“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.

Trackback URI | Comments RSS