Essential Financial Modeling for Your Startup
Financial modeling for startups helps communicate your business potential in a language that investors understand. While VCs and investors love to hear about exciting and disruptive ideas, what gets them excited are cold, hard numbers.
However, financial models for startups are about more than just convincing investors that you're a solid bet. They're also about getting into the weeds and understanding if your business is a viable option. Even the best ideas can go by the wayside if managed incorrectly. A solid startup financial model helps you understand what is required to stay solvent and deliver on your startup's promise.
Dive Deep: Why Startups Need Robust Financial Models
Financial models are about making solid forecasts. While no one has a crystal ball, a robust financial model can give you insights into not just the future of your business but how specific scenarios or decisions will help or hinder your startup.
Building a financial model will help you in four main ways:
#1. Forecasting your future expenses and revenues.
#2. Establish whether your business idea is feasible
#3. Understand how various decisions will impact your business, both positively and negatively
#4. Evaluate how investment can impact your business
Answers to these questions are critical for startup founders because they ensure that they do not rely on assumptions or wishful thinking when making business decisions.
Financial planning and analysis (FP&A) for startups is too often an oversight. So many great ideas have failed because founders dedicated too much of their time to other priorities or failed to make data-driven decisions.
Financial modeling is one of the core pillars of FP&A, alongside budgeting, financial planning, and reporting. There are three big reasons why your startup can't ignore FP&A.
#1. You need to understand if your business can eventually turn a profit.
#2. You need a solid model to show investors or to get other sources of capital.
#3. You need to set solid targets that your business is working toward.
Building a Financial Model: Best Practices and Templates.
A startup financial model template is a great way for founders to understand and present the fiscal side of their business. Many entrepreneurs' biggest strengths lie in creating great, disruptive companies and communicating big ideas. However, when it comes to the nuts and bolts of capital, they can fall short.
The obvious problem here is that while VCs and investors love hearing about new ideas, they can only invest in viable opportunities. This scenario means that founders have two choices: learn how to build a financial model themselves or get some help.
While learning a new skill is always beneficial, if you're a busy founder trying to launch a product, you just won't have time. This is where a financial model template for startups can come in handy.
When you're modeling startup expenses and revenues, the right template acts as a guide to help you know what you need to include to make reliable forecasts and predictions.
A financial model should have three key components. They are:
Income Statement: These details show how much money your startup is making. If you're a SaaS startup, this section will typically have a Monthly Recurring Revenue (MMR) and Annual Recurring Revenue (ARR). MRR and ARR can tell you similar things. However, MRR is more granular, and it can help account for seasonal ups and downs.
Balance sheet: A balance sheet is a simple document that helps you (and potential investors) understand what assets you own, any money that you owe, and if you have shareholders and equity partners.
Typically, a balance sheet is split into:
● Assets: Cash you hold in your account, equipment or property that you own, such as furniture, equipment, company vehicles, and so on.
● Liabilities: Liabilities cover anything that your business owes to others. Typically, liabilities include employee salaries, business or equipment rents, outstanding invoices, insurance, and other outstanding business expenses.
● Shareholders or owner equity: If your business has shareholders who already own a portion of your company or you have invested a specific amount of your personal capital into your startup, it should be detailed on the balance sheet.
As you can see, a balance sheet is a handy way for you or potential investors to get a snapshot of your business's health.
Cash flow statement: A cash flow statement is an integral part of your financial planning because it lets you and your investors know about money coming in and out of your business. Cashflow problems or mismanagement have derailed many high-potential startups over the years, so it's important to keep track of these figures.
Your cash flow statement should detail your income sources, whether your suppliers and staff are being paid, and any investment and financial activities. Understanding how much cash flow you need to stay solvent is crucial. Similarly, if you have a surplus, it can be a sign that you can invest more in your company.
Top-down or bottom-up forecasting
There are two main types of forecasting that startups can use: top-down or bottom-up. Both have advantages and disadvantages.
Top-down forecasting helps you take a macro view of your market and whittle it down into a micro view of your business. Here's a simple overview of how to do it with the TAM SAM SOM model.
TAM: TAM stands for Total Available Market. In other words, it's a measure of the worldwide size of the market for your product or service.
SAM: SAM is short for Serviceable Addressable Market and measures the amount of your TAM you can reach based on your geographical location.
SOM: SOM means Serviceable Obtainable Market and demonstrates the amount of your SAM that you can win from your competitors.
In essence, SOM is your sales target. From there, your financial model should calculate the various expenses you need to hit your SOM, including things like production, R&D, sales, employees, administration, and so forth.
The problem with this model is that some founders can be too optimistic about how much SOM they can win and underestimate the difficulties of winning market share.
Bottom-up forecasting takes a different approach. It uses your company data to build predictions about your future performance. For example, the bottom-up approach will look at your existing products, customers, and market. It will take these things individually and aggregate the data to make a forecast.
Some valuable metrics here include things like Customer Acquisition Costs (CAC), Customer Lifetime Value (CLV), and Average Revenue per Customer (ARPC).
In contrast to top-down modeling, the bottom-up approach can be considered a more pessimistic or highly realistic approach to forecasting. While staying grounded is important, it can fail to ignite investors' interest. As such, using both models can help you achieve a balanced outlook on your startup's true potential.
Financial modeling best practices
Using a financial modeling template is an excellent idea because it allows you to draw on the past experiences of others and helps you track the metrics that matter. However, there are a few other best practices that you need to ensure your model is capable of making solid predictions.
#1. Back up your assumptions: It's challenging for startups to populate their models with hard figures if they don't have historical data to draw upon. However, there is no room for guesswork. Ensure you can justify every figure on your sheet with, at minimum, solid research.
#2. Keep it simple: Financial modeling is complex, but the art of an excellent document is making it easy to understand. So, break things down clearly and support your findings with visualizations where possible.
#3. Get help: Going it alone might work for some, but it's essential to seek help and advice from people who have been there and done it. Reach out for expert assistance before you finalize your model to ensure you haven't made mistakes.
Q: Why is financial modeling critical for startups?
A financial model for a startup helps give founders and investors solid insights into the future of the business. However, they're not the only vital benefits. For example, an excellent financial model can also help you decide on the impact of marketing campaigns or other investments.
Another essential aspect of evaluating the financial health of your business is that it helps you understand your strengths and weaknesses. This information can be the difference between success and failure if you have the foresight to remedy the issues that are holding your business back.
Q: What distinguishes SaaS startup financial models from other startups?
A financial model for a SaaS startup is different from typical startup models for several reasons. Perhaps the most pertinent is that SaaS businesses are almost exclusively subscription-based.
As world economies went through a digital transformation over the last decade or more, startup valuation became a sophisticated process. A slew of insightful KPIs and metrics helped teams understand the data that predicted success and failure. These KPIs are the language your investors use to talk about and evaluate your startup.
Q: How can startups leverage financial models for venture capital pitches?
Sold financial modeling for venture capital pitches is essential to demonstrate credibility and competence. When you go into a meeting to present your idea, you're going to face hard questions. No matter how innovative or novel your pitch is, investors will demand you can back it up with data.
The days of investors getting swept up in exuberant pitches and promises of a rosy future are gone. While that passion is essential, return on investment (ROI) is the priority.
A financial model template for your startup can become a cornerstone of your pitch. It will demonstrate to investors that you are the serious, practical type of founder that they can trust with your money. They're going to ask these key financial questions anyway, so you might as well be upfront and give them the data they need to evaluate your product or service.