Financial modelling best practices or the most common ways to scare the investors off with your numbers
Ask any founder or investor about his opinion concerning start-up financial modelling best practices – the answer will be always the same. Financial models are BS (aka total rubbish). Everyone knows the numbers are made up and will probably bear zero resemblance to real life. The question is – why should we care about them at all?
The answer is pretty simple. While nobody cares about the hockey-stick growth forecast, investors do care about your strategy to drive that growth. The financial model is viewed as a critical step to reduce execution risk – easily the #1 problem with early-stage founders.
Your forecast in this case is not about how good the numbers are – it is about how good your strategy to get to these numbers is. And you should treat your model as an essential tool to prove to the investors your business acumen, understanding of the industry, and ability to execute.
The question is – how do you build a model that can convey all that and secure funding? A good start is to avoid these most common start-up model mistakes.
Half of our newbie clients claim they will have a billion dollars in revenues by Year 5. More timid ones usually settle for $100M. The justification is bulletproof: applying the desired rate of month-on-month growth (aka 20% as most VCs want to see) for the first three years, and then just doubling the revenue numbers from there onwards. While there is nothing wrong with showing the hockey stick growth you do need to be aware that all (and I mean ALL) investors know your projections probably are false – and hence they want to know the story behind those numbers. Which means your financial model needs some thorough thinking around the revenue growth drivers.
What to do about it: Persuade the investor you know where the growth will come from. Are new buyers going to discover your website through ads? Then project ad expenditures and traffic you might get, apply the standard conversion rates, and justify the revenue amount. Are you planning on using email marketing or influencers? Estimate the approximate reach and, again, think about conversions to defend the numbers you have at hand.
The key thing to remember here is that your financial model has little to do with math. What investors want to see is that you have sound financial acumen and a thorough strategy on how to drive growth. Whether or not you hit those targets later – that’s a totally different story.
Everyone wants their business to be profitable. And that’s totally fair. But you do need to understand that balancing growth and profitability is often an impossible task for early-stage start-ups. History shows all the largest and most successful companies took years to reach profitability (7 years for Groupon and 4 years for Zynga). Most are not profitable still (Uber). Why? To expand quickly you need to burn cash really, really fast to outpace other players and satisfy investors’ growth ambitions.
And while projecting profitability is not an issue as such, projecting it at a magical 70%+ in Year 3 (95% of our clients did that at some point in time) is something no investor will buy. Industry benchmarks show that high-performing companies have an EBITDA of 20% after Year 2-4, with SaaS companies reaching 30%. Telling the investor you will earn twice as much will only make him seriously question your sanity.
What to do about it: Take a realistic and honest view of your business. Consider whether you have accounted for all the possible expense categories – hosting, customer support, legal? Have you checked what other companies in your industries are spending? Have you realistically assessed your personnel needs? A good example is sales & marketing expenditure. Most of our clients project it at 10-15% of the revenue in the last forecast year, while established technology companies usually spend at least 30-40% (and 100%+ in the first few years). Do you think you can achieve the same level of growth as the competition with lower budgets? Doubtful.
The financial models we typically see are pretty universal. Honestly, they can be applied to software subscriptions, music start-ups or even toilet seat sales. This is not a problem per se, but be aware that investors will ask for your industry-specific metrics. In SaaS it will be CAC, LTV, MRR or churn; in marketplace businesses, total transaction volume and take rate; in gaming or social networks, daily active vs weekly users; in e-commerce, rate of returns and average value. Not knowing (or not showing) those in a financial model instantly gets across a really bad message: you don’t know your industry and have no clue about how the business operates.
What to do about it: Financial forecast aside (and we’ve already established it is rubbish), what investors really care about is how sustainable your business model is. What is your customer acquisition cost vs what they will pay you? How often will the customer repurchase? These operational metrics are the key to securing the funds. They show you know your customer, you know your market, and you will use the funds wisely. So, if you haven’t already done so, get down to that industry reading and put those most prominent metrics in bold. They are your ticket to a successful round.
Too many founders I’ve met estimate their cash requirements on a tissue based on the magical intuition in their head. I’ve had a client who decided he needed $1M (as it’s a pretty number) and then had a friend recommend he should go for $10M (because why not, the more the merrier). You might already know the end of this story. That guy ended up looking for the investment for 10 months straight before finally sitting down to do a more reliable estimation.
What to do about it: Calculating the amount of funding to raise might be challenging but, in the end, it comes down to two simple variables: a) how much money you really need, and b) how much money investors are willing to give you.
Financial modelling best practices suggest to start with determining how much funding you require for the next 18-24 months. Calculate your CAPEX (one-time expenses) and OPEX (operating expenses such as marketing / personnel etc.). Don’t forget to estimate your working capital. Revenues do not equal cash, and things like accounts receivables or inventory will affect the amount of cash you have at hand, and hence your funding requirements. Once you’ve calculated how much cash you’ll be spending in each given month you’ll have your burn rate and runway numbers.
Why only 18-24 months? Because it is a common understanding that after that period you will raise another round. Also, because investors probably won’t give you more, not at such early stages anyway. Before they commit a considerable amount of funding, they need to verify your ability to execute and hit the determined milestones.
Don’t raise more than you need. Don’t show most of that funding will be used for salaries (or administrative expenses for that matter). Do know your math. If they offer to give you less, you need to know how long it might last, or at least be prepared to defend why that desired sum is what you need to hit the growth barrier.
Somehow there is this widespread myth that the more spreadsheets you have, the more solid your model looks. 10 is good, 15 is better, and 20 is incredible. Add some complicated formulas on top, make sure no one can trace the logic of the model, and voilà, investors will hand you the money.
The reality is a bit different. Most investors lack both the time and motivation to spend hours on understanding where the numbers are coming from. Hence, complicated and messy models are destined for the bin. If you are lucky, your model will get into the hands of an associate, or analyst. He will send you a long list of 40-50 questions, torture you for a few weeks, but the end result will be the same – the bin. The pitch logic applies to the models as well – if you are not able to convey your model in an attractive, clear format, you probably don’t know what you are doing.
What to do about it: The best course of action: don’t overcomplicate your model. Don’t add a thousand different variables – it will make your model vulnerable to mistakes. Avoid hard plugs.
Financial modelling best practices include clearly marking your assumptions / inputs and separating them from the calculations and model outputs. This will make the calculations easy to understand and digest for an outside reader. Your end goal is to build a flexible, and effective model where anyone can audit the drivers and stress-test the assumptions.
There is a beautiful term in finance everyone loves. GIGO – garbage in, garbage out. In simple terms, it means that the financial model created is only as good as the assumptions used to build it. So, get prepared to defend your numbers.
What to do about it: Start researching. Download benchmark studies, google competition, mail industry associations. Ask your customers, or better yet try putting the product in the actual market and test your assumptions. Ask other entrepreneurs about what they see in their businesses. This process may be burdensome, but it can provide a great “reality check” for your strategy and understanding of the business.
Don’t say your projections are conservative because a) they are rarely such, and b) VCs don’t want to see conservative numbers.
Do know how large your market is. While this number does not come up directly in your model, investors will want to check your forecast against the size of your market.
Don’t take “shortcuts” to your projections (such as “we will capture 2% of the market by Year 3”). Always think about your revenue and cost drivers first and create a defendable, granular forecast.
Do try to show the numbers investors will like (10-20%+ MoM growth, 8-12x ROI on investment etc.). But don’t simply plug in these to project growth – rather use them as a sanity check for your assumptions.
Don’t build DCF valuation. Many investors consider it useless at this stage, prone to errors and subject to too much guesswork.
Do research competition – and don’t be arrogant. Don’t try to prove you will grow faster that other companies or spend much less money.
Don’t assume that “word of mouth” and other free / low-cost solutions will be enough to build customer awareness and secure your market share.
Do visualize your data in a way that is simple and easy to understand for investors. Add a nice and catchy dashboard with all the key numbers, graphs, and charts.
Building a solid financial model is no easy task, but it is a rewarding one in the end. Having financial projections you can rely on will be a critical milestone for your team in setting the right KPIs for growth.
At Waveup we specialize in building investor-proof models for seed / Series A+ rounds and would be happy to chat and help you to transform your business vision into hard numbers for your next round. Find out more information on what we offer & pricing here.