In this article series, I discuss what approach startup founders should take when building a financial model based on a friendly debate Troy and I had. I shared a template I developed for Prota Ventures’ portfolio companies, and Troy had a strong negative reaction to it. He advised us to never use templates and to build each model from scratch instead.
Table of Contents
We Will Cover The Following
It will take four parts for us to walk you through the necessary components for building a financial model from scratch:
- Introduction to financial modeling: why and what
- A second part is devoted to assumptions
- In this part, you’ll learn how to customize detail tabs for income statements.
Financial Models – What Are They?
Essentially, a Startup financial model is how a company functions (and, more importantly, how it is going to function in the future). Inputs and outputs define the model. For example, your inputs would be things such as the cost of customer acquisition, your churn rate, how much you pay your employees, etc. Based on the assumptions, a set of projections shows how the company will perform. Different assumptions can result in different projections.
How Are Financial Models Important To Founders?
During fundraising for SurePayroll, our pitch deck contained some very high-level financials. A VC will not be able to resist asking where the numbers came from. Whenever they asked me how I arrived at it, I would tell them that we had a detailed financial model. I was setting the bait…
A copy of the model would be requested in this situation, but I would refuse to send it to them. To share it with them, I would need to sit down with them and review the model in person with their associate and then leave them a copy of the model to play with further.
How Correct Is A Financial Model Built From Scratch Before Any Funders Get Involved?
It’s simple to find templates online, but those templates were built with a specific business in mind. This is problematic because every business is different.
Make sure you don’t overlook anything important when you learn from other people’s models, for example. When building your own models, you shouldn’t use their templates, though. The more you don’t understand something, the more you’ll hit your head against the wall when it comes time to change something, and the more you’ll be confused about some nuance that will come back to haunt you.
Profit is Not the Truth, But Cash is
In a year, you’ll get ten different answers regarding how much profit (or loss) you had because of various accounting nuances – such as fixed asset depreciation and deferred revenue. Despite having similar accounting opinions, each will report your “profit” differently.
It is a fact that your ten accountants should agree on that the balance of your bank account is a number to point at.
A Financial Model Is Important To Investors
By developing a strong financial model, you show investors that you are a logical thinker who can defend your plan and understand your business.
Nobody expects your model to be perfect, as a matter of fact, whenever we present a model, we always begin with the following: “The only thing we know for sure about this model is that it is wrong.But if we critically examine it, we can gain a better understanding of the drivers of the business and the areas we need to focus on to reduce risks. Investors are looking for the big home runs, but they are also looking to reduce their risk, the model can help them do that. By lowering their risk, the model can help them become more comfortable with it.