Most startup founders probably already know that having a financial model is important. It helps you raise investment capital, measures your growth over time, and lets you make better daily decisions about your business.
But even for seasoned founders, building a financial model can be tricky. Deciding which data to use and which metrics to measure isn’t always easy. And condensing it all down into one very complicated spreadsheet is always hard.
In this week’s class Logan Burchett, founder of Forecastr provided SKU Atlanta and SKU Austin ’22 founders with a detailed overview of financial modeling for emerging businesses.
What Is a Financial Model?
A financial model is a tool for organizing and analyzing your business’s finances. The biggest difference between traditional financial statements and a financial model is that your statements show real historical data, while your model includes both real historical data and a future projection.
At some point, you might have wished that you had a crystal ball so you could predict what will happen in your company’s future. A financial model isn’t a crystal ball, but it’s about as close as you’ll get.
By extrapolating a forecast from your past financials, a model allows you to answer some very important questions such as:
- At our current burn rate, when will we run out of money?
- When will we break even and become profitable?
- What are the most threatening risks we face in the short term?
- What are the most promising opportunities we have in the short term?
A solid model lets you plan and manage your growth targets and compare them to your actual performance. This highlights problems where you need to rethink your strategy or provide more resources. It also highlights the areas where you exceed expectations so that you can pour gas on the fire.
A great financial model is invaluable during fundraising. It shows that you have your finances under control, you have examined and challenged your assumptions about growth, and you understand your risks and have plans in place to mitigate them.
If you keep your model up-to-date with your monthly performance, it’s equally valuable as an internal tool to help you make better decisions daily.
Scenarios are especially powerful when you’re fundraising. If there’s a specific question or concern that you’re hearing from potential investors, you can often model different scenarios to illustrate the area of concern and show them the most likely outcomes for different approaches to solving the problem.
Biggest Benefits of Financial MOdeling
Investor Confidence
After the investor is hooked and you’re in the room answering those questions, that’s when your financial model becomes your tool of choice.
These are just a few of the questions you’re likely to hear:
- How much funding does your business need, and on what schedule?
- How will your company spend the funds?
- What are the assumptions underlying the story you told in your pitch?
- What financial risks and opportunities does your company face?
You can impress investors with quick and accurate answers to questions like these, with supporting data and context. Investors need to quantify their financial risk and assess a company’s performance and competitive viability. A big part of their assessment comes from their opinion of the founders’ leadership capabilities and understanding of their business.
When you’re able to present quick and accurate answers to an investor’s questions, it builds trust and confidence. By sharing a detailed and well-built financial model, you demonstrate that you have taken the time to examine every aspect of your business.
If you’ve put in the time to challenge every assumption and check every metric against industry benchmarks, it shows that you’re on top of your game as a founder, and investors will inherently begin to trust your decision-making skills and your ability to lead the company.
Accurate Runway
A financial model provides a clear picture of how much cash is available today, and how quickly your business is spending it. With a clear understanding of your burn rate, there’s a much lower chance that you will run out of cash before your next raise.
Your model lets you project your runway accurately so that you can plan for your next raise. With this capability, you’ll be raising when the time is right, avoiding any cash flow emergencies.
New Insights
A financial model lets you break down and analyze your timeline for growth, including key elements like new hires, new product launches, and new market expansions.
You get an educated estimate about how these changes will impact your bottom line immediately and over the following months. It lets you make informed decisions about allocating resources and when to pull the trigger.
Evaluate different Scenarios
A financial model can help you do creative planning and troubleshooting by building alternative scenarios to test the impact of changes in your environment. You can use scenarios to gameplan for potential changes like new regulations, pricing changes, and changes in your conversion rates.
This helps you make better, more informed decisions about your business. For example, you can run a test within a subset of your prospects to see how a price change impacts your conversion rate. With a financial model, you can extrapolate your findings to see how that price change will likely impact your bottom line when it is rolled out.
Scenarios are especially powerful when you’re fundraising. If there’s a specific question or concern that you’re hearing from potential investors, you can often model different scenarios to illustrate the area of concern and show them the most likely outcomes for different approaches to solving the problem.
5 Best Practices for Financial Modeling
Build From the Bottom Up
Rather than applying arbitrary assumptions across your entire operation, analyze your historical data at the most granular level, and build out from there.
Let’s look at customer growth as an example. The right way to project customer growth is to analyze the historical performance of each acquisition channel, determine a realistic growth rate for each, and project them accordingly.
If you pick an arbitrary target and apply it across your entire acquisition strategy, investors will likely spot this flaw and view it as a red flag.
Your financial model is only as good as the assumptions it’s based on. A well-built model documents all of your key assumptions and shares them transparently. Be sure that your assumptions are based on reality and can be proven when challenged.
Don’t Overlook Presentation
Can a stranger quickly make sense of your model? If not, invest some time in creating a more intuitive layout and organization.
Include a branded cover page with your direct contact information. If you have more than a few sheets of data, provide a linked table of contents to help investors and stakeholders navigate quickly.
Always Start With Your Real Data
Never make up data to fill in gaps in your model. Even if the actual number is currently zero, it’s still better to be transparent and show your real numbers.
Your goal in using a financial model is to impress investors and improve your operation with better-informed daily decisions. Fake data quickly undermines both of those goals.
Unfortunately, there are no shortcuts here. Every data point should be traceable back to its source in your books. If a number in your model doesn’t make sense, make the correction in your books. If a number is accurate, but it doesn’t go along with the narrative you’re telling, adjust your narrative, not your numbers.
Update Your Model Monthly
Never let your financial model get stale. Monthly updates prompt you to compare actual results against your forecast, giving you valuable insight into the areas where you’re succeeding and those where you need to improve.
If your model is current when you hit the next fundraising round, you won’t need to build a whole new model from scratch, which prevents a huge time suck. Instead, you can simply update your assumptions based on your recent performance, and you’re ready to raise again.
Know Your Model Like the Back of Your Hand
Investors will ask a lot of questions about your financial model. You should never let your model stand alone, but always be present – either in the room or virtually – to hold the investor’s hand and provide context for the assumptions and the thoughts behind them.
Show investors that the model uses your current actual numbers, and be prepared to defend every assumption. If an investor disagrees with an assumption, you can respond by creating a scenario that shows updated projections based on their alternate assumptions.
Best Practices for Financial Modeling
Now that you know how valuable a financial model is and the basic dos and don’ts of creating one, here are the three most common approaches to help you decide which choice is the best fit for your business.
Financial Modeling Spreadsheet
Historically, this is the way financial models have always been done, and it’s still the default choice for many startups. However, you should understand that creating a financial model in a spreadsheet is cumbersome for most founders.
The biggest reason founders choose a spreadsheet model is because it’s “free.” But you need to consider the amount of time it’s going to take you and your team to update your books, gather your inputs, calculate your assumptions, and build the actual spreadsheet. This is a very expensive undertaking for most startups.
Another disadvantage of a spreadsheet model is that it’s very hard to create alternate scenarios, and your spreadsheet becomes exponentially more complicated with each scenario you create.
Keep in mind that you need your final output to be clear and intuitive for a stranger who has very little background information about your business.
If you still think that a spreadsheet model is the best approach for your startup, you can save time by using these free financial model templates from Forecastr.
Outsourcing Your Financial Models
Outsourcing your model to a contractor or service provider is a good option for startups whose budget can support the cost. This is a low effort solution, but it won’t be cheap.
There’s one key risk you should consider with this approach. As we discussed above, one of the biggest benefits of your model is that it demonstrates that you have personally taken the time to analyze all of your historical data and to challenge every assumption about your growth.
If you’re not directly involved in building your financial model, you haven’t really invested that time in analysis, and investors can sniff that out.
Be sure to spend plenty of time with an outsourced model before you present it. You should be able to quickly cite the source for every data point and explain the reasoning behind every assumption. If you can’t, your presentation could backfire, leaving investors with the impression that you don’t understand your business very well at all.
Financial Modeling Software
Financial modeling tools are a relatively new software segment that is quickly becoming the best choice for most startups. This approach is a nice compromise between the efficiency of an outsourced model and the low cost of a spreadsheet.
Software allows you to build your model quickly. You still have to polish up your books, but it’s much easier to create the model because there is no spreadsheet to create – just a set of fields that are configured to fit your business model.
Calculations are handled by the software, so there are no Excel functions to worry about. When you do run into issues, there is a support team waiting to help you.
For some founders, online support is the biggest advantage of using financial modeling software. Take this into consideration when you select a vendor. Forecastr provides a pair of dedicated analysts for a 30-day onboarding process, quarterly consulting, and ongoing support as needed.
Software makes it easy to model alternate scenarios. And when it comes to presenting your model to investors and stakeholders, a friendly UI provides a huge advantage over a spreadsheet.
Conclusion
In the ever-changing environment that all startups face, finding financial stability is a huge challenge. A financial model can help by providing you with insight into your current financial situation, along with a glimpse of your likely future.
The bottom line is that you’re able to make better decisions and better understand the impacts of those decisions.
A financial model is also an important tool for fundraising. It allows you to determine how much capital you need and when you need it. It also helps you secure capital by impressing investors and earning their trust.