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Financial Modelling for Startups: a Key Tool for Founders
Financial modelling for startup is essentially projecting out your expenses and earnings to determine best estimates around the impact of future decisions and events.
Financial modelling for startups is a key asset for any startup seeking success with a limited budget. This modelling goes beyond number crunching and essentially involves the ability to incorporate your business planning into a tangible financial format.
Reasons for having a financial model as a start-up
A financial model or financial budgeting is really important for a startup as you need to have rough signposts on what will make a economically viable business. How many users in year 5 and what impact does this have on free cashflow? Does the company remain afloat with 30 staff or do you have to keep it at 25 for now?
These are also key during a the fundraising process because the financers will most likely want to guage your expectations for the business and see how much you need to succeed. If your model says that after the capital raise that your cash balance is in the red after 6 months then it might be cause to rethink your strategy.
Another main motivator for a financial model is to inform yourself and the shareholders on how the company is doing compared to the financial KPIs as developed in the model.
Two approaches to financial modelling for startups
Making a financial model is not always a problem. The issue comes in on how to get the numbers. There are two main methods that you can use to solve this issue: top-down forecasting and bottom-up forecasting.
1. Top-down forecasting
This is the first of two ways to approach financial modelling for startups. In this approach, you work from the outside-in direction towards a micro view. Total industry estimates are made and then narrowed down to the targets that fit for your company. The TAM SAM SOM model is helpful in this forecasting because it captures the market size on three levels: the Total Available Market (TAM), the Serviceable Available Market (SAM), and the Serviceable Obtainable Market (SOM). This approach however might make you forecast too optimistically.
2. Bottom-up forecasting
This approach is less dependent on external factors such as the market but relies on internal company-specific data. It begins with a micro view and builds towards a macro view. This means that the projection is made based on the main determiners of value in your business. This approach is not suitable for fundraising as it does not have the optimism needed to convince your financers.
It is advisable to use the two approaches hand in hand to project a strong growth curve utilizing external financing. The bottom-up approach should be used short term for the first two years while the top-down approach should be used long term.
Three outcomes of a startup's financial model
All business models and investors are different in terms of interests and metrics matter most. Therefore every model should be tailored for the situation. A good financial model has three outputs: financial statements, a KPI overview and an operational cash flow forecast.
A good financial model should include a forecast of these three financial statements: the profit and loss statement, the balance sheet and the cash flow statement. The P&L is an overview of all the income and costs your company has generated over a certain period. It shows the gross margin, EBITDA and the net margin. The EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) provides investors with insights into the operational performance of your company and allows them to compare efficiency with other companies. The P&L is used when comparing different periods, budget versus actual performance, performance against other companies, etc. The Balance Shee is an overview of everything the company owns and its liabilities at a certain time. The Cash Flow Statement indicates all the money going into the business and all the money going out at a certain period.
1. KPI overview
These are the key performance indicators of which there should only be a handful to keep it manageable. Based on these metrics, you can track the performance of your business, experiment on different business models, acquisition channels and cost structures.
2. Operational cash flow overview
Cash flow is a critical component of financial modelling for startups. The Cash Flow overview addresses questions that yearly financial statements cannot answer and it also provides you with the opportunity to track your actual performance versus the expected budget monthly which helps in cutting costs and being ready for cash dips on later months.
The inputs to a startup's financial model
The first input sheet of a financial model is the revenue forecast which is performed using a combination of the top-down approach and the bottom-up approach. The way you build your revenue forecast depends on the type of business model you want, for instance, for a SaaS business it is better to make a revenue forecast based on existing customers, new customers and churn rate and other SaaS accounting metrics.
Cost of goods sold (COGS)
These are the costs that need to be made for a company to deliver a service or product. It differs based on the type of offering you sell. You can forecast COGS by looking at the sales targets defined in your revenue forecast then add the costs of raw materials and labour costs. This is particularly key for most Ecommerce businesses where the inventory can easily take up a significant piece of the cost of goods sold and tie up your capital.
Operating expenses (OPEX)
These are the expenses incurred by a business as it does its daily activities and operations. They include costs of the supporting and operational side of business such as sales and marketing, research and development and general administrative tasks.
A personnel forecast projects the number of employees hired and their respective salaries. It is advisable to split your personnel into different categories such as direct labour, sales managers, development team and general administration.
Investments in assets (capital expenditures)
Capital expenditures are funds used by a business to upgrade and acquire physical assets such as property. This is done by companies to increase and maintain the scope of their operations. Capital expenditure depends on the type of business and market – businesses with inventory might in invest in a warehouse, whereas a engineering firm might invest a portion of their R&D into existing core technology required for a prototype.
In this sheet of the financial model, you would add financing streams such as loans. Other supporting elements of a startup’s financial model include these four elements:
1. Working capital
This is the capital that you need to sustain your daily operations. Working capital is a comparison of the value of your current sales against your current liabilities. This is very important for startups because it is a measure of both efficiency and short term financial ability. Many founders also refer to this as “cash”.
This is the value reduction of assets a business owns. Depreciation is a part of the profit and loss statement and impacts the value of assets on the balance sheet. A financial model should have a separate scheme that calculates depreciation based on the investments and their usefulness.
Every registered company has to account for tax annually via a tax return. Taxes are removed from your total in the profit and loss statement if your business has a taxable net income. Alternatively, carry forward tax losses is where you carry your losses forward to reduce the amount of tax to be paid in a future period.
In financial modelling for startups, the best method to use in the valuation is the discounted cash flow method (DCF). This method is preferable for a startup that may not have any historical performance yet but expects huge future earnings. The main steps to follow when performing a DCF include; creating financial projections for your company, determining the projected free cash flows, determining the discount factor, calculating the net value of your free cash flows and final value by using the discount factor and finally summing up all the results.
Scenarios and sanity checks
It is wise to create different versions of your financial model. Most entrepreneurs are optimistic by nature but their businesses tend to be a bit more disappointing in practice than on paper. This is why it is advisable to have a different scenario that is less optimistic than the original business model. These two models are often call best-case scenario and a base-case scenario.
It is also recommended to perform a sanity check on your financial model to ensure you avoid common mistakes in the financial models of startups. Such mistakes include funding needs that are not well explained, inadequate personnel, overoptimistic or overly pessimistic revenue projections and operating expenses that are not catered for. Business mentors and VCFOs are great for getting outside opinions on what figures might suit best here.
This is the stage where you need to raise money for your startup. There are different ways to obtain startup funding which are often categorized into two camps: financing via debt and financing via equity.
Financing via debt is whereby you receive a loan from a bank or an individual on specific terms regarding interest and payback. Some advantages of using debt include; the ownership and control of your company remain yours, interest on debt can be deducted from tax and debt disciplines the management in that the cash flows are limited hence the management is more efficient and creates value. Given a startup’s lack of historical financial performance, it is not common for them to obtain debt financing.
Equity financing is far more popular amongst founder whereby you acquire funds from an investor in return for issued shares in your startup. The equity investor risks all of their investment by buying shares in the startup since there is a chance for nil return. You may partly lose control of your company because many significant investors (particularly VCs) want to occupy a part of your board not to mention share ownership. Other ways to fund your startup include crowd funding, convertible notes and subsidies.
Need help with financial modelling for startups? Contact Fullstack for help with outsourced financial modelling expertise.
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Stuart Reynolds is the founder of Fullstack Advisory, an award-winning accounting firm for businesses leading the future. He is a 3rd generation accountant who specialises in tech companies, agencies and entrepreneurs.