First time founder Series: Part 2 - Planning Your Financial Future: Building and Utilizing a Financial Model
In the first part of this series we talked about how to set up and do your accounting. Ideally this should give you a relatively up to date set of financials. Let's use these as a basis to set up a financial model and plan ahead.
The Power of Financial Models
What is a financial model good for?
Some people argue that financial models for startups are not very useful. I respectfully but decidedly disagree. Even if incorrect they enable and support analytically thinking through the strategic foundations that will lead to the startup succeeding.
If a financial model is purely used to communicate outsized and unrealistic numbers to investors in order to get them on board then arguably they destroy value.
Financial models help startup founders in at least these ways:
- They help with cash-flow planning
- They clarify the intended strategic positioning of the company
- They make evident unrealistic assumptions
There are two discrete situations where they can help early stage startups tremendously:
1) In the early stage of a company where the initial approach of the startup is being discussed among founders and early investors. Then it can help clarify and align assumptions and hypotheses.
2) In the day to day running when the rubber starts hitting the road and some of the early hypotheses in the model are beginning to be validated or rejected. If the learnings are added to the model continuously, the model becomes a medium through which the learning of the startup is being summarized. Learning is arguably one of the most important things in the early stage of a company.
Laying the Groundwork: Starting Your Financial Model
There are probably three sensible ways to start setting up your financial model:
1) Take your actuals and project them forwards. This makes sense when your actuals show pretty clearly how your business is making money. Believe it or not, that's seldom the case for early stage startups.
2) Start from an empty spreadsheet. If you don't yet have stable actuals to base your projections on because you have not yet generated revenues or because you have not set up your accounting process yet you can also simply open a new spreadsheet and start from scratch.
3) Use a tool such as Causal. I recommend against this at first. When you are just starting it's important that you get a feel for your numbers and spreadsheets are unrivaled in being able to flexibly play around with numbers.
I would recommend against using a spreadsheet from the internet. They are often over-engineered and too complicated for a startup. It is also important that you understand how your numbers are constructed and what better ways than to build the model yourself?
So let's do it, shall we?
Time scale
Financial models for startups should be monthly. There are probably some people out there modeling on a quarterly basis but this is not granular enough. Monthly models allow you to determine quickly if you are on track or if you need to change course. In startups things can change quickly and the model should reflect this.
Deciphering Drivers: What fuels your business?
As a first step you should ask yourself what it is that drives your revenue numbers. This might be harder than it sounds for some startups. And it can be embarrassingly easy for others. For example, for a service business the number of projects serviced together with the average value of a project determines total revenues.
For a marketplace this question can be a little bit harder to model. Probably the amount of supply and demand in the marketplace are drivers of revenues but how exactly depends on the exact model of the marketplace. In any way, together they will determine the number of transactions on the marketplace which is usually where marketplaces take their cut and make revenues.
You can set up some assumptions such as the average value per project so that you can see how your model reacts to changes in these values.
It makes sense to think of variables as either constant, i.e. they don't change over time or as variable, i.e. they do change over time. On my assumptions I like to take this into account by having a column for constant values and then a time series of variables that change over time.
Crafting the Profit and Loss Statement
The driver of your business determines revenues. Model them out. Assume random growth rates if necessary so that you have a starting point. You can adjust the model later on.
Then move to your expenses. What do you already know about your business? Perhaps how many employees you need in order to generate the assumed amount of revenues? How much you would like to spend on marketing? How many customer support agents you need? Do you need office space? If you don't know the answer make generous assumptions instead of overthinking.
Now it becomes possible to start thinking about some implied values. What is the ratio of customers per customer success representative? How much revenues do sales representatives bring? How much are you spending on marketing per signed up customer? How many months until you earn back the money spent on acquiring a customer from the revenues that this customer brings? Are these values realistic? You can benchmark these values from other companies in your industry.
Do all of these things but don't spend too much time on them for now. Let's first set up your balance sheet and with it the most important metric for most early stage startups: the cash balance.
Demystifying the Balance Sheet
This is the hardest part of the financial model.
It might seem straightforward to assume that revenues = money in the bank and expenses = money out of the bank but some businesses unfortunately don't have this luxury. If you can reasonably make this assumption then you should absolutely skip the Balance Sheet part of the model and focus on building your business instead. In that case cash can be calculated very simply from profits taking into account taxes (and other items like depreciation in case you are tracking it).
Ah I see you decided to read on... Ok then, let's see how we can go about modeling the Balance Sheet in a way that makes it reasonably easy.
Let's talk about the core problem for a second. We want to get to a place where we can model out the cash position of the business over time given our projected profit and loss statement from above. The issue is that net profit at the bottom of the P&L does not necessarily mean that the same amount of cash hits our bank account. Sometimes customer's pay with a delay (or not at all), sometimes we need to first buy inventory before we can sell it onwards to customers and sometimes we pay suppliers on credit. These sorts of "Working Capital" details can make a huge difference in the cash flow of a business. In fact they are so important that they can mean the difference between a healthy business that generates loads of cash versus a business that fails.
Let's start with receiving money from customers. Think through how your customers are paying you and whether it is possible for them to pay with a delay, or not at all. If this is possible in your business model you should model Accounts Receivable i.e. money owed to you by your customers. Revenues become Accounts Receivable and only a certain amount of Accounts Receivable get converted to Cash as your customers pay up. This is important because a wrong assumption here can easily be company ending. It's also important to note that businesses with slow customer payments can lose more money the faster they are growing revenues.
Let me explain this with a stylized example:
Let's assume an average customer generates $10 of revenues, but it costs us $8 upfront to deliver our service to them. If that customer takes 30 days to pay their invoice, we’re out of pocket $8 during that period. Now, as startups scale and acquire more customers, this deferred payment can strain cash flows, necessitating a larger working capital buffer. This cash flow challenge is a critical reason many startups, despite having promising products, can face financial difficulties.
There are multiple ways to model this effect and finance people disagree quite a lot on what the best method is. It's common to make assumptions on how many days customers on average take to pay an invoice. There are simple and more involved but correct ways to use this assumption in modelling out accounts receivable. Here is a nice little write-up on a simple and a more involved but correct method.
Paying suppliers works analogously. I like to not assume that I will be able to pay my suppliers with a delay as a way to make my assumptions around cash a bit more conservative but this is personal preference.
We have not yet talked about capital. If your business needs to invest in machinery or has other forms of capital needs then you need to account for it in the balance sheet as well.
Cash is then derived by taking the previous periods cash, subtracting all expenses, and adding Revenues back making sure to account for Accounts Receivable. I like to construct a mini Cash Flow statement under the Balance Sheet which in turn feeds the projections.
Finally you can make assumptions about where the money will be coming from. Will there be loans taken or investments raised? This also goes into the balance sheet and optionally into the mini Cash Flow statement.
How to Leverage Your Financial Model
A financial model isn't just a static document; it's a dynamic tool that can serve multiple purposes. Here's how you can make the most of it:
1) Track financial actuals against your plan
- Why it's crucial: It offers a reality check. By comparing your actual performance to your projections, you can identify where you're on track and where adjustments might be needed.
- How to do it effectively: Regularly update your financial model with actual figures. This not only keeps the model relevant but also helps in proactive decision-making.
2) Communicate your plans internally (i.e. your team or the board)
- Why it's crucial: Alignment is key in any startup. When everyone understands the financial trajectory and goals, it can boost team morale and ensure everyone is working towards the same objectives.
- How to do it effectively: Use visual aids like graphs and charts to make the data more digestible. Regular financial update meetings can also foster transparency and open communication.
3) Communicate your plans externally (i.e. investors)
- Why it's crucial: Investors want to see not only where your startup currently stands but where it's headed. A robust financial model can build trust and confidence among potential investors or partners.
- How to do it effectively: Tailor the presentation of your financial model to your audience. While some investors may want a deep dive into the numbers, others might prefer a high-level overview. Always be prepared to justify and explain your assumptions.
Remember, the focus of your model might vary based on its purpose, but its foundation should always remain consistent and rooted in reality.
In Conclusion
Mastering your financial model isn't just about playing with numbers; it's about understanding the heartbeat of your startup. From grasping the power of these models to deciphering what truly drives your business, we've walked through the fundamentals that can set the stage for success. But remember, while a financial model is a powerful tool, it's the insights you draw and the actions you take that truly make a difference. As we wrap up this segment, it's clear that finance is an evolving journey for startups, rich with lessons and strategies to be unearthed.