Building a startup from the ground requires meticulous planning. Understanding how a rupee comes in and how it is spent is critical for the success of your startup.
Most startups fail because they run out of money. To avoid this pitfall, it is essential to develop a startup financial model.
What is a Startup Financial Model?
A startup financial model is an important component of the business plan for startups. It provides visibility of how the startup’s finances may look in the future and acts as a roadmap for achieving targets.
According to the Corporate Finance Institute “ Financial modeling for startups is a process of forecasting the company’s customers, revenues, employees, expenses, and capital costs into the future to assess the viability of the business.
The process is closely connected to the startup’s business plan and budget, which serve to carefully guide the company in its early years.”
The financial model showcases your business goals. It predicts key numerics such as how many customers you will have, what revenue you will achieve, the number of employees you will hire, what will be your fixed capital, and what will be your working capital requirements?
Most of the data in the startup financial model are projections based on assumptions and guesses. However, the difference between actuals and projections will help you derive insights into your business’s potential.
What is the Importance of a Startup Financial Model?
Financial planning and budgeting are essential for every business, but startups need them for three important purposes –
- Your startup has to be economically viable to achieve success. Preparing a financial model helps to quantify crucial data and validate it to get clear insights into the viability of the business.
- Most of the time, things do not go as planned and that is bad news for startups. However, creating a financial model allows you to assume different scenarios and make projections accordingly. It helps entrepreneurs to be prepared for the worst-case scenario.
- A financial model possesses all the crucial data required by investors to make an informed decision about investing in the startup, so they are crucial for fundraising. Investors (angel investors, venture capitalists, banks or financial institutions) will demand the financial plan when you approach them for capital.
- Financial models provide key performance indicators to track the progress of the startup. It is required to carry out timely assessments on how you are executing the business plan.
- The financial model aids in finalizing hiring plans to suit the overall business performance. You can assess different scenarios on how different headcounts affect your bottom line before you start hiring people for your team.
When Should A Startup Need a Financial Model?
A majority of first-time entrepreneurs think that creating a startup financial model is a waste of time as it is based on assumptions and guesswork. However, building one is crucial for your success.
- An accurate financial model based on tested assumptions is the extension of your brand story. It highlights what your business can achieve and portrays your ambition to the potential investors and stakeholders. It showcases important information such as what is your funding requirement, when do you need it, how will you utilize the funding and the return on investment.
- Preparing a financial model is necessary if you have plans to scale your business. It provides significant insights into your main growth drivers and key performance metrics, which are crucial for the process of scaling up the business.
Types and Approaches
Preparing a startup financial model is easy when you have the numbers in place.
But most entrepreneurs are clueless about where to get the numbers from? There are two approaches to getting data for the financial model.
This approach starts on a macro level and zeros down to the micro-level. While following the top-down forecasting, you take the industry estimates and narrow them down to fit your business. This approach helps to forecast data based on the market share you plan to capture in a fixed timeframe.
The TAM SAM SOM model is one of the popular models in top-down forecasting. TAM refers to the Total Available Market, SAM refers to the Serviceable Available Market, and SOM refers to Serviceable Obtainable Market. In this model, we start from the industry data and zero-in to the company based on the market share we wish to capture in a set time.
In the bottom-up approach, one starts at the micro-level, that is, the current financial statements and sales figures. When using this approach, you have to choose the lowest point of your business to project data for future scenarios. For startups, this model involves making 5 to 15 assumptions about the business and making forecasts based on the assumptions.
Types of Financial Models
There are different types of financial models. Some of them are
- Three-statement financial model
- Merger &Acquisition (M&A) model
- Forecasting model
- Discounted cash flow model
- Comparable company analysis
- Assets and liability management (ALM) model
- Sum-of-the-parts model
- Capital budgeting model
- IPO model
- Leveraged buyout (LBO) model
- Option pricing model
Components to Include in a Financial Model
The financial model of an organization varies based on its industry, size and stage. The financial model of a Saas company will vary from that of an eCommerce company.
However, certain components are common for every business and must be included in every financial model.
Financial Statements – A good startup financial model should consist of three financial statements – the profit and loss statement, balance sheet and the cash flow statement.
Financial statements are an accepted way of communicating financial information to banks, investors and other stakeholders.
- Profit and Loss statement – The P&L or the profit and loss statement showcases all your income and expenditure for a specific period. It predicts key metrics such as gross margin, net margin, and earnings before income, taxes, depreciation, and amortization. (EBITDA). The profit and loss statement shows the operational efficiency of a company and allows investors to compare performance across different periods and the industry.
- Balance Sheet – The balance sheet showcases the assets and liabilities of a business at a specific point in time. The liabilities section of the balance sheet shows how a company has financed itself using various tools such as shares, debt, etc. On the other hand, the assets section of the balance sheet highlights how the fund has been utilized to acquire different assets for the business.
- Cash Flow Statement – As the name implies the cash flow statement showcases the cash coming in and going out of the business during a specific time frame. The cash flow statement consists of three sections – operational cash flow, investment cash flow and financial cash flow. Operational cash flow is the cash flow due to the core operations of the business, investment cash flow refers to the cash inflow and outflow for investment purposes, and financial outflow showcases cash flows due to financing activities such as raising capital, paying dividends, interests, etc.
To arrive at the financial statements, every financial model should include the following components.
- Revenue Forecasts – A forecast of the revenue for a specific period (coming months or years). Startups can use the top-down approach to predict future revenues as they do not have any previous data to project revenue. You must also take a close look at different revenue streams, your products and plans for acquiring customers before calculating revenue forecasts.
- Operating Expenses – The forecast of the ongoing expenses to run the business. These expenses can include rent, wages, payroll, taxes, sales & marketing costs, R&D costs, etc.
- Capital Expenditure Forecast – Capital expenditure is the fund invested in acquiring assets for the company, such as machinery and building.
- Cost of Sales or Cost of Goods Sold Forecast – It is the prediction of the amount you will spend to sell your products. It may include the cost of manufacturing, cost of providing service, cost of customer support and costs of any third party services you might use to make the sale.
- Working Capital Forecast – Working capital is the fund needed to take care of the daily operations of a business. Working capital forecast showcases a company’s short-term financial health and operating efficiency. Before you calculate the working capital forecast, you have to consider the revenue targets and cash flow projections for the specific period. This will help you identify the timing of your cash inflows and outflows to have a clear picture of the working capital requirements. Working capital is calculated based on the cost of goods sold, revenue earned and the number of days outstanding for your sales, revenue and inventory.
How to Build a Financial Model for Startups?
Here is a step-by-step guide to building a financial model for your start-up.
- Define the Goal for Creating the Model – The first step is to determine your goals for creating the financial model. This helps you to choose the right model. Some examples can be fundraising, market sizing, or a detailed cash flow for strategic decision making.
- Define Your KPIs – Defining Key Performance Indicators (KPIs) is crucial while building a financial model for startups. KPIs are the detailed numerical factors or assumptions that you can track. Defining KPIs allows comparing the projections and actuals after a specified time to analyze your performance.
- Get a Financial Model Template – You can build a startup financial model on excel or Google sheets or use the templates available on the internet.
- Start With Revenue Estimates – Estimate the revenues first, also pay closer attention to what will help you achieve the projected revenues. For example, the marketing spending, sales personnel or advertising required to achieve the revenue. Also, consider the costs of goods sold while projecting the revenue.
- Estimate Hiring requirements – Wages and payrolls are one of the highest expenses for a startup. Businesses need people to expand and grow. Consider how many people you will need and the costs to hire them.
- Estimate Other Expenses – There are several expenses that you must incur to take care of the day-to-day operations of the company. These expenses include rent, maintenance, office expenses, printing and stationery, etc. You can see how other businesses in your industry are calculating the expenses and use them for your model.
- Estimate Working Capital Requirements -Working capital is essential to keep your business afloat. It helps to manage short-time fund requirements and estimate the gap between receivables and payables.
- Review the Model – Once you input all the components, it will be easy to get the three financial statements required for your model. Review the model once it is complete. Is the model projecting the story of your startup as you envisioned or is it just wild guesses promising unachievable returns?
The startup financial model is essential to get insights into the expenses and earnings of the company under different scenarios.
These models are used by banks, investors and other stakeholders to estimate the valuations of a business and compare their performance to other businesses in the industry.
There are two approaches to gathering data for financial models – the top-down approach and the bottom-up approach.
There are 11 types of financial models that can be used according to the goal of preparing the model, industry, size of the business.
Financial models are prepared by considering five basic components-revenue, cost of goods sold, capital expenditure, operating expenses and working capital.
It is always recommended to review your financial model to ensure that it conveys your business story to the investors.
Let us know if we missed out on anything in this article How to build a Startup Financial Model and share your thoughts in the comment section.