Questions to Answer with Your Financial Model
Financial Modeling is scary, but it doesn’t have to be. On top of all of the work that goes into actually building a model (although there are some that you can more easily download online), you have to account for an insane amount assumptions.
Somebody once explained to me that finance is accounting for the future. Which is a nice way of saying that finance is the practice of trying to figure out what the heck is going to happen over a given period of time. In order to make decisions, companies use their finance function to try and predict the future and assess profitability of certain projects / expenses. When you build a financial model, that’s what you are trying to do - assess the potential profitability of your business plan.
Some financial models are used internally during management meetings. Others are put together for board meetings and to vote on critical decisions. Sometimes a company makes a model for a specific project. Frequently models are used to compare how actual results correspond to plan. And in almost all cases, your financial model is reviewed by potential and existing investors. For whatever reason, when you are putting together your model, you need to answer the following questions:
Where are you going to get money to fund your business? This can be one of the most straightforward answers or most complicated, depending on your funding source. If you are a pre-revenue startup who is getting money from equity investors, the money can only come from them. If you are a founder bootstrapping your side-gig into a full-time enterprise, you might find a lot of different sources of capital to plug into your cash flows.
Sometimes revenues can be adequate to fund your business. And sometimes debt can fund certain projects. What can be tricky is trying to make it as clear as possible what funds are funding what project, product, or function. This isn’t always easy to do because a lot of times the money is all put into one pile and then redistributed from there - but the more you can isolate where funding is being funneled, the better you can calculate the return on the capital you are allocating. The better you can do that, the better you can make decisions.
What are you going to use this money on? In that same vein, you need to explain the uses of funds, along with your sources. This is important for investors to understand because they can more adequately assess your business plan in that manner. It can also help keep you, the entrepreneur, focused on what you are trying to accomplish.
This probably seems pretty basic - your financial model should explain what your expenses are. Duh! But the trick here can be effectively estimating expenses. The more you can tie your expense assumptions to real data - an invoice, a quote, an offer letter, etc. - the better your model will flow. If you have a firm grasp on your expenses, you can really know what type of targets to set, what kind of goals you need to achieve, and how to acquire effective unit economics.
What are your unit economics? I have written about what unit economics are in the past, but they are the basic building blocks for understanding your business - not your product, team, market, or anything else, but your actual business. How does money come in and how is it filtered through your capitalism machine to turn a profit. The more financial data you have and the longer you have been in business, the easier it is to explain your unit economics via a financial model.
Startups don’t normally turn a profit, and they burn through cashflow pretty quickly. So simply looking at a net income line item or gross profit data point doesn’t really do the trick here. You need to show how profitable your startup will be once it starts to achieve scale. What are the core costs of your product and acquiring your customers, and how much revenue can you bring in through your business? The formula is a little more complicated than that, but not by much. And don’t rely on your model’s audience to figure this portion out on their own - control your own narrative and make you unit economics very clear.
How are you attracting customers and who are they? It is not just enough to show off some of your traction - you want to explain how you got that traction as well. In the early days of a startup, assessing each and every customer can be a critical piece of the fundraising experience. When there are only a handful of customers, each one really matters.
And it’s not just about your current customers either - who are your future customers going to be? Remember that an investment is a decision based on the future, not the past. Not about what you have already done, but what you are going to accomplish in the near and long term. A customer pipeline should be one of your most important dashboards. And even if you are not an enterprise SaaS product (where pipelines are the most important and relevant), it’s good to know what the sources of your customers are. What sort of channel partnerships or distribution partnerships have you set up to turn on your growth engine? Anything that tells your audience about how you are going to achieve continued success is important.
As previously stated, there are a lot of uses for a financial model, especially for seed stage startups and as a result there are a lot of questions you need to answer. But one of the primary questions investors ask when reviewing your model is why they should invest in your company. While that may seem straightforward, it really isn’t. Not because modeling is so hard, but because every investor has a different investing thesis and methodology - so what they are looking for in your model is going to be different across the board. That’s why it’s important to not massage your model to meet their needs - create a good model that accurately represents what is going on in your business so your future partners get into business with you with eyes wide open.
So there you go - you have the rubric for putting together a model (or at least part of one). If you have any questions for me, you know where to find me.