It’s important to distinguish between financial planning and forecasting linkage. A financial plan usually is an undated firm-specific budget and might be used as a control device. Forecasting would typically involve a set of financial projections linked to proposed and/or anticipated activity. The difference is subtle, and I often use the term financial plan to describe the entirety of a financial model. That is probably a reflection of many years spent in cost planning roles, but it still holds true for start-up and young companies. During this time, the financial plan might well be the only modeled view of the future, but older and more established companies whose financial plans may have become overly rigid should still understand and employ the concept of a framework with specific forecast scenarios.
Regardless of the scope of the model, the financial theory behind it is a core driver of the model results. This is stating the obvious, hopefully, but how many times have we used a simple rule of thumb when a decision that feels financial should have been made based on more solid financial information? A solid financial model will help test the viability of a decision.
Financial models are a tool that can be used to project the future for a business. Depending on the purpose of the model, the level of complexity can vary widely. For instance, a financial model can be used to forecast the expected financial performance of a mature company while a business plan is being developed. At the other end of the spectrum, a start-up business might develop a very high-level financial model to help raise a new venture round of financing. In this case, the model might consist of a series of simple decision rules.
1.1. Importance of a solid financial model
A good financial model can help you determine whether your business will be viable, predict and plan for the future, and play with various assumptions to see how they will affect your business. The bank and investors will want to see how their money is going to be spent and that it will be spent effectively to create more sales. If you can show that you have a well thought out plan (or at least show that you have the ability to plan), you are far more likely to be taken seriously. A financial model is a good way for you (and for potential investors) to see how your business is going to work. A clear map of what you think will happen in the business process and what you want to achieve is a useful tool for understanding your business. Your business will always stray off the course you have set for it, and you will always need to adapt your plans and assumptions, and a financial model is a good way to do this.
As a startup consultant, I aid my clients in M&A advisory, fundraising strategy, pitch presentations, financial modeling, valuation analysis, and more. I have witnessed firsthand the challenges startup founders face when they don’t follow one simple rule: Consider your financial models from an investor’s perspective.
Why You Should Avoid Financial Model Templates for Startups
When it comes to preparing financial models for your startup, using a professionally designed template might seem like a convenient option, especially if you lack financial expertise. However, templates often fall short of expectations. They may have sections that don’t apply to your business or contain embedded formulas that are hard to adjust.
Starting from scratch, although requiring more effort upfront, yields more tailored and professional results. In this article, I discuss how I’ve assisted founders in creating investor-ready financial models from the ground up, along with tips on using these models to craft compelling pitches.
Focus on Key Performance Indicators (KPIs)
When building your financial model, strike a balance between providing essential information about your startup’s financial health and avoiding overwhelming investors with excessive detail. Focus on key performance indicators (KPIs) that showcase your startup’s progress and potential.
Begin by gaining a deep understanding of your business model and industry dynamics. Identify specific metrics that investors would prioritize based on your startup’s objectives. For example, a SaaS startup might emphasize metrics like monthly recurring revenue (MRR) and customer acquisition cost (CAC), while a retail business might focus on average transaction value and inventory turnover.
Highlight these KPIs prominently in your financial model using charts, graphs, or dedicated dashboards to ensure they are easily understandable by investors. This approach helped one e-commerce startup I worked with secure funding by presenting key metrics in a clear and compelling manner.
Integrate Your Cap Table
To provide a comprehensive view of your startup’s financial and ownership structures, include the capitalization (cap) table in your financial model. The cap table outlines founder equity, investor shares, employee stock options, convertible securities, and potential dilution scenarios.
Maintaining consistency between your financial model and cap table enhances transparency and clarity for investors.
Create a Sense of Urgency
A robust financial model can underscore time-sensitive opportunities and market trends that could accelerate your startup’s growth. For instance, highlight potential revenue from a limited-time government initiative or the consequences of delaying funding in a competitive landscape.
By leveraging your financial model to demonstrate urgency and the potential for rapid growth, you can persuade investors to act swiftly to capitalize on these opportunities.
Optimizing Your Financial Model for Clarity and Impact
Now that you’ve identified what to include, it’s time to build your model. While thoroughness is essential, smart design is equally important. A well-designed financial model should be as easy to navigate as a well-organized filing cabinet. Here’s how to do it:
- Organize by Tabs: Divide major components of your financial data into separate tabs. Typically, include tabs for assumptions, income statements, balance sheets, and cash flow statements. You might also add tabs for scenario planning and your cap table.
- Avoid Overcrowding: Instead of creating a new tab for each view or analysis, use a single tab for each statement or topic. Adjust variables to toggle between different views.
- Use Clear Differentiation: Employ prominent headings and subheadings to divide sections. Use bold text for headings, different font colors for assumptions, inputs, and outputs, and italics for comments or notes. Lines and background colors can further differentiate tables, dashboards, and other information chunks.
- Maintain Consistency: Apply consistent formatting and styling throughout the model. Ensure uniformity in headers, subheads, inputs, and outputs. This consistency enhances the model’s clarity and coherence.
- Incorporate Visual Aids: Develop clear charts, graphs, or tables that visually represent key aspects of your financial model. These visualizations help investors quickly grasp vital information and make your presentation more engaging.
Formatting may seem superficial compared to your business idea, but it significantly impacts the model’s impact. Consider a real-life example: a SaaS company struggling with a complex financial model that obscured its potential. By applying consistent formatting and organization, the model became more accessible to both founders and investors. As a result, the startup secured the funding it needed.
Testing and Iteration
A robust, well-tested financial model not only demonstrates your business understanding but also enhances credibility. Ensure accuracy and effectiveness by following these steps:
- Validate Assumptions and Calculations: Base assumptions and inputs on solid data and market research. Validate calculations to ensure accuracy and logical consistency.
- Conduct Sensitivity Analysis: Stress-test your model by altering key variables and assumptions. This exercise helps identify potential risks and uncertainties associated with your business.
- Seek Feedback: Share your model with experienced professionals for constructive feedback. Incorporate suggestions to improve weaknesses or inconsistencies.
- Regular Updates: Keep your model current with new data and market changes. Regular updates showcase your commitment to managing your startup’s financial health.
Preparing for Investor Questions
Investors prioritize the reasonableness of numbers and your comprehension of business dynamics. Prepare to address inquiries effectively:
- Understand Assumptions: Explain the origins of your assumptions based on industry research and trends.
- Clarify Methodology: Detail how you arrived at your financial numbers to build trust and credibility.
- Research Thoroughly: Use reputable sources to support your assumptions and projections.
- Anticipate Questions: Prepare responses to common queries related to your business model, scalability, and growth strategy.
Refreshing and organizing your financial model can significantly impact investor perception. A well-formatted model facilitates decision-making and enhances your ability to secure vital investments for business growth and success.