For start-ups and companies in their infancy a financial model should be much more than a set of operational metrics and financial statements – it’s an opportunity to create a roadmap that explores how your business proposition, marketing, organisational and strategic decisions will impact your financial position, and how likely what you are betting on will pay off. A financial model also isn’t just about the top or bottom-line, but rather it’s an organic set of data that will help you to focus on your processes and market drivers, and test your assumptions on growth, customer acquisition, and pricing.
Pulling together a financial model can be a daunting task, so here are some tips to help you if you’re a company in start-up mode, are in the early years of operation, or want to see how you can take your business to the next level.
Think simple, logical, and defensible
A well-designed financial model has a clear purpose, flows intuitively from input to output, is clearly documented, and is easy to read and use. When drafting your financial model, look at your business as a whole and then modularly. Most importantly, it should be realistic and reasonable, so you can stress test and defend each of your projections, and know what will have an impact on the success or failure of your business.
Don’t isolate the financial model from the rest of your business
It should play a key role in the major discussions you have with internal and external stakeholders, and different pieces of the model will be relevant to different conversations. For example, your revenue growth, cash burn rate, and money in the bank will help to support your hiring plan or even your pricing strategy.
The three G’s
Your financial model should articulate your growth drivers, unit of growth, and growth milestones. Know what drivers (i.e. web conversions, free to paying customers) will have the biggest growth impact. Test your hypotheses to achieve a predictable growth engine – what resource or leads do you need to accomplish each unit of growth? Set sequenced growth milestones, have the resource in place to fulfil the milestones, and share with your team so they live these milestones too.
Five things in your business model to include in your financial model
1) User acquisition: this is a more intelligent metric than revenue. Think user acquisition channels, sizes, and time i.e. returning users, repeat and renewed users, and churn.
2) Revenue projections: test your assumptions on customer types, channels, acquisition costs and revenue models – per month, quarterly and annually. This should help you to see how revenue models compare against business development initiatives and cost of sales.
3) Cash burn and flow: if you know you need an injection of external funds then identify this need based on projected cash shortfalls; and include funding expectations as a line item. Explicitly project when you expect the business to hit run rate and when cash burn is no longer negative.
4) Staffing: People are your most valuable and costly expense, especially in the scaling phase. Roles, salary, and timing must be reflected in your financial model, with built in flexibility.
5) Fixed and variable operating costs: Split out fixed costs that are regardless of revenue and cash generation from costs that can be turned down, off, or accelerated as needed.
Don’t include all possible scenarios but a number of defined ‘what ifs?’
Build a financial model for a defined number of ‘what ifs’ that are your highest priority; like not achieving a targeted price, needing to change sales volume projections, having too aggressive growth projections, of if a customer doesn’t pay on time.
Avoid common mistakes
For example, don’t falsely assume that revenue and sustainability will come with customer scale. Also, don’t focus on point estimates for conversion rates like 5% or 10% but look at a range of estimates to help evaluate your potential results. Apply the Pareto Principle that roughly 80% of the effects come from 20% of the causes i.e. don’t optimise everything in your model, as it won’t yield a more effective result. Additionally, don’t omit sensitivity analysis but rather look at the impact of your key assumptions on their own (univariate analysis) and in tandem with other key assumptions (multivariate analysis). Finally, don’t omit non-financial key metrics as it’s important that stakeholders understand the input drivers underpinning the financial outputs, like customer growth and churn, contract size, pricing and the timing of your sales funnel.
By Ian Brookes, CEO, Cake Invest
