Startup Financial Modeling, Part 1: What is a Financial Model?
Note from Will: this article series is the result of a friendly debate I had recently with Troy Henikoff regarding the best approach for founders to take when building a financial model. More accurately, the “debate” was a strong adverse reaction from Troy after I shared a template I built for Prota Ventures’ portfolio companies. His feedback was, essentially, to never use a template and instead build each model from scratch.
He invited me to a 90-minute lecture he gave where he overwhelmingly convinced me and the room that, indeed, founders need to take the time necessary to build their models from scratch. After I asked him where I could find his lecture material online, he suggested we co-author this article series since there weren’t many solid resources available. We sincerely hope you find this series helpful. Feel free to ping us on Twitter (@wclittle, @troyhenikoff) with any questions.
HERE’S WHAT WE’RE PLANNING TO COVER
Our plan is to break this out into a four-part series and guide you through the components necessary for building your own financial model from scratch:
- Part 1: The why and what of financial modeling
- Part 2: Assumptions
- Part 3: Income statement and custom detail tabs
- Part 4: Cash flow, balance sheet, and keeping the model updated (Download a copy of our example model here)
Subscribe to Will’s newsletter to stay updated on when we publish the remaining three articles.
WHAT IS A FINANCIAL MODEL?
In short, a financial model is an abstract mathematical representation how a company works (and more importantly, will work going forward). The model has inputs and outputs. The inputs are the assumptions that drive the model, things like what drives your customer acquisition cost, what your churn rates are, how much you pay people, etc. The outputs are a set of projections that show how the company will perform if the assumptions are true. One model can produce multiple sets of projections given different assumptions.
Based on a set of assumptions, a financial model is used to make smart decisions (e.g. how many sales people to hire and what to pay them). The model includes financial projections that are tied mathematically to the assumptions, which allows operators to “play with the variables” in order to understand how certain decisions might affect the future health of their company.
WHY SHOULD FOUNDERS CARE ABOUT BUILDING A FINANCIAL MODEL?
Troy has an important story to share on this topic:
“When fundraising for SurePayroll, we had some very high level financials in the pitch deck. Inevitably, VC's would ask where the numbers came from. I would tell them that we had a very detailed financial model that drove it, I was setting the bait...
They would ask to be sent a copy of the model and I would refuse. I would only share it by first sitting down with them and an associate and reviewing the model in person and after that 90 minute session, I would leave them a copy of the model to play with further.
They would insist that they could figure it out without the meeting, but I ALWAYS held my ground. I wanted the meeting not just to save them time and frustration learning a new model, but more importantly to get more face time with them in a situation where I was going to shine.
I knew the model inside and out since I built it; I could answer any question about any cell and look like a genius. In the end I did 8 of these meetings and EVERY ONE of the firms that did the 90 minute meeting with me on the financial model either made an investment in the company or made an offer to invest in the company. Every single one.”
WHY IS IT IMPORTANT FOR FOUNDERS TO BUILD A FINANCIAL MODEL FROM SCRATCH?
While it’s easy to search around and find a template to use, those templates were built by someone with a particular business in mind. Since every business is unique, this will lead you into trouble.
While it’s often helpful to learn from other people’s models to ensure, for example, that you aren’t missing anything important, you should never build your model using their template. You’ll end up banging your head against a wall when you need to change things, and you’ll inevitably be confused about some nuance that will come back to haunt you since you don’t understand it.
In other words, while you may think that a template will help you save time, what you are actually doing is acquiring “technical debt” that will end up costing you more time in the long run.
Plus, it’s critical to understand every column, row, cell, and tab in your spreadsheet for two key reasons; it will help you better manage your business, and when the time comes to explain it to an investor, you’ll be able to explain exactly how it works and increase your odds of landing funding.
WHAT ARE THE COMPONENTS OF A SOLID FINANCIAL MODEL?
Since most people are using the financial model to communicate projections to investors, it is critical that you speak the investors’ language. They are used to having financials in Excel, so you should build your model in Excel. Google sheets is convenient for making changes and having multiple people editing, but sending an investor a model in Google sheets signals that you are not financially savvy. Investors are also used to seeing three standard statements; an income statement, a balance sheet, and a statement of cash flow. Each of these is more credible if it has BOTH the past performance and the future projections in the same spreadsheet.
Your spreadsheet should contain a tab for each of these outputs along with an “assumptions” tab and custom detail tabs needed to help calculate the main outputs. We’ll walk through a specific example later in this series so you have a better understanding of what this should look like.
PROFIT IS A MATTER OF OPINION, CASH IS FACT
Because of various accounting nuances - such as fixed asset depreciation and deferring revenue - if you assign ten accountants to finish your books at the end of the year, you’ll get ten different answers for how much profit (or loss) you had in the year. While hopefully not far off from the others, each will have a slightly different report of your “profit” based on their accounting opinions.
However, the balance of your bank account is a specific number to point at; it’s a fact that your ten accountants should agree on.
Therefore, it’s important to remember that your financial model will have your own opinions baked in regarding your profit. This means that examining your cash flow carefully as you fine-tune your business assumptions is critical.
WHY INVESTORS CARE ABOUT YOUR FINANCIAL MODEL
Having a solid financial model is a significant step in communicating to investors that you are a logical thinker with a defensible plan and clearly understand your business and the levers that drive it.
Nobody expects your model to be perfect, as a matter of fact, when we present a model, we always open with the same line: “The only thing we know for sure about this model is that it is wrong. But, if we look critically at it we can better understand the drivers of the business and what we need to be focused on to reduce our risk.” Keep in mind investors are looking for the big home runs, but they are also looking at reducing their risk, the model can help them get comfortable with the risk.
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In our next post in this series we’ll dive in a step-by-step guide of how to build a financial model, starting with the assumptions tab. Subscribe to Will’s newsletter to get notified when the next articles are up. As we mentioned above, feel free to ping us on Twitter (@wclittle, @troyhenikoff) with any questions.