How To Create Successful Financial Models For Startups
Let’s assume you have an idea for a startup that you’re ready to pursue. What’s next? How do you know if this idea will succeed and be able to bring in sustainable revenue and how much money to raise from investors?
This is when having a solid financial model is a vital component for any startup’s success. This is even more important when moving from seed to series A and B as the importance of the financial model to the investors increases.
You think you need an external business consultant or expensive and complex specialist software to construct a financial planning model? No! By no means! With just a little bit of effort, you too can create a sophisticated financial model by using the Excel software that you have on your own computer. This article describes what you need to pay attention to and which Excel template might be a great help and guide.
1.What is a financial model?
In short, a financial model is an abstract mathematical representation of how a company works. Such a model has different inputs, calculations and outputs. The inputs are the assumptions that drive the model (e.g. revenue, costs, capital expenditures, payment terms, tax rates etc.). The outputs are a set of projections and Key Performance Indicators (KPIs) (e.g. profitability, cashflow, balance sheet items, but also funding requirements, break even, customer acquisitions costs, customer lifetime value etc.) that show how your company will perform if the assumptions are true.
A smart, cheap and flexible way to prepare a financial model is to use a spreadsheet tool like Microsoft Excel.
2. Why you need a financial model
Financial models are important not only for calculating funding requirements and raise cash but to help you plan operational activities in the short-term, forecast for the mid- to long-term, and serve as a management decision tool.
By far, the biggest purpose your financial model serves is to help you to understand your cash to really know your burn. It is essential that you know how long your money is going to last and what milestones you are going to be able to achieve with that spend.
3. Skills needed to set up a financial model
Setting up an integrated financial model from scratch can be a challenging task, especially for entrepreneurs with only minimal previous experience in this area and/or without a financial background.
In principle three different skills are mandatory:
- Modeling Standards
With regard to “Finance” it is important to have at least basic knowledge in corporate accounting and finance as well as in financial analysis (understanding and setting up integrated financial statements, making adjustments, calculating ratios etc.)
Modeling is a distinct skill; don’t confuse it with “Excel”, which is just an environment for modeling.There are several international established modeling Standards (e.g. FAST). These standards and conventions provide a comprehensive and detailed set of guidelines relating to every stage of the spreadsheet model development process, but do not limit the customizability of spreadsheet-based analysis in any way. Put simply, these standards explain how to develop best practice Excel models, not what numbers to include. Adopting these conventions increases productivity reduces errors and makes a model easy to understand, review and adapt.
Last but not least basic Excel know-how is necessary. However, this skill is fairly easy to master to a sufficient level. When adopting the aforementioned modeling standards you only need to know the basic arithmetic operations and only some additional Excel formulas.
Having read this, most entrepreneurs without a financial background are inclined to abandon the essential planning task. However, when using the right Excel tool (like e.g. Excel-Financial-Model, see link at the end of this article) all skill areas will be supported and only minimal knowledge is necessary to prepare highly professional and presentable projections.
Tips for financial model creation – Avoid common mistakes
Below we have compiled some tips and best practices for creating a good financial model.
1. Keep it clean and simple and make sure your model is connected
Before you actually start building the model, spend some time and think through the logic of the model’s structure. It should be simple and easy to follow.
Create an instructions tab and show the model structure in a simple graph. Define abbreviations and special terms used in the model. Most important, separate the model inputs and assumptions from the calculations and model outputs. This makes things easier to follow and understand.
Make sure you give enough detail of the main drivers of your business, like revenue (price x volume) and costs (cost x volume, salaries, marketing, etc.). To identify the main drivers of your business you need to understand which variables impact on your profit the most.
Make a connected model that reflects how things might change if you alter certain variables. For example, if you change how many customers you plan for a certain month, you want to be able to directly see how this affects not only revenue but also variable costs, staff requirements and overall cash consequences etc. Make sure the model reflects this. This might sound obvious, but it is amazing how many people forget to link their models correctly to reflect the most important possible changes.
2. Allow flexibility and never ever mix inputs with formulas
According to the aforementioned modeling standard it is crucial that you have a separate format e.g. for cells that will contain inputs/assumptions, so that everybody can identify and easily change these.
According to the modeling guidelines you should include the following key elements:
- State dimensions and labels concisely
- Develop customized style guides
- Worksheets labelled, grouped and color-coded (dependent on content)
- Include integrity checks and control cells
- Use conditional formatting
- Use data grouping and a clear heading hierarchy
- Use line summaries
3.Give insight into your business model
Setting up a financial model forces you to think through all of the variables that affect the potential profitability of your business from staffing and professional service requirements to sales and marketing costs. Your financial model serves as an image of your business model, highlighting its strengths and weaknesses. This insight gives you valuable information that you can use to improve your business model.
As every business is unique there cannot be a “one-size-fits-all” model template. It goes without saying that a manufacturing or distribution business model, for example, has different requirements and KPIs than an online subscription business model.
Thus, if you decide to use an excel template, make sure it fits to your individual business and is openly and easily adaptable.
For example, when developing Excel-Financial-Model, we created different versions to accommodate the various types of business models. All assumptions and calculations as well as key operational and financial metrics are tailored to the specific type of business. In addition, each version offers various generic inputs and provides numerous spare rows to handle your individual requirements.
4. Provide a comprehensive financial picture
We recommend setting up a monthly bottom up planning logic as backbone of the model. However, when it comes to presentation a financial model is big picture thinking. You take all the pieces – revenue, costs, personnel, capital expenditures, funding etc. – and put them together to see the big picture mainly by presenting integrated financial statements (profit and loss statement, cash flow summary and balance sheet). To easily convey the key results, essential data and performance indicators, together with numerous graphs and diagrams should be presented in an investor-friendly, deal-proven way on separate output sheets as quarterly and annual summaries
5. Keep in mind the “gigo” principle – Validate your assumptions
The acronym “gigo” stands for “garbage in – garbage out” signifying that no matter how sophisticated your financial model is, the quality (accuracy, relevance, timeliness, etc) of the information coming out of it cannot be better than the quality of the information that went in. For any small-business owner, the term serves as a warning that the value and accuracy of a financial model created are only as good as the assumptions used to create the model.
Therefore do your research and validate your assumptions thoroughly. Inform yourself about the industry you’re in, and about the economic and competitive environments your business is likely to face in the future. Speak with key customers and consult trade associations’ publications or websites to obtain average performance metrics for your industry. That can also serve as a “reality check” for your assumptions.
Keep in mind that building a financial model isn’t a one-and-done exercise, the ongoing efforts to enhance your model sets up a valuable iterative process in which you are continuously improving your assumptions.
6. Include some scenario tables or “sensitivities”
As mentioned before, the main output of the financial model should definitely be the financial statements, statistics and key KPIs. This is important, not only for your investors, but for the entrepreneurs themselves. Depending on the business show MRR, churn or other relevant performance indicators.
In addition, a top tier financial model also includes a scenario or sensitivity analysis. As we all know, especially in early stage ventures, things hardly ever go to plan as a lot of your assumptions are unproven. Perform some scenarios (e.g. price and volume sensitivities, cost increases etc.) to evaluate the impact of changing key assumptions on your model’s outputs. Once you’ve thought through different scenarios, you will be able to see the cash impact of the variables, and you may rethink your forecasts to make them more realistic
7. Satisfy investors
And yes, a financial model also exists to satisfy potential investors. They want to know that you have thought through all the numbers, understand them intimately, and have clear and realistic financial goals. It also lets potential investors understand why you’re asking for the funds, what they will be used for and how much they can expect to get as a return on their investment in the long run.
Your financial model is so much more than a mere accountings exercise; it’s an opportunity to show, with numbers, the very real potential of your business and to proactively manage your growth. So don’t waste that chance and present your key results in an investor-friendly, convincing and deal-proven way.
By the way, Excel-Financial-Model was conceived and built by an experienced entrepreneur and venture capital investor to meet the most thorough due diligence requirements.
Fig. 3: Extract from the investor summary showing capital requirement, funding as well as detailed sources and uses (Source: www.excel-financial-model.com)
8. Don’t reinvent the wheel – Use a robust and proven template
Unless you spent the first couple of years of your career cutting your teeth inside an investment bank, your best bet is to lean on existing resources for a robust and proven spreadsheet model. Instead you should use the time saved for fine-tuning a professional template so that it perfectly fits to your specific business model and also to validate your input assumptions.
However, while we don’t recommend building your model from scratch, it is necessary that you understand how the model has been constructed and how it works. In case the model chosen is compliant with an international modeling standard (e.g. FAST), this is not a difficult task, even for entrepreneurs with only minimal previous experience in financial planning.
Having more than two decades of experience in startup business and financial modeling we know the challenges, problems, and hiccups especially young entrepreneurs are facing when setting up their own excel model. That is why our developers poured all their heart and soul into Excel-Financial-Model, to create an outstanding, flexible, easy to use but affordable Excel tool.
Convince yourself of our solution and DOWNLOAD free sample
For purchasing the full version of EFM, please follow below links:
Excel-Financial-Model (Classic Economy) : https://order.shareit.com
Excel-Financial-Model (Digital Economy) : https://order.shareit.com
Watch this video to learn more about Excel-Financial-Model.