The first use case of a financial model comes during the funding phase, but its purpose goes far beyond raising money. From projecting future earnings to planning your overall path, your financial model is a critical part of your young company’s foundation. The right model will consist of intelligent, reasonable projections and a comprehensive, dynamic spreadsheet.
Of course, bringing all of these elements together is a big task. Many startups put too much focus on “being right” and not enough on answering key questions to get you from Point A to Point B. If you’re at a loss, take a deep breath. Simply follow these steps and you’ll be able to design a sensible financial model for your startup in no time.
Bottom-Up or Top-Down?
When building your first financial model, you’ll generally opt for a top-down projection. That’s because the top-down approach allows you to start even though you don’t have a lot of information about your own company yet. Instead, you’ll make forecasts based on the overall market and identified demographics, which will allow you to set a realistic target.
A top-down model requires in-depth research into the size of your market. You’ll also need to analyze any public metrics available that are relevant to your industry and company. Using the KPIs (Key Performance Indicators) that are applicable to your industry, you can begin your calculations.
These top-down projections are often described as “not particularly useful,” but they are necessary so that investors can see the potential for your young startup. As you gain experience and metrics, you can begin to use the bottom-up financial model, which is much more accurate and dependable for the long-term.
Creating Your Basic Model
Your model will begin as a dashboard with a few key details and you’ll expand on it with time. Here are the steps to assembling it.
#1 Compare Revenue to Expenses
A young startup has no clue what there revenue will actually be, but you can estimate it. However, you will know for certain what your expenses will be, so you can create a curve graph that shows the answers to these two key questions:
- Where is your break even point?
- When do you anticipate reaching the break even point?
#2 Calculate Revenue Per Employee
You can calculate revenue per employee by diving total revenue by the total number of workers. Make this calculation based on operational headcount (i.e., how many employees you need to run your company), and increase your expense calculations accordingly.
- How much revenue will each employee generate (on average)?
- How will you increase the revenue per employee without increasing expenses?
- What is your expense per employee (total revenue/total expense)?
On average, the expense per employee comes out to $180,000 to $200,000 for new startups.
#3 Add Up Accumulated Losses
- How much money do you need and when do you need it by?
- When do you estimate reaching your break-even point or when will you be cash flow positive?
#4 Base Growth on Assumptions
With all of the above calculations complete, you can now begin to make assumptions about your growth, which will help you tell the story of your startup to investors and partners. The data should answer the following questions.
- How many clients/users do you need to acquire and by when? How will you prove that you can achieve this target?
- Can you use a valuation metric to measure your company’s future earnings?
- When will you use a hockey stick graph to demonstrate dramatic increases/decreases in clients/users?
When drawing your graphs, always place curves on assumptions and explain these assumptions to potential investors. It will help you gain support and backing when they understand your reasoning for increased user acquisition or other factors.
Creating Your Advanced Model
As your startup gains experience, you will use your cash flow statement, income statement, and balance sheet to continue predicting (and adjusting) your company’s future finances. You need to use all three of these documents because each one gives you different information.
- Your income statement tells you if your startup is profitable.
- Your balance sheet tells you what your startup has, what it owes to others, and what’s left over (i.e., the company’s value).
- Your cash flow statement tells you if you are generating cash.
#1 Project Your Client Growth Rate
You should project how many new clients or users your company will get month-over-month and include this information in a document accessible by founders, partners, and investors. It will help spark discussion as your company grows. Numbers should be summarized each quarter and organized. Start at a 20% monthly growth projection, which is considered standard. Project out 24 months into the future with this monthly growth rate.
#2 Work Out The Details
Your balance sheet, which summarize how many assets or liabilities your company has, follow the formula of Assets = Liabilities + Shareholders’ Equity. Your income statements (or “profit and loss” statements) will allow you to calculate:
- Year-over-year revenue growth, profit growth, and net income.
- Using margin and growth rate analysis, you can calculate the gross margin for COGS (Cost of Goods Sold), SG&A (Selling, General & Administrative), effective tax rate, and more.
With this information, you can go on to calculate prepaid expenses, accounts receivable days, and accounts payable days for your business. For instance, you may have to pay your bills in 60 days, but you want your customers to pay you in 21 days. This part of your financial model should detail that information.
#3 Update Assumptions Over Time
As the numbers change with time, so should the assumptions your projections make. For instance, your client growth rate may prove to be above 20% or it may cap at 8%-10%. It all depends on the market you are in, the service you are offering, and your marketing strategy. Start with the baselines given and adjust as more information becomes available to you.
Based on your ratios, you should make future projections for your income statements and balance sheets. You should also work to build a “Statement of Cashflows,” which will bring your income statement’s net income information together with cash information from the balance sheet. You can then use the Statement of Cash Flows’ cash balance in your balance sheet to “Balance the Balance sheet.”
This process is complex, but eventually everything is tied back into your income statement and you end with updated financial statements and projections. If you’re looking for a thorough explanation, read about Three Statement Financial Modeling, which is considered the standard for investment banking analysts and other industry experts.
The most difficult part will be using tricks, like spinner bottoms, to collapse your projects and compare different outcomes or revenue projections per month and per client/user. It will take time to do all of this, but it’s worth it. If you need further assistance, reach out to Founder’s CPA to setup your free consultation.
Common Projection Mistakes
With all of the different numbers in front of you, it’s easy to get confused and make a few miscalculations. The best way to avoid mistakes is to work through your financial model in sections. Avoid overwhelm by starting with the basic model and doing all the research possible to ensure its accuracy. As time goes on, you should build on your financial model using the most recent statistics and best practices.
In the meantime, it’s worth considering some of the most common mistakes that startups make when assembling their financial models. Here’s a look at a few of them.
#1 Assuming that efficiency comes with growth.
One of the most fatal assumptions startups make is assuming that efficiency will magically come as a company grows. This is not a fact, and it can put great strain on a young business that is trying to find its way.
To help avoid this assumption and the side effects that come with it, always work multiple scenarios into your model that cover low, medium, and high estimates for revenue. Also, remember that expenses will increase year-over-year as well, including the cost per employee as salaries continue to rise.
Glenn Kelman, Founder of Redfin and FI Mentor, said it this way: “By developing different scenarios based on different levels of demand, you can later calibrate hiring and spending according to which scenario fits reality best.”
The assumption that X amount of users will equal sustainable revenue is simply not dependable. Applications often operate on this kind of projection, but revenue doesn’t always come with scale. This is especially applicable to SaaS, or “Software as a Service”, companies and marketplaces that build revenue models into their business plan. They often don’t do their research and they may also underestimate CAC (Custom Acquisition Costs), both of which make this projection method even more unreliable.
#2 Focusing too much on financial statements.
The financial statements are important, but a financial model should also include other key metrics and explain how they contribute to the bottom line. For instance, contract size, customer growth, and customer turnover will all play a critical part in financial projections and they should be included in the financial model.
Jim Franklin, Former CEO of SendGrid and FI Mentor, states: “If your company has created an iPhone app, you might take a look at the number of consumers who have purchased apps for their iPhones. If there are 80M active iPhone users and half of iPhone users buy at least one app per month, you can extrapolate from here. Being conservative, you could estimate that of the 40M active iphone users who purchase apps, .2% of these consumers will purchase your app. That would give you 100K new customers.”
This goes back to conducting in-depth research about the industry you are operating in. You should collect all relevant public metrics available that could impact adoption rates, subscription length, and other aspects of your company’s success.
#3 Leaving out the details or including too many.
Oftentimes, one of the trickiest parts of compiling a financial model is finding the balance. Startup often find themselves asking, how do you balance assumption with data? Perhaps more importantly, how do you balance information with digestibility?
At the end of the day, your financial model has to be detailed enough to be reliable but consumable enough that you (and everyone else) will actually take the time to look through it. That’s why the best financial models will go through quite a few phases of editing, adapting, and revising before they’re ready to go to work.
in other words, start with the basics and add to it overtime, removing assumptions as they fall out of favor and adjusting other information as new numbers become available. By keeping it up-to-date and expanding it over time, your financial model will prove both more accurate and more effective for all of your purposes.
Utilize Your Model
After spending all of that time creating your financial model, it is essential that you utilize it at your company going forward. Beyond getting funding, the right financial model will allow you to stay on track towards meeting your target earnings while growing your company on top of a strong foundation. If you need help, reach out to Founder’s CPA for professional assistance with keeping track of the complex financials that are driving your startup.