Six Ways to Sharpen Your Startup’s Financial Model
As 2023 dawns, it’s time for founders to do some business model housekeeping. Have you designed your financial models such that they serve up accurate projections, so that you can run a healthy business and attract top partners? Now is a perfect moment to take stock and make adjustments as needed.
Advice in one sentence:
Early investors don’t look at financial models to get an accurate projection of revenue; they look at it to understand how the founder thinks about their business.
Advice in one tweet:
Financial projections are not about being right, but rather the exercise of building the model, diving into the weeds of your business & being thoughtful about what drives potential success/failure. Doing this very fundamental work makes you a better #entrepreneur. #StartUpLife
Advice in one checklist (more details below):
- Build a financial model even if you’re pre-revenue.
- Assume investors will unhide every tab in your model and read it. Better yet, don’t have any hidden tabs.
- Have a separate tab for your assumptions and a separate tab for a dashboard of KPIs over time. Also, try to hardcode as little as possible and have the projections be formula driven.
- Avoid perpetual growth rates (we wish this was true but it never is) and static margins. Growth and margins in good projections are the results of the assumptions that drive them, not the driver themselves.
- Make sure the KPIs make sense for your business model (SaaS, Marketplace, Lending, Consumer, etc).
- Don’t have “conservative” projections (less true in the later-stage companies).
Advice in one blog post:
“Forecasts usually tell us more of the forecaster than of the future.”
— Warren Buffett
If you were to ask hundreds of founders or investors about the accuracy of projections, I am betting 99% would say they were totally inaccurate. So why build models?
As a naive analyst in the earliest days of my career, I came across what seemed like a curious observation. Almost every company we decided to take through our diligence process conveniently ended their last year’s projection with approximately $100M in revenue in their financial model. I thought it was absurd to think that all these different companies each in different markets selling different products could all have nearly the same growth trajectory if they were all fixed in a single point in time. After prodding a mentor of mine about this, I learned that I was looking at the financial model with the wrong goal. $100M is an arbitrary milestone much like a $1B valuation as a unicorn. I made the mistake of thinking that my role from the seat of the VC is to look at a forecast and decide, much like a public market analyst, whether the company is going to miss, meet, or exceed their financial targets. While this is true to a small degree, it leaves out the most use for a financial model in my opinion which is assessing the founders rigor and thought process.
A financial projection at the early stages of a company is not merely a financial forecast but a model for how the business works. It serves as a numerical story much like a product roadmap. It has a story arc where your sources and uses of investor funds are deployed based on a founder’s assumptions that lead to growth and profitability, which in turn result in exits and investor returns. It’s a financial representation of your product market fit, how you plan to scale and the inflection points in your value creation journey.
A financial model should be seen as the numeric complement to a pitch deck. Much like a good pitch deck, a good financial model will include many of the key aspects of a pitch deck such as TAM, traction, market penetration, headcount, fundraising goals, and competitive landscape. In fact, a lot of that investor deck or management presentation comes straight from the financial model.
While it’s not disclosed, I think the reality is that $100M in revenue is the starting point for many models rather than what you end up with after taking into account all the assumptions. It’s not really a bad thing but I think both founders and VCs could stand to be more intellectually honest about what’s happening here.
When should you have a financial model?
Investors generally organize their perspectives on whether a company needs a financial model by stage and founders will often hear varying advice as to whether they need one or not. The conventional wisdom is the earlier in stage a company is, the less important a financial model becomes. Some will say before the Series A; others may say as soon as the company becomes revenue generating. There’s nothing wrong with these approaches but at the end of the day, these milestones are almost as arbitrary as $100M revenue or unicorn status. My advice is simply: the earlier the better.
How to build a financial model?
I’ll comment on some tactical tips below on what I’ve observed but I think that the VC community has enjoyed hearing itself speak ad nauseam on this topic so here are a few great resources I’ve personally used that are very good. All these I’ve personally used and in some cases even spent my own money on:
- https://www.youtube.com/c/EricAndrews1
- https://foresight.is/
- https://www.startupsos.com/
- https://www.youtube.com/c/Slidebean
Tactical Advice:
1. Make a financial model before you think you need one.
It’s certainly true that many investors, especially at the pre-seed/seed stage, won’t even open your financial model. That said, I personally wouldn’t start a company without one because it requires me to think through all aspects of the business and allows you to convey the journey of the company. Founders with well built models are seldomly taken aback by questions raised by VCs about their metrics and business models. The best founders will often have a savant-like recollection of where the company is on its most important metrics and what it takes to reach anticipated growth. It provides a framework to operate against and challenges the founder’s assumptions and prods them to iterate.
2. Assume investors will unhide every tab in your model and read it. Better yet, don’t have any hidden tabs.
As an analyst looking through a financial model, my first step as a matter of practice is to unhide every tab in Excel. It seems like a small thing but it’s amazing the things you might find in these hidden tabs. I’ve come across sensitive personal info which looks bad on founders but multiple times I’ve come across the “real” projections rather than the ones on the primary tab on the model.
3. Have a separate tab for your assumptions and a separate tab for a dashboard of KPIs over time.
The drivers of a financial model should be easy to understand for someone looking at it so separate all your assumptions in a separate tab. For example, if your revenue growth is driven by the size and efficiency of the sales team, on the assumption tab I should clearly be able to see how headcount of AE/SDRs change over time and the amount of ACV each rep is closing on periodically. If growth is driven by marketing spend, there should be a clear funnel of how marketing spend translates to revenue and how this changes over time.
4. Avoid perpetual growth rates (we wish this was true but it never is) and static margins.
Investors may say they want X% MRR growth per month but that shouldn’t lead founders to having that be the driving assumption in their model. Growth rates need to be contextualized. In line with my advice above in point 3, think about how much of the market is up for grabs and work through how much of that your resources get you. From there, you’ll be able to neatly convey how a dollar of investment leads to marginal growth.
5. Make sure the KPIs make sense for your business model (SaaS, Marketplace, Lending, Consumer, AdTech, etc).
Before building a model, or even starting a company for that matter, consider what your revenue model will be. VCs have different methods for evaluating and benchmarking companies based on their revenue models. In fact, some venture firms like Craft Ventures only invest in certain revenue models as a foundational part of their thesis. For example, SaaS investors will want to see the breakdown of net dollar retention, gross margin, and LTV, and customer acquisition cost.. Similarly for marketplace companies, investors will focus on GMV, take-rate, retention rates, etc. Nailing down these metrics and having goals to execute against early signals competency to investors.
6. Don’t have “conservative” projections (VCs know the game they’re playing).
At the early stages, we understand how binary the outcomes generally are for us as investors. I recommend not adjusting the numbers for ‘what could go wrong’ but tell the story of ‘what can go right’ (while being grounded)! When we’re reviewing financial models, we’ll apply our own ‘grains of salt’ to the financial models when we convey our thesis to the investment committee. Along with point 4, this is more true in the early stages and less true in the later stages where scenario modeling becomes more useful and the company has more data to work with. Scenarios allow you to ask the “what if” questions about your business and think through the possibilities. What if we raised $2M instead of $5M? What if we hired five sales people instead of three? What if the market gets competitive and there is pricing pressure? A good financial model can help you answer these questions and more and enable you to give thoughtful answers to investors, showing you are a founder worth investing in.
The flipside of “build your business model early” is “it’s never too late to sharpen your model.” If you don’t have the skills to build a solid model, make the investment in someone who can translate your business into a great projection. It is worth it! So take this time as the year emerges to do a bit of financial model housekeeping so that you can make accurate predictions, avoid unnecessary slowdowns, and achieve your health moonshot faster.
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