When an investor asks a founder to reveal their financial model, they are looking for the best possible attempt to provide a consistent, financial representation of the expected performance of the startup.
It consists of well thought out projections about the future of the business, and a properly structured, understandable, and dynamic spreadsheet with easy-to-read charts.
A high-quality financial model is important to demonstrate to investors that a founder is building an economically sustainable business. It is also a roadmap to keep the business and shareholders updated.
A financial model is a common request often initiated by a prospective investor in the early stages of due diligence. But the process of needing, and then building a financial model is as helpful to the founder as it is the investor. This forces the founder to decide what their plan actually is and forge the path to achieving the milestones necessary for a sustainable business.
A financial model must be aligned with the startup’s plans, clearly displaying the cash and funding requirements to run the business as well as the operating costs. It allows a founder and investor to see when a business will become profitable as well as anticipate and resolve cash flow issue. It is perfectly fine for a business to lose money in the early stages.
A financial model will contain a lot of assumptions, as this is a forward-looking model, where very little is certain. That said, industry metrics and historical performance should be utilised to demonstrate that assumptions are credible. Where a founder is able to research exact costs or expenses, then this should be done with a high degree of accuracy.
All assumptions around growth rates of the business should be spelt out. The financial model will articulate whether expansion of the business is based on the assumption of a bottom up or top-down strategy.
Top-down v bottom-up
The often-optimistic top-down strategy will start by determining size of the market and then plan specific ways of achieving the end goal in a phased approach. Conversely a bottom-up approach is grounded in the business itself and what is needed to get the product or service to market. The bottom-up model considers production capacity, team-specific expenses, and addressable market in order to create a more accurate sales forecast.
The financial model should clearly state these assumptions, giving both the founder and the investor the opportunity to challenge the assumptions made in the plan. If the numbers don’t stack up in the financial model, then the plan needs to change.
The financial model allows founders to generate financial statements that help an investor to understand the health of the business. Profit and loss statements, balance sheets and cash flow statements are all outputs that paint a picture about whether the business is on track to meet its goals.
Having the right information will only serve the founder well if it’s presented in a quality format. This is not an exercise in creativity and in fact a more standard spreadsheet design will be both easier to construct and easier to understand. There is an abundance of resources for spreadsheet design such as “Best Practice Spreadsheet Modelling Standards” from the Spreadsheet Standards Review Board.
A template such as the Standard Startup Financial Model developed by Taylor Davidson has been used by over 15,000 people across the world, from single founders to companies raising large VC rounds.
The financial model should include a clear summary that makes it easy for investors to see key statistics, assumptions, and outputs at a glance.
A robust financial model can also be used in discussions with a wide range of stakeholders. It should be informative enough to assist with hiring plans and detailed enough to enable a business to pivot its distribution strategy. Founders who take the time to challenge their own assumptions and validate their thinking will find themselves with a useful tool that allows them to focus on what is important to success and sustainability of the business.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in bold and visionary tech founders.