04 January 2011

Your Financial Model Is A Work Of Fiction; Build It Anyway

Startup Financials Series

Startup financial models are a pain in the ass. They take a ton of time to build. They are complex and often messy. They are never truly “right.” And they are outdated almost the moment you finish them.

Yet building a solid financial model is absolutely one of the best things you can do for your startup. Here’s why.

Why Build A Model? 

I've been building startup models and forecasts for over a decade now, and I've seen the entrepreneurs and founders that I work with gain a lot of value by going through the model-building process. Here are a few of the core benefits:

Analytical Lens:  First off, building a model brings a much-needed analytical lens to your startup. It’s a great framework for thinking through your business in an objective, critical manner, and it forces you to construct numbers around each assumption you have about your business model. Consider the model a vehicle that captures all the drivers and levers of your business plan in a single, cohesive place, and explores how sensitive the business is to these levers.

Operating Roadmap:  A model is, by its nature, a chronological way of laying out what you expect to happen and when—and what it will cost—in a very granular manner. As such, it becomes a roadmap for your business, and a great way to set milestones, track progress, and identify issues or problems as they arise. It’s also a great way to set goals with your team (e.g. monthly sales quotas per salesperson) and to manage expectations with the board, investors, and other stakeholders.

Risk Assessment:  Identifying the key levers (and sensitivities) of the business helps illuminate the risk points of your startup— in particular, the magnitude of downside risk. For example, at most startups, expenses precede revenue. Matching cash outlays to a timeline helps us monitor our "burn rate" and remaining months of runway, and it helps us get a handle on how deep in the red we might get before hitting breakeven. (Notably, this can be very illuminating and even a little frightening—on more than one occasion, I’ve worked with founders who decided to pull the plug after building a model and uncovering the real economics of the business; this is healthy.)

Scenario Exploration:  Models allow for multiple forms of really useful business model analysis. For example: what happens to our break-even point when we lower prices by 10%? Or, how much extra money will we need to raise if sales take a lot longer than we expect? Or, what do margins look like if we hire a direct sales team vs. recruiting a network of affiliates? When we isolate a key factor to analyze, we’ll often do a best case, base case, and worst case version of the model. Trying out various business model scenarios in a spreadsheet is far cheaper and easier than learning by trial and error.

Pitch and Sales Tool:  Last but not least, models are a great way to bolster your pitch to investors, lenders or strategic partners. At its most basic, the model eloquently explains how much money you need, and how much you will make for the investor or partner. And in my opinion, it’s a perfect left-brain / right-brain combo when you can go in with an excitement-inducing pitch deck or demo (which sells your vision and appeals to the emotional side of the brain) as well as a solid model (which speaks to the logical, rational side of the brain). I’ve seen numerous situations where the model is the icing on the cake, the tool that ultimately helps seal the funding round or deal.

That’s it for now; in my next installment of this Startup Financial Model series, I will cover several attributes that make a really excellent model. Let me know what you'd like to see addressed, or how you’ve used your models to solve business issues.

In the meantime, here is a presentation we gave at Plug & Play Tech Center a couple years ago: Financial Modeling Tips for Startups Plug and Play Tech Center  

1 comment:

  1. Well stated and directionally different from the mythology. We call your approach the controller's mentality. Looking forward to reading more of this kind of sensibility.