Startup Financial Modeling: Revenues Projection Made Easy
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
There are many reasons for startup founders to build a revenue projection for their business.
Every goal requires a different set of data and strives for a different outcome.
There are two main financial modeling approaches applicable to revenue projection.
In this post, we’re explaining the two approaches, how, and when to use them when building your startup financial projection.
Very early on the life of a startup, founders typically face the need to present a revenue projection either for an investor, a bank or for internal financial or business planning. There are many differences between these three target audiences.
An investor (and this is a broad generalization) would be interested in how you would make your business grow, what drives that growth, and how the business actions of the founders will benefit the investor's exit potential. A bank is usually interested in a business's ability to return a loan, which significantly depends on cash flow management. For internal purposes, meeting the operational plan, roadmap, and milestones is the top priority, and the financial plan is needed to help make them a reality.
The three different audiences and their many different interests and unique data points require different granularity levels in planning and calculating revenues. There are two approaches to build a revenue forecast that, when mixed, could address all topics and requirements.
Top 13 KPIs Every Software Startup Should Track
There are so many KPIs startups could use.
Where should you start?
Here's our list of the basic 13 KPIs, every startup should track.
1. Top-Down Forecast
The top-down approach, also known as the TAM / SAM / SOM model enables founders to forecast future revenues by looking at the business from the macro level and slowly drilling down to the single company level.
To use this model, you need to model three market sizes. You start from the top, the TAM, aka, the total addressable market, which is the overall market for a product or service. The next level is the size of the relevant niche that you're aiming for. This level is the SAM or serviceable available market. The next level is the market size that your business will obtain out of the niche. This level is the SOM, aka the serviceable obtainable market. In percentage terms, the SOM is your business market share, and in the dollar terms, the SOM is your business revenues.
The annual revenues can increase year over year in this model, either by increasing the estimated market share that the business will obtain each year or by the natural increase of the niche/market or a mix of the two (this is usually the case).
Additional read: What is the TAM-SAM-SOM model?
More additional read: Startups Financial Modeling: Simplicity is King
2. Bottom-Up Forecast
Building the revenue forecast with the TAM / SAM / SOM can be useful in some instances. However, in other cases, the market share assumptions used for the SOM calculation are skewed and biased based on the founders' expectations of their product's success.
The bottom-up approach could either be used together with the TAM / SAM / SOM model to mitigate over-optimism in the market share assumptions or as a standalone calculation to show projected revenues resulting from unit sales growth and unit price fluctuations over time. The bottom-up approach fits many startups and more mature businesses since it applies information that already exists in the company, easy to understand, and relatively easy to project how they will fluctuate over time.
Financial Modeling
It’s often overlooked, but revenues in every business and industry across the world depend on just two factors: quantity and unit price. That’s it.
In an earlier post, I elaborated on the bottom-up approach. In that post, I mention that it might sound dumb or obvious. Still, it's often overlooked that revenues in every business and industry are driven by two elements: quantity and unit price. That's it.
The first element, quantity, could be a straightforward number, such as the number of users buying licenses every month or the number of units sold every month. But, it could also be more involved, depending on the business model. These figures are not static and should evolve throughout time, either monthly, quarterly or annually.
Learn more about Finro startup financial modeling services >>
The second element is the price per unit for every period. If the quantities are forecasted monthly, the price in the financial model would be a monthly price. If the forecast is on quarterly or annual levels, pricing should be adjusted.
The Outcome
Throughout the work on the financial model, you need to keep in mind that the goal of the exercise is to make the document accessible for the reader to follow, understand, and drow its conclusions. Therefore, it is essential to keep a clear set of assumptions that could be viewed, explained, and adjustable to show different scenarios with different assumptions.
Need help building your financial projections? Contact Finro today to hear more about our financial modeling solutions.
