Sudhanshu Malani | June 25, 2015

How startups can build Financial Models

Talk to any entrepreneur about the products they are building to solve problems, and their eyes light up. But ask them about the financial side of the business and their reaction suddenly changes. Obviously, it’s more fun to build a product than to work on numbers that don’t even make sense!

But this is not entirely true. Building financial model is a valuable exercise. The numbers might still not matter, but the underlying logic behind building the financial model certainly does. The financial model is a means to quantify the entire business model and to convey the story behind the business. It also helps to build overall strategy in the short-term and then forecast for mid- to long-term. It also defines the fundraising goals in terms of when and how much money needs to be raised to ensure smooth running of the business. As early stage startups go through a lot of uncertainties while developing their business models, they should focus on monthly cash flows with a rough estimate of yearly forecast. Financial models can be used to track monthly performance against the planned KPIs to inform operational activities.

Entrepreneurs generally stick to a template publically available while building their financial models. This, at times, restricts their thinking and doesn’t capture all the aspects of the business model. Ideally, a financial model needs to be built from scratch. Here are some pointers:

Input all the assumptions
It is very important to enter realistic assumptions in the model. The best way to get realistic assumptions is to gather insights from actual users and customers. The more you go out and interact with the customers, the more accurate these assumptions get. You may also refer to the actual data from other comparable companies.

Forecasting revenues
Sometimes entrepreneurs adopt a ‘top down’ approach to forecast revenue by assuming a certain percentage of total market in certain time. This is often unrealistic in case of early-stage enterprises. Another approach of forecasting revenue is to assume a fixed annual growth in the historical revenue. While this approach works for more mature companies in steady state, it is still not realistic for early-stage startups. In early years of a company, it is advisable to build a realistic hiring plan and assume sales target per resource to forecast the revenues.

Estimating costs
Entrepreneurs often underestimate the costs as they don’t think through the human resource requirement in early days. In addition to cost of goods sold, marketing and sales budget, and operational and capital expenditure, it is very important to build an extensive hiring plan and estimating the costs according to the qualifications and job role.

Mind the ‘macroeconomics’
While forecasting revenues based on drivers or estimating costs it is important to keep in mind the bigger picture. While it’s exciting to see the revenue numbers going up year on year, you would need to check if there is enough market to reach those numbers.

Create scenarios and sensitivities
While listing down the assumptions and drivers for revenue growth, it is beneficial to include a range to cover the best, worst and expected scenarios. It would be interesting to see what impacts your profits the most.

Calculate cash burn
Lastly, it is very important to keep a track of cash burn and months of runway for an early stage company. You should capture the inflow and outflow of cash and monitor it regularly in order to avoid the risk of running out of cash.