Financial Modeling Tips For Early-Stage Startups
Building a financial model is an important milestone in the life of a successful business. It means that you have focused in on a particular revenue model and sized the scope, schedule and budget for achieving your business goals. Having the model gives you the ability to identify, delegate and manage specific tasks while being able to tie them to the big picture. It gives you an answer to questions like, "why do we have to release v1.5 next month?" and "why can’t we buy a booth at this trade show?"
Don’t fall into the trap of thinking that a financial model is "for the investors." It is, in fact, for you and your team. It’s how you will eventually make money and achieve your dreams. So with that background, here are a few tips on financial modeling:
- Don’t reinvent the wheel. Financial models and the basic building blocks thereof are readily available online and through friends and colleagues. Don’t waste your time trying to reverse engineer the fully burdened cost of employees, hosting and facilities. Instead, use actual costs from comparable startups. One of the best examples of comparable data is from Redfin posted by Guy Kawasaki. There are many other good sources.
- Start from the output and work backward. For your initial model, you could easily create a 10MB model with 50 worksheets and Monte Carlo simulations, but it will never see the light of day. Save this for later. Instead, start with the output first, which in this case is a 30-50 page PowerPoint deck and pro forma financials (income statement, cash flow statement and balance sheet). You can begin by developing a "blank slide" presentation as well as pro forma financials. For the presentation, you’ll want to identify each key driver of your business on the revenue and cost sides. On each slide, you should be able to write one sentence or a couple bullet points that explains the key driver. For the pro forma financials, focus on what line items you will be showing and the period of time over which you will be forecasting. Once you have these templates, then get to work building the simplest possible model that allows you to reasonably complete the slides and financials. Your model should have an "assumptions" worksheet that allows you to tweak the key drivers you identified earlier.
- Be conservative. There is nothing worse than raising money based on a wildly optimistic plan you hoodwinked some investor into believing. You won’t last past the first year as CEO (and deservedly so) because you’ll end up missing plan badly. It’s not sandbagging, it’s called reality. There is a lot of pressure to build a model with $100MM of revenue in Year 5 because that’s what VC’s fund, but most businesses cannot realistically project this. If your car has a 4-cylinder engine, don’t enter it into a drag race…instead focus on raising money that matches your realistic expectations for the business.
- Vet your output with trusted third parties. Once you have your model (remember the output is not the mambo Excel spreadsheet, but rather the presentation and the financial statements) you should set up a few sessions with some experienced entrepreneurs and investors. Go through the model and be brutal. At my last company, we called this process "8-Miling." If you’ve seen the movie 8-Mile, you know that the climactic scene at the end of the movie has Eminem saying everything bad about himself to his competition instead of letting them say it. Do yourself a favor and 8-Mile your business before potential investors do it for you.