Creating a Financial Model forces an entrepreneur to plan very specifically how their business will work, how users and customers find and use their products, and how those processes create revenues and costs.
As tempting as it might be to outsource this project, it is important to create your own model in order to organize your thoughts, and quickly take action. Constructing your own model will help you predict potential obstacles, make calculated decisions, and see how the business will perform with a given set of assumptions.
In a talk from the Denver Founder Institute, Jim Franklin, former CEO of SendGrid and active startup advisor and board member, explains the step by step process in planning your company’s financial model. He advises founders to only take investor cash if necessary, and to always think about business as a long term entity. Those who do seek investor financing should use a financial model to prove credibility.
To help you grasp the concept, we listed the basic components and techniques of modeling, highlighting the problems you should solve with data in each section.
How Do You Begin?
- Acquire a copy of Microsoft Excel (or set up a Google spreadsheet for free)
- Become familiar with basic formulas and general formatting. (SUM, Multiplying and dividing cells will different tabs.)
Your model should follow the “Top Down Model", defined as: “A forecast, that looks at the overall market and uses this information to identify your company demographics and target mark.”
Example: “If your company has created an iPhone app, you might take a look at the number of consumers who have purchased apps for their iPhones. If there are 80M active iPhone users and half of iPhone users buy at least one app per month, you can extrapolate from here. Being conservative, you could estimate that of the 40M active iphone users who purchase apps, 1% of these consumers will purchase your app. That would give you 400K new customers.”
The model you create should plan for the next three years and should have a structured dashboard.
Intermediate Modeling - Less Detailed Dashboard
Models always start with a dashboard. The basic components that make up the most simplified dashboards include graphs for: Revenue vs Expenses, Revenue/Headcount, Accumulated Loss, and Active Users. Make sure the following questions are answered within the data you provide in each section.
Revenue vs Expenses
You don’t know what your revenue is going to be, it’s all estimates. But you do know what your cost is going to be, making expenses very predictable. Do your math with curves, not numbers, and be broad. With curves you can tell the probability of any value. Make sure your data answers these questions:
- When will you break even?
- When does your revenue cover your operations?
- What’s the zipcode or timecode that you will breakeven?
Revenue per employee is calculated by dividing a firm's revenue by its total number of workers (Revenue/Number of Employees). Increase headcount and add this to your monthly expense.
- What will be the average revenue generated by each employee?
- How will you find a way to squeeze more sales (revenue) out of each employee?
- Rule of Thumb: Expenses per Employee is usually around $180-200k.
Determine how much money you need to raise for your project.
- How much do you need to raise by when?
- When will you be at your low point?
- When do you estimate your high point?
You're doing pretty well if you have five to ten thousand users in the first year. Build realism in your model, and have no surprises. When you have no surprises, you increase your credibility, helping you tell your story better. Make sure your data answers these questions:
- What’s the naked number you’re solving for? Target the number of users over a certain time span.
- Can you measure your company’s performance and future earning through a valuation metric?
- How will you prove the likely number of registered users and customer acquisition count?
- When will you place your monthly active users on a hockey stick graph, which shows dramatic shifts overtime? This graph is defined, “as a line chart in which a sharp increase or decrease occurs over a period of time, mimicking a hockey stick.”
- Rule of Thumb: Placing curves on your assumptions helps you back them up.
Separate Your Assumptions
Any good financial model lives and dies by assumptions. Create a separate assumptions tab and plan for them to change overtime. Create a bulk of assumptions, listing out revenue, loss, Cost of Goods Sold (COOGS), etc., all laid out and organized in clear formatting. Start thinking about your business and how it will pan out.
- How much are things going to cost?
When are you going to have to pay this or that expense?
Input on one sheet, and the rest of your tabs/financial statements are driven off of these assumptions.
Advanced Modeling - Financial Statements Based on History and Assumptions.
Creating a more advanced dashboard includes using formulas to converge your financial statements and assumptions. The three statements include your income statement, balance sheet, and cash flow statement, used to predict future finances going forward. All financial statements are linked together. In an advanced model this information can be in separate tabs or visible through one tab in excel, establishing a one-stop shop of information. This one tab can drive founder, mentor, or investor discussions. Listed below are the most improtant aspects of your model that will tie together.
What will be your user growth rate month over month? Summarize by quarter and organize by low, medium, or high, month to month. Start at twenty percent, which is normal for a monthly user growth rate. Multiply 20% over the next 21 months.
Input historical financial data on your income statements and balance sheets, then calculate ratios with your statements to establish gross margin, net income margin, accounts receivable/payable days, etc.
- Income statements (also known as the Profit and Loss Statement) begins with an entry for revenue and subtracts from revenue, the costs of running the business. It will calculate: Year-over-year growth rates of revenue, growth profits, and net income. Margin and growth rate analysis will calculate Cost of Goods Sold (COGS) gross margin, Selling, General & Administrative (SG&A), effective tax rate, etc.
- Balance Statements summarize the company's assets and liabilities and follows this format: Assets = Liabilities + Shareholders' Equity. An example would be, “you want to pay your bills in 48 days, but you want your customers to pay you in 26 days.” This section will calculate: Accounts Receivable Days, prepaid expenses, Accounts Payable Days, etc.
Make future assumptions for projecting the income and balance sheet based on these ratios, which will change overtime.
Build a “Statement of Cashflows” by tying together the "net income from your income statement and cash from balance sheet."
Then tie ending cash balance from the “Statement of Cash Flows” into the balance sheet. (Balance the Balance sheet.)
Once all checks are balanced, calculate interest expense and tie into income statement.
The complexity doesn’t entirely set in until you use tricks to collapse your projects like spinner bottoms that are used to compare different outcomes/ revenue per monthly user.
Get a more detailed explanation from the Three Statement Financial Modeling, from the Street of Walls.
There are various templates for constructing your financial model, but this information sums up the basic elements.