Mastering the Financial Model for Startup Funding Success
As an ambitious entrepreneur, you’ve nurtured an innovative concept and transformed it into a budding startup. Business is going well until you reach that critical juncture where you need additional funding to take flight and thrive.
As you start courting investors and discussing your success, you notice a similar pattern: the conversations seem to stall and fall short of funding as soon as they dive into the financials.
If this scenario sounds all too familiar, you may be relying too much on your pitch deck alone to do the work. When courting institutional investors, you’ll need a strong financial model to demonstrate the viability and potential of the business.
What Is a Financial Model?
The simplest way to describe a financial model is to think of a spreadsheet that tells your historic and future business story in numbers. It answers some key questions, such as how much cash you're going to burn before you start to make money, how fast you think you'll grow, and all of the costs associated with expanding your business.
To demonstrate this effectively, your financial model will be based on future-looking projections called assumptions. To generate these assumptions, you’ll ask a number of questions, such as:
- How many leads will I generate?
- How many of these leads will I convert?
- How big will the average order be?
- What is my average overhead cost per pound of revenue?
To answer these questions, the most effective route is to extract real data on actual performance of the business to date. For example, ideally you’ll have data on marketing spend, how many leads result and convert from those efforts, as well as the average spend per customer. Based on the historical data, you can extrapolate for future growth, determining what happens to each of those drivers as the business expands.
What Investors Want to See in a Financial Model
As investors review your financial model, they’re looking for clues about your startup’s potential. One of the first things they will want to see is how you plan to make money. For instance, a technology company may start by selling consultancy projects, but plan to move into data sales before expanding into the sale of software packages.
Next, investors will want to understand your ambition and how big you plan to grow. They’re looking to see if your goals and objectives align with the returns they need to make. For instance, an institutional investor will need to demonstrate to its limited partners (it’s own investors) that your business has the potential to meet the return levels required by them.
However, it’s also important that you’re demonstrating a realistic picture of the future. Stating that you plan to reach a revenue goal of $1 trillion in 5 years may sound impressive, but it’s probably unrealistic. Since investors are likely to demand explanations when projected targets are unmet, be certain you’re balancing an ambitious sell against the reality of your financial data.
Tips for Creating a Financial Model
As you create your financial model, remember that you are also selling investors on your business, so packaging might be as important as the information you include. Neatly organize your spreadsheets and follow these tips to employ a best practice approach:
- Make certain your assumptions are simple to find and understand by using clear headings and highlighting key figures.
- Color code cells to delineate ‘hardcoded’ data from calculations.
- Use charts or graphs on the dashboard to make it easier to visualize data on KPIs (Key Performance Indicators) like revenue growth or cash flow.
- Limit tabs within your Excel sheet to 5 or 6, including those for an introduction or overview, assumptions, calculations, monthly financial statements and annual financial statements.
Your financial model reflects the competence of the founding team and how quickly and neatly you present it to investors reflects the competitiveness of the deal. The assumptions in your plan, the way you forecast growth, and how you intend to manage costs all tell a story about your team's expertise and savvy. As such, the act of simply having a tight financial model will put you ahead of your competition.
In the end, your financial model should showcase a clear path to profitability and growth. Putting in the time and effort required to get it right will enhance your credibility with investors and put your business on a stronger course toward funding success.
FAQs
All the answers you need for all the questions you’ve got.
(But also TL;DR)
How should a startup business prepare its budget?
To prepare a budget for your startup, begin by listing all potential expenses you anticipate in starting and operating your business. Next, organise these expenses into categories. After that, estimate your monthly revenue and calculate the total costs required to start and run your business.
What are the key steps to creating an effective budget?
Step 1: Determine and track your income sources.
Step 2: Make a list of your cost. Include both fixed and variable costs.
Step 3: Set achievable financial goals.
Step 4: Develop a plan to meet those goals.
Step 5: Put everything together to build your budget.
Step 6: Regularly review and revise your forecast to ensure it remains effective.
What does capital budgeting entail for a startup?
Capital budgeting for a startup involves allocating a set amount of funds for specific purposes, such as purchasing new equipment or expanding business operations. This process is crucial as it supports making strategic investments that are expected to yield long-term benefits for the startup.
FAQs
All the answers you need for all the questions you’ve got.
(But also TL;DR)
How can a startup forecast its cash flow?
To forecast cash flow for a startup, follow these steps:
Step 1: Create a sales forecast by estimating the revenue your products or services will generate over the forecast period.
Step 2: Develop a profit and loss forecast to understand your expected expenses and income.
Step 3: Prepare your cash flow forecast, which involves calculating expected cash inflows and outflows. This can often be done for longer-term by using assumptions around payment terms to forecast a Balance Sheet, and using the movements in Balance Sheet and Net Profit/Loss to calculate the cashflow.
Step 4: Consider ways of improving cash flow by improving your invoicing methods, considering short-term borrowing, and negotiate better payment terms to manage cash flow effectively.
What is the most accurate method to forecast cash flow?
The most accurate method for forecasting cash flow in the short-term is the direct method, which utilises actual cash flow data. In contrast, the indirect method is better suited for longer term forecasting using projected balance sheet movements and income statements to estimate future cash flows.
How is cash flow calculated?
Cash flow is calculated by deducting cash outflows from cash inflows over a specific period. This calculation alongside forecasts of future cash flow helps determine if there is sufficient money available to sustain business.
How do you project cash flow over three years?
To project cash flow over a three-year period, undertake the following steps:
Step 1: Collect historical financial data.
Step 2: Identify all expected cash inflows, which could include revenue, investment, grant income, etc.
Step 3: Estimate all anticipated cash outflows including expenses, suppliers that need to be paid, investments into assets, debt repayments, etc.
Step 4: Calculate the net cash flow by subtracting outflows from inflows.
Step 5: Consider your cash reserves and explore financing options if needed.
Step 6: Regularly review and adjust your projections to ensure accuracy and relevance.
FAQs
All the answers you need for all the questions you’ve got.
(But also TL;DR)
When should a startup consider hiring a CFO?
A startup should think about hiring a Chief Financial Officer (CFO) when it begins to experience rapid growth, finds it challenging to manage finances, or needs to navigate complex investment scenarios. A seasoned financial professional can provide the necessary expertise to handle these challenges effectively.
What are the indicators that my business might need CFO support?
You might need to hire a CFO or consider outsourcing this role if you notice any of the following signs: a decrease in gross profit margins despite increasing revenue, uncontrolled business growth, lack of cash reserves despite having a financially successful year, or a halt in business growth.
Does my startup really need a full-time CFO?
Recruiting a full-time CFO is an expensive hire. Given budget constraints and the need to prove the viability of your business idea, founders will often need to prioritise investing into building and commercialising their product. That's where CFO services for startups are a cost-effective solution for founders looking to take their financial management to the next level.
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