Oleksandr Matsiuk, Founder & CEO of RiseGuide by venture builder SKELAR, in a guest column for AIN, talked about why startups and investors need a financial model, how to draw it up correctly, and what to avoid while doing it.
There is a common belief among startup founders that the financial model is first and foremost needed by investors, that it is some kind of clumsy and archaic attribute of the fundraising process demanded by venture capitalists for some unknown reason. “Why make a model, if it’s not gonna work anyway?”, “How can I make the right assumptions at this stage of a startup’s lifespan?” and other phrases can often be heard from funders. I believe that it is the entrepreneur who actually benefits the most from developing a model.
An effective financial model is a very important element in business success. As you invest your time in creating a financial model, you begin to better understand what factors are really important, the mechanics of making a profit, and the relationship between various elements of the business model. Let’s look at why it is needed, what it consists of, and what the main requirements are.
So what do founders need a financial model for? Reason 1 – To turn your business into an equation and better understand how it works
In the first place, a financial model allows you to better understand your business at all levels. Since every financial model is based on an operations/growth model, you’ll understand what drives your startup’s growth and how your market works by drawing up a financial model. You have, for example, a B2B SaaS where Sales is the main distribution channel and you build a growth model. In the process, you’ll need to model a funnel for each sales employee and understand what percentage of leads he or she needs to close for the company to grow effectively and break even at the sales level. This allows you to identify key metrics in key business areas. Modelling financial processes also serves as a powerful prioritisation tool. For example, you may find out that a 5% increase in customer retention is much more profitable for you than a 5% increase in conversion. This means that you should focus your organisation’s resources on this particular issue to improve business performance.
Building a financial model also helps to set benchmarks for operational and financial performance. When launching a startup, it is very difficult to determine what indicators are standard for a particular industry. When creating an operational and financial model, not only do you identify the main drivers of your business, but you also ask yourself what they should be, what benchmarks and guidelines exist for your industry and business model, and start researching. The source for such benchmarks can be analytical reports, market research, investment funds, and your co-workers in the same industry. Going back to the previous example, you ask yourself how feasible is the percentage of leads closed by a salesperson in your B2B SaaS startup, and you start looking for an answer. Or you realise that the burn rate (monthly net loss) you set for the Seed Round is twice as high as was in the famous SaaS Funding Napkin by Christoph Jantz, a partner at Point Nine Capital, and that you need to change something in your vision of how the business should grow.
Being involved in the financial model development gives you an understanding not only of certain milestones, but also of how to achieve them. To reach $100 million in revenue per year, for example, you need to burn through $200 million in investment. Doesn’t sound very attractive, does it? Very often priorities are reassessed at this point. Entrepreneurs can either temper their ambitions, realising the complexity of implementing them, or raise the bar of expectations, or find other ways to accomplish them.
So what do founders need a financial model for? Reason 2 – A bad plan is better than no plan at all
The financial model’s key indicators should serve as the company’s goals, which you will use to guide you in dealings with your employees or partners.
The model will also be a handy tool for checking the soundness of your business. Sharp deviations between actual and planned figures can indicate critical business problems and encourage you to deal with them faster and move forward with more frequent iterations!
Another benefit is the ability to align different teams working in your business. They may have different metrics and intermediate goals, but a common goal can help them better grasp the end result, their contribution to it, and interdependencies. It makes no difference if the sales team meets their KPI for the percentage of closed leads, when marketing doesn’t generate enough leads or their cost is sky-high.
And, of course, developing a financial model has certain advantages in your relationship with investors. They will have a better understanding of your business, allowing them to make an informed decision rather than relying on their own assumptions. Also they will certainly see that you have the right qualities to be successful, such as analytical thinking and strategic planning.
The timeframe for your financial model
While your main goal will of course be to focus on the future, you shouldn’t forget about the past. Your financial model has to cover the operations of your business from the very beginning or at least the last 12 months. The best choice is to prepare a financial model on a monthly basis . It is essential to understand that past performance should be included in the same file as current results and plans for the future. This gives you a better picture of the company’s growth trajectory. To make it easier to distinguish certain time periods, they should be highlighted in different colours.
The financial model’s most important component is the near future. This section shows potential investors what you can achieve with their contribution. The planning horizon is normally set at 18-24 months. Why? That is the expected run rate for a typical funding round, so both the investor and you must understand how the funds raised will be invested and what you will achieve with them. The depth of detailed elaboration is 1 month.
The financial model should also include your main goal, like achieving annual revenue of $100 million, for instance. Such goals are set for the long term, usually up to 5 years. The depth of plan refinement is a quarter or a year.
The structure of the financial model
- Assumptions. Non-financial drivers of your business, for example, conversion funnels, cost of lead attraction, etc.
- Revenue generation model. With the cohort approach, you model how your revenue will accumulate from month to month. Below is an example of the way it works for a combination of platform and user acquisition channel
- P&L (Profit and Loss Statement). It is best to use the cash-flow method, as no one expects the correct IFRS or GAAP reporting from you. Though some areas may have their own caveats. For example, for SaaS services, monthly recurring revenue (MRR) is important, which may differ from monthly revenue if you sell annual or quarterly subscriptions.
- Team. The team composition including positions. Salaries must be indicated, as they account for up to 50% of total expenses in nowadays startups, especially in the early stages.
- Dashboard. Visualisation of the key elements, goals, and benchmarks of the financial model by means of graphs.
- Unit economics of your business. Summarising the results. Demonstrating the financial model operation on a per-unit, per-user, or per-product basis.
How do you make a model attractive to investors?
Even the best idea can be killed by a poor presentation. Therefore, you need to create a certain style of your document to display your financial model to potential investors in all its glory.
To begin with, use no more than three colours so that the colourfulness does not irritate or distract. Be sure to highlight past and future events to avoid misconceptions about your plans. You should also underline strategic goals and KPIs, drawing attention to them.
Use the following rule of thumb to understand which metrics can be presented in a general table and which should be placed on a separate page of the presentation: if an indicator accounts for more than 10% of income or expenses, it should be disclosed in as much detail as possible on a separate page. At the same time, the financial model should be easy to understand. If a certain calculation does not fit on a laptop screen, it should be simplified, perhaps by grouping certain indicators or showing a general perspective with a lower level of detail.
When pitching a financial model to an investor, you shouldn’t expect them to have the same knowledge as you. Rather, display your expertise. Decode acronyms and explain key metrics.
Again, it’s worth emphasising: don’t overcomplicate your presentation! Don’t use extensive formulas and don’t force the investor to scroll through several pages looking for links. They are more likely to reject your proposal because of such hardship in understanding your business. Remember that an analyst works on no fewer than ten different deals at a time, and you need to make his or her life as easy as possible.
Bad practices of financial modelling for startups
- Indicators, such as “market share by a certain year”. Sadly, this is how most companies model their growth. This reflects high expectations and a lack of understanding of basic financial modelling principles.
- Calculation based on profit or the number of customers. This approach turns everything upside down. You need to start with the question of what exactly needs to be done to achieve certain outcomes, such as profit or number of customers.
- Focusing solely on financial indicators. This may sound counterintuitive, but the financial model should be more than that. You have to understand and explain to the investor exactly how you actually plan to make money, not what kind of profit you want to get in two years.
- Deception or concealment of facts. When making an assumption, add a reference to the source. This can be either independent research or the performance of your business in the past.
- Excessive optimism. The brighter the picture you draw, the more critical investors will be. We all adore “hockey sticks” (the so-called exponential growth of startups — ed.), but it is better to be pessimistic.
Financial model dynamics
A well-built financial model will help you attract investors’ attention and get the funding you need to grow your business. This doesn’t mean, however, that you can take it easy after your idea is approved. The financial model may be revised in the following cases:
- A change in the business paradigm — a pivot, for example;
- A sharp deviation from the initial plans;
- Errors detected in assumptions;
- The need to raise additional funding;
- Preparing a report for investors.
It is recommended that you review your financial model at least on a quarterly basis if you plan to use it as an action plan or set of goals. It is also worth reducing the analysis period to one month, meaning that in early October you should have a full set of actual September figures.
Author: Oleksandr Matsiuk, Founder & CEO of RiseGuide by venture builder SKELAR
