Necessary Steps For Building A Robust Startup Financial Model
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
A startup financial model should be clear, simple, and easy to follow. Many founders overcomplicate it.
A good financial model reflects the founders' beliefs and expectations as well as the business' potential.
In this post, we'll cover the necessary steps founders should follow when building a financial model for their startup.
As a tech financial consultant, I talk to many startup founders and tech investors every week. I'm amazed to see the differences in the way of thinking and understanding of private market investing between the two groups.
Although there are many differences between the way founders and investors think about building a business and raising funds, there is one item that is much more significant than the rest in my opinion. Many founders that I talk to want to show investors what they think investors want to see that will convince them to invest. However, when talking with investors or going through documents they receive, the most crucial element is understanding the business in front of them and its potential.
In this post, I'll focus on how this difference in perceptions is reflected in the financial models that startups send investors and will show six essential steps that could help to build clear, genuine and useful financial models that will deliver any startup's potential in the best way possible.
Investors that I work with are looking for simplicity. They want to see financial models and forecasts that genuinely explain the founders' beliefs, plans, and expectations for the future. They are looking for presentations that concisely explain the product, service, and business model. However, in many cases, what investors get is far away from this vision.
What is a startup financial model?
First, let’s start from the top and the very basics of financial modeling. A startup financial model is a visual representation of the startup’s projected financials. A startup financial model is the instrument startups should use to reflect the company’s financial performance in the future from executing its roadmap, business plan according to the goals and expectations they set. Here are the six crucial steps to follow when building a startup financial model to build a clear, simple, and useful financial model.
Additional read: Startup Financial Modeling: Revenues Projection Made Easy
More additional read: 5 Essential Elements To Include In Every Startup Financial Model
Step 1: Revenue Model
Understand how the business will generate revenue in a simple way that can be explained in a few sentences. Try to describe the business model to your parents, friends, and tech or startup savvy people. This way, you will see if it’s clear and straightforward. If you cannot explain it, you will not be able to model it.
Step 2: Revenue Unit Metrics
Revenues, no matter in which sector, market, or niche include two parts: units sold and price per unit:
Units sold: define what the units that the company offers are. A unit could be a physical product, a software license, a service, billable hour, or every service or product you can think of.
Price per unit: defining a specific price per unit depends on how you define the units. Price per unit could be the price of a physical good, a license fee per year or month, hourly rate, etc.
Successfully defining the unit matrix, will enable smooth modeling later.
Additional read: Breaking Down The Startup Revenue Forecast
Step 3: Growth Drivers
The pricing model and units sold matrix are not static. Instead, they drive the company’s growth. To understand how they help to grow the company, you need to define at a high level what will drive the growth of the number of units sold and the unit prices.
Growth drivers can be connected directly to the company’s roadmap or organic growth as a result of marketing efforts. Typical growth drivers include a growth in the client base (driven by various reasons), the introduction of new features/versions, the launch of new products, new price points, extraordinary prices, and offers, acquisition, and many more.
Successfully defining the growth drivers, enables to build a sustainable and reliable forecast.
Step 4: Headcount Costs
Defining the top-line model with a solid unit and pricing matrix and clear growth drivers is the first phase of every financial model and a significant one. However, it would be best if you also defined the costs required to fulfill the vision.
The main cost in every tech startup is payroll, which makes the headcount (staff) forecast a fundamentally important phase in the financial model development. The headcount forecast should include four typical areas or functions: (1) research and development, (2) Customer success (post-sales support), (3) sales and marketing (4) general and administration.
Successfully defining the headcount enables to forecast CF later on accurately.
Step 5: Payroll and OpEx Costs
Headcount is the primary resource in a tech company and should be associated with the most comprehensive payroll estimation to present the real staff costs.
However, there are many additional costs for every company beyond payroll with two approaches:
Tops down: Payroll + XX % of OH
Bottom-up: breaking down all expenses in R&D (licenses, lab equipment…), G&A (rent, legal fees, accounting…), S&M (paid content, PR, PPC…)
Headcount is a fundamental piece of the puzzle, but with all the costs, you can have a complete view of the projected income statement.
Additional read: Making Sense of The Startup Payroll Forecast
Step 6: Cash Flow
Many startup founders focus on modeling the number of users, revenues, headcount, and even margins but neglect the cash flow.
Cash flow is the most critical aspect of the business; it will determine if the company will succeed or fail. Many transactions impact the cash flow and not reflect on the income statement, such as dividend payments, stock or debt issuance, debt repayment, and CapEx spending.
The cash flow forecast usually unveils funding problems that cannot be found otherwise.
Summary
There are many details and complexities in developing a well structured and useful financial model. A simple model allows the readers of the model to follow it easily, understand the business, the potential of the company, how the forecast was built, what impacts it, and whether it fits the investors' investment strategy and portfolio.
Need help building your financial projections? Contact Finro today to hear more about our tailor-made financial modeling solutions for your startup.