustments to make them useable and ready to analyze and drive conclusions.
Type 2: Okay
These are financial models built for a comparable company that uses a similar business model and adjusted to this particular company.
These models might use the right jargon but might emphasize different elements than the company highlights and uses other terms as the pitch deck and business plan.
Calculations and the general flow of these models might be okay and close to what investors are looking for but still require adjustments. However, fewer adjustments are needed to make them useable than type 1 above.
Type 3: Top Notch
These are custom-made models built to describe this company's specific business model and do that accurately. In this group, financial models capture the costs and revenue growth correctly, provide additional insights through detailed and adjustable assumptions, and showcase relevant KPI metrics that add value.
Naturally, you want your tech startup financial model to fall into the Type 3 category. Including the five must-haves will get you started in the journey to up-level your financial model from okay to excellent.
1. The model should reflect YOUR business
When using a general financial model template or a financial model of another company that already successfully raised funds, you inherit a business model that is not your own. It uses growth drivers you're not entirely comfortable with and assumptions metrics that do not necessarily fit your startup.
There's a reason why I put this as the #1 item on this list.
If your financial model does not reflect YOUR business, it's useless.
Investors are not interested in your friend's business or the general business that your template reflects. They want to know more about YOUR business and how you expect to grow it.
Embrace the fact that your business is unique. It has a unique business model, individual growth drivers, exceptional burn rate, unique assumptions, a unique way to generate revenues, and unique ways to spend money. Make sure your model reflects that. Anything else is just missing the point.
2. Use Simple and Comprehensive Assumptions
There are two mistakes that we often witness in the assumptions sections of tech startups' financial models.
Assumptions are often too general, so it's tough for the reader to understand the drivers behind the growth, or those assumptions are also detailed and complicated to follow.
Like everything in life, the optimal point is somewhere in the middle.
Financial modeling assumptions should be detailed and easily changed so investors can understand the drivers and even stress test your assumptions quickly.
If it takes investors much time to understand the model, they will request you to adjust and simplify it.
This back and forth could consume more time and money and drive frustration, which we want to avoid.
3. Powerful Duo: Income Statement and Cash Flow
Financial statements are the backbone of your financial model.
While most venture capital investors will not challenge you on why you accounted for a specific item in your cogs instead of the operating expenses, we use generally accepted accounting tools to build financial forecasts and measure projections.
Your financial model's most basic requirement is to provide an income statement projection for a particular horizon.
The income statement should detail the expected revenues per product line or stream, cost of revenues or cogs, breakdown of the operating expenses, and the gross and operating profits after computing everything together.
To provide an additional layer of information, you need to add a projection of your startup's cash flow statement.
In many cases, especially in seed stages, the startup will not have any idea of how its working capital will look like or how capital expenditures it will need to support the future fixed assets, if any. However, founders will have an idea of when and how much they will raise.
In these cases, the cash flow statement will be very similar to the income statement plus financing activities, which is fine.
Showing the overall picture of the income statement and cash flow projections provide a holistic view for a potential investor and adds value to the decision.
However, many clients ask us about adding a balance sheet projection to their financial models.
Our policy for early-stage startups is that if certain assets or liabilities don't play a significant role in the business, the added value in building and adding balance sheet projection to the financial model is extremely low.
Most early-stage cloud and SaaS startups don't need to waste their time building balance sheet projections.
It's a bit more complicated in late-stage startups. It depends on the business model, its current balance sheet, and whether a balance sheet projection will add value to investors. Otherwise, it could deflect the conversion to another direction.
4. Handpick Your KPI
The KPI metrics complete the projection picture for the reader of the model.
In early-stage startups, KPI projection can focus the discussion with investors and bring an essential topic to the table.
In a late-stage startup, the KPI metrics can highlight strengths or difficulties in the business.
Therefore, it's crucial to use the right KPIs for your business.
Every industry, sector, or niche has a different set of KPIs used to analyze businesses' growth, strength, difficulties, etc.
When using a general model with general KPI metrics, you miss a valuable opportunity to show your business potential. So, make sure to research and use the right KPIs for your business.
5. Keep It Simple
Let's take this off the table. Investors are not interested in your Excel skills.
Financial modeling is a tool to show your financial projections, the drivers behind them, and the main assumptions.
It should make it easier for the reader to understand your business.
I know there are many spreadsheets online that offer you "59 different ratio calculations", "more than 30 charts", "US GAAP, IFRS, and Non-GAAP Statements."
But, these are only more ways to complicate this.
The startup financial model's primary goal is to translate your business model, estimations, and projections into a spreadsheet that will allow the reader to know your business better and assess whether they want to hear more about it or invest in the company.
To communicate your business idea and potential, you need your message to be delivered clearly and easy to follow.
Excel is the tool that most of us use to deliver that message.
Long, complicated Excel formulas, sophisticated financial engineering, and dozens of tabs will probably not help your message be heard correctly.
Put yourself in the reader's shoes and make sure that your message is clear and easy to follow.
Conclusion
These were my 5 must-haves that every startup financial model should include.
But now I'd like to hear from you.
What element is most important to you?
What topic do you feel we should cover in our next post?
Let me know by leaving a comment below.
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