Sep 04 2007
The Truth about Financial Models
“I don’t know what my business will look like three months from now let alone three years!”
Every entrepreneur hates the dreaded financial model. Just the thought creating one can cause heartburn, fatigue and endless discussion about the unnecessary burden put on entrepreneurs in order to raise money. Less-experienced entrepreneurs often will try to dodge financial modeling with claims that “our market is so big, you don’t need a model to convince yourself we have a great business” or “I’m too busy running a business to spend any time building spreadsheets”. But the reality is that if you’re going to raise money, you’ll need to build a detailed three to five year financial model. The surprising news is that the exercise of building a model will help you better understand your business and make you a better entrepreneur.
Some of the reasons that investors require a financial model are obvious. They want to see how big a business is possible, potential margins and cash flow, and the long term funding requirements to project how much additional cash may have to go into the company. The model will give them a starting point on how they should think about valuing your business. Equally as important, however, is that they want to see how you, the entrepreneur, think about your own business. Your financial model will be a detailed discussion guide to walk potential investors through the intricacies of the business. Investors will want to see how you’ve thought about growing your revenue base. Does it grow as a step function or along a smooth growth curve? How does pricing change over time? What is the impact of competitors in the market? They’ll have you walk through customer acquisition methodology, using the model as a backdrop on how you think about marketing to your customer base. They’ll want to see a detailed hiring plan and how you think about staffing the company to support your projected growth. And so on…
The financial model walk-through is often the center of the fundraising process. At the end of the discussion, the potential investor has probably made up his/her mind on whether you have a fundable business and whether you, as an entrepreneur, are qualified to take the company through its next phase of growth.
When presenting to investors, you won’t need to show the entire financial model in your first or even your second meeting. Rather, your pitch deck will have a top-line summary of the model with an emphasis on revenues, profit margins, and cash requirements. I usually present the summary as a table, showing quarterly projections for the first 24 months, with year three summarized in a single column. Potential investors will examine this slide to see if it looks directionally correct and that you have taken the time to build a supporting model. They’ll typically ask to see the backup at a future meeting.
The outcome of all this work isn’t just a satisfied investor. You will walk away with a much better understanding of your business and quite possibly awareness of key decisions that need to be made immediately if you are going to hit your numbers. For example, if you want to be on track to drive $1 million in revenue in 2008, you realize that you’ll have to have your beta customers up and running by Q4 2007. Your focus may quickly change to get beta technology live and initial customers signed up. You’ll also learn much more about the key drivers in your business: how quickly does a new salesperson need to become productive to hit his quota numbers? upon which assumptions is the model most sensitive (e.g. is pricing really important or not that important)? The financial model can also help you set objective and quantifiable goals for the entire company. Nothing motivates a team like a set of specific and crystal clear objectives.
A few final thoughts:
- While it may sound counter-intuitive, it is better to be too conservative rather than too aggressive. If there is one thing that turns investors off it is “hockey stick” projections that they simply cannot believe. One way to test how reasonable your model is is to look at the growth of other companies you can research: What’s the strongest performance that’s ever been achieved in a related company? What are the average sales per year / per employee for other companies in your market? What is the best EBITDA margin of potential competitors? If you feel you will set new records with your performance you should be prepared to deal with skeptical investors.
- Take the time to build the model yourself. Handing it off to a friend or team member may ensure that a model gets built, but you’re doing yourself a disservice by not understanding every assumption upon which it is built. Your lack of understanding will come out in the investor conversations and more importantly, in how you run the business.
- There are a lot of ways to build a financial model - we suggest you start with a template. Recently, Guy Kowasak posted a good example model for an early stage company; you can download that model at his site.
June 23rd, 2008 at 12:21 am
Could’nt agree more with the thoughts expressed in this article on the importance of a financial model in instilling discipline in a start up business plan.
I manage a Financial Modeling site that imparts tips & advice on how to build and analyze financial models:
http://www.financialmodelingguide.com/
A vibrant community that shares financial model templates for peer review, as well as answers related questions (think of it as a Linkedin Answers lite for Financial Modeling & Analysis) has also grown rapidly around the site.
The Financial Modeling Community is currently 2,600 strong - surprising that such a niche topic would find such an audience - with a good many entrepeneurs and small business owners seeking guidance and financial model templates for their startup business plan.
I would be very appreciative for either a link back from the Momentum Blog or just for this comment to be approved:
Many thanks!
June 23rd, 2008 at 12:26 am
Could’nt agree more with the thoughts expressed in this article on the importance of a financial model in instilling discipline in a start up business plan.
I manage a Financial Modeling site that imparts tips & advice on how to build and analyze financial models:
http://www.financialmodelingguide.com/
A vibrant community that shares financial model templates for peer review, as well as answers related questions (think of it as a Linkedin Answers lite for Financial Modeling & Analysis) has also grown rapidly around the site.
The Financial Modeling Community is currently 2,600 strong - surprising that such a niche topic would find such an audience - with a good many entrepeneurs and small business owners seeking guidance and financial model templates for their startup business plan.
I would be very appreciative for either a link back to Financial Modeling Guide from your blog or just for this comment to be approved.
Many thanks!
July 7th, 2008 at 3:32 am
[...] Another blogger’s perspective on the truth of financial models. [...]
February 9th, 2009 at 8:54 pm
thanks for post
March 4th, 2009 at 10:22 pm
I liked the way you explained certain points in this post, I am impressed, thanks for the great work, Keep posting such interesting articles. thanks:)
March 5th, 2009 at 10:16 am
I like this article… Thanks
March 12th, 2009 at 7:31 am
“I don’t know what my business will look like three months from now let alone three years!” - goodluck with the business.
March 17th, 2009 at 8:35 am
Thanks for the article. It is very well-written. However it deals with financial modelling mostly from an outsider's perspective i.e., you are mostly concerned about the use of financial model for a venture capitalist or some other investor. A financial model has a lot of uses for the promoter himself. As a matter of fact, a financial model is expected to speak of how the company's financial condition would look, according to the promoter, in 3-5 years. It is necessary for the promoter to go through this exercise so that he/she would know the micro-details of the expenses. While working with the promoters we have seen some promoters get surprised/shocked by the unreal assumptions they had carried in mind while structuring the business idea. When all the numbers are put together in a cohesive structure, there is a higher probability for the numbers to be real than when they are seen in isolation.
It is quite true that the promoter need not show the entire financial model to the prospective investor. It is because the financial model is a strategic document and is targeted at the promoter himself. He needs to share with his prospective investor only that portion of the model which he thinks is absolutely necessary to convince the investor. You can visit http://financialmodel.net for more information on building financial models for various businesses.
March 28th, 2009 at 7:30 am
yup.. you said it right.. its all there.. i am too afraid of my business, with the financial crisis still lurking its head around. thanks for the post.. its really nice.
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April 29th, 2009 at 7:55 am
Great post, really help me alot. Thanks.
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