Some Founders don’t love Financial Models. Some say it’s pointless to try to predict revenue in 36 months time, others worry that it will prevent them from running their company flexibly and being able to pivot, if necessary. Many entrepreneurs tend to adjust their forecasts based on what they are trying to prove to their investors, so they end up being too conservative for fear of coming off as “too sales-y” or making the exact opposite mistake.
All of the above are common misconceptions about what a Financial Model should be, and more importantly what it is for. A Financial Model is an instrument to better understand how your company works and what are its growth drivers.
Of course, there are many variables to accurately forecast cash flow and revenue far into the future, and we all know how quickly a business can change when you’re at an early stage.
It’s not a question of predicting revenue and meeting targets, but rather a question of identifying which areas of your business will impact growth and how. Remember: models can always be updated based on changes to your business model, but it’s fundamental to have a snapshot of how your company works financially at a given moment in time.
A Financial Model speaks to an investor (especially a VC with a background in finance) on multiple levels. It’s not just a numerical representation and forecast of how healthy your business is. It shows them your seriousness and honesty about your business’ success. Ideally, your knowledge of a Financial Model reflects how well you understand the relationship between your company and the market.
As I will discuss in later chapters, an investor will want you to provide a confident and rational answer to the questions “How much money do you need?” and “What will you use it for?”. A Financial Model basically tells you how to answer these questions. Hence, preparing a Financial Model is one of the first things you need to do when approaching a Funding Round.
In this guide I will explain what are the main elements and characteristics of a Financial Model that make a good impression on an investor, and the ones you should really focus on.
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When to prepare your Financial Model
Financial Models are based on assumptions about your company and the market.
They and are the main source of error and uncertainty in any forecast. That’s because – by their very nature – assumptions are hard to verify. This is even more true for early-stage businesses, especially those bringing a completely new product to market.
Once you are up and running and you are making revenue, your assumptions about cash-flow and growth are rooted in the evidence and data collected during the development phase of your company.
However, early stage businesses cannot rely this data. Variables such as adoption rate, market penetration and consumer lifetime value are extremely hard to estimate (let alone assume) at the earliest stages.
For all these reasons, angel investors asking to see Financial Model at pre-seed and seed stages often end up being disappointed or having to deal with Models that rely on very fragile assumptions. Ones that usually turn out to be quite unfit for their forecasting purposes.
On the other hand, if you are approaching a Series A+ investment round that is likely to involve VC firms, you will need to present your Financial Model with a comprehensive understanding of the underlying assumptions and how they work. At this stage, the model is a precious instrument to identify what are the drivers for growth and how you can justify your plan to spend any investment.
Key elements of a winning Financial Model
Leaving out the technicalities, which are available in other guides, there are several things your investors will want to see in your Model. It’s important you include them and make sure you fully understand their implications.
As mentioned before, assumptions are the backbone of a Financial Model. All of the formulas, regardless of how correct they can be, will be pointless if they use the wrong data. In order to avoid this you need to make sure that all of your assumptions are corroborated by evidence.
A good example is given by Marc Andreessen in this YouTube interview. In it he says that, as an investor, he likes to see company “doing nose counting”. This simply means talking to someone you know within the industry and asking them how much they would be willing to pay for your product or service. This simple scenario is an example of how investors want to know that your predictions are based on factual information, not on your own opinions. As hard as it can be to make accurate assumptions at an early stage, gathering data about customers (as well as other areas of the business) from the very start can help you massively.
You need to be crystal clear about what your drivers for growth are. In other words, you need to show your investors the levers that will result in faster growth. You can then justify how their money is going to help you pull those levers.
For example, if you are raising your Series A in order to scale your sales team, your Financial Model needs to show that the number of leads qualified by your sales team is the single main driver of incoming business for your company.
It’s not always easy to correlate the numbers in your Financial Model with concrete resources like staff, marketing campaigns or production units. It requires a good sensitivity analysis, but most importantly it requires you to fully understand how the variables within your model are interconnected.
A good VC will always question your Financial Model and ask you to explain the rationale behind formulas. So, make sure you spend enough time with the finance professional who is preparing your spreadsheet (unless you are experienced enough to make your own!) to understand what everything means. A Model is much more than your forecasted revenue!
A good Financial Model is clear about your objectives and milestones for the foreseeable future. That is something your investors will be really interested in, as well as something that will represent the benchmark in all of your future board meetings. For example, If your model assumes a certain monthly growth rate, make sure you identify the KPI responsible for that growth rate and explain to your investor how their funding will help you reach the necessary milestones for that specific KPI.
At the end of the day, the investor wants to know that their money will be used wisely and rationally to achieve clear and set objectives. This is what your Financial Model should help you prove.
Pitfalls to avoid
Doing all of the above should be enough to make a good impression on any VC. But you can never be too careful! There are just a couple of red-flags that you should avoid at all costs in order not to come off as naive (or worse, sloppy) in the eyes of your investors.
Red Flag 1: Don’t over-simplify revenue forecasting with a top-down calculation.
A top-down calculation is one in the typical format: “assuming that the market size is X, by capturing Y percent of our market we will make Z revenues”. This is a very simplistic approach that is extremely hard to justify: “how do you achieve Y percent market share? Why not more? Why not less?” etc.
These are a few of the questions your investors are going to ask and the top-down calculation will be insufficient to give a thorough answer. As the Marc Andreessen example illustrates, an estimate of the customer’s willingness to pay is a better starting point to build a revenue forecast.
With a bottom-up calculation you can estimate your revenue by multiplying the WTP by the initial number of clients, and then project this revenue in the future according to your expected growth rate. This solution also contains uncertain variables, but you will likely be able to justify your estimates for each of them, showing your investors that your plan is well grounded in data.
Red Flag 2: Avoid appearing too confident in your Financial Model.
No matter how accurate the assumptions or how sophisticated the formulas, all Models are exactly that: models. They do not reflect the reality in all aspects and it’s ok to admit that they are inaccurate or, at the very least, uncertain.
Referencing your Model too much in front of an investor, treating 24+ months forecasts as if they were given facts and generally showing that you are overly reliant on it will lead VCs to think that you are underestimating the risks and that you wouldn’t be able to pivot quickly enough if you needed too.
How to present your Model
Be upfront and explicit with your investors about the assumptions and the logic of your model. Show that you know how it works but also be ready to recognise its shortcomings.
A good investor will understand the difficulty in forecasting and will be ready to help you by offering their perspective on your calculations. If you can get them involved in helping you with your Model, you are one step closer to getting an investment as they are already buying into your business with their time!
Don’t forget that this is a test of character as well. Investors evaluate Founders and teams, so it’s important that you use your approach to your Model to show that you are smart yet humble, proactive yet cautious, driven yet down-to-earth.