Financial Modeling for Startup

You’ve heard the stories about companies getting funded. Are you ready or should we say, do you have what it takes to raise capital, update investors and engage your team to get financial backing that you startup may need to disrupt the market?

Why Build A Startup Financial Model?

A financial model is the numerical expression of your startup’s goals - how many customers you’ll have, how many people you’ll hire, how your margins will improve.
The creation of a financial model should tease out the key metrics and assumptions that you will test as you execute your business plan.
The best startup financial models are usually not “right” - but the differences between the projections and the actual results can drive insight into the company’s potential and the targeted industry’s dynamics.
Understanding the difference between your projections and your actual results can also help your team make important business decisions.
The model allows you to “play with the variables” in order to understand how certain decisions might affect the future health of their company.
When building a financial model, a similar philosophy applies.
Before breaking the business into discrete pieces and asking yourself which direction each will go, first look at the business as a whole and understand both what you as an organization are trying to accomplish as well as what the intended use of the model and startup financial projections you are building will be.

Why Investors Care About Your Financial Model?

Having a solid financial model is a significant step in communicating to investors that you are a logical thinker with a defensible plan and clearly understand your business and the levers that drive it.
Basically all financial models are wrong but are very useful – that should not be a reason not to have one, as matter of fact if you don’t have one you have already public declared your startup as part of statistics failure candidates.
In other words, trying to build the perfect financial model should not consume all your initial resources because there is no such thing as perfect financial model.
Nobody expects your model to be perfect, as a matter of fact, when you present a model, the potential investor or backer will always open with the same line: “The only thing we know for sure about this model is that it is wrong. But, if we look critically at it we can better understand the drivers of the business and what we need to be focused on to reduce our risk.”
Keep in mind investors are looking for the big home runs, but they are also looking at reducing their risk, the model can help them get comfortable with the risk.
A well-constructed financial model displays a professional approach to running your business and shows that you “take seriously the fact that you are deploying other people’s capital.”

Financial Modelling Approaches

There are some commonly used financial modelling approaches: Bottom-Up & Top-Down models.

A Bottoms-Up Financial Model – where you start with e.g. 5 – 15 core assumptions about the business – is most useful for a company contemplating a specific product direction, distribution strategy (i.e. invest in paid advertising), or a certain partnership that could potentially have a major impact on the business.
A Top-Down Financial Model - may be most useful for a company who, for example, knows that it will need to go out and Rands X million in a about certain months e.g. 20 months from now and has spent time gathering data on what types of revenue, margins, and growth numbers they need to hit to have a successful fundraise.

Common Financial Projection Mistakes

Assuming that revenue will come with scale - While this has long been a criticism of social networks and consumer apps hoping to monetise a critical mass of eyeballs through advertising, many companies who have revenue models built into their businesses from the start. Falsely assume that revenue, to the extent they need to be sustainable, will happen once they reach x number of users.
Focusing too much on point estimates and not range estimates – Instead of agonising over whether your conversion rate will be 2% or 5%, focus on the possible range or conversion rates and evaluate the results based upon the range of estimates, not the point estimate of 6% or 15%.
Underestimating Customer Acquisition Costs (CAC) – To be an entrepreneur requires great optimism, and a very strong belief in how much customers will love your product. Unfortunately this same attribute can also lead entrepreneurs to believe that customers will beat a path to their door to purchase the product. This frequently causes them to grossly underestimate the cost it will take to acquire customers.
Not doing your homework – There is a tremendous amount of information available, for free, that can help you gauge your performance and benchmark your growth. New businesses need sales and customers as soon as possible, and market research can ensure that those sales and customers don’t stop coming. After you’ve done your market research, it'll be clear to you who you want to reach out to, at what cost(your target customers), where you can reach them, at what cost(your marketing channels), and what they're interested in(revenue power test).

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