Startup Financial Modeling: Things to Know

What are some of the different uses of startup financial forecasts, and what is the one thing we know for certain about them? Financial forecasting is an essential business planning tool. For startups, financial models are critical tools that serve many purposes and ultimately embody the financial implications of a host of strategic decisions and assumptions.

Uses of Financial Models

Financial forecasts are used:

• By investors to understand the financial growth and profitability potential of a startup. The temptation is to try to shade your assumptions to demonstrate to investors how attractive this business can be, and investors know this, so they often arbitrarily discount the obligatory financial models included entrepreneurs provide. This is also the territory of the often joked about “hockey stick” growth curve, a somewhat inevitable result of linear assumptions carried forward over the years. Introducing the unanticipated variability that will unfold in reality into your assumptions is practically impossible.
   
• By CEOs and their Boards of Directors to estimate an investment-dependent startup’s dry well date when they will need investment to continue to develop. Since it often takes six months or more to raise financing, reasonably accurate financial forecasts are essential for estimating when the startup will run out of money and informing decisions about fundraising timelines. Philosophically, I prefer to conservatively estimate the timing and amount of incoming revenue and accurately estimate cash expenses with some contingency built in to ensure that I minimize the chances of a negative surprise. When I am leading an early-stage startup, what I want to see is that every month, when we update the financial model with actuals, the runway extends a bit. That assures me that I am unlikely to have a negative surprise and abruptly run out of money. 
   
  
• By the startup’s management to explore the implications of different decisions and inform planning and operational decision-making. Scenario planning using a solid financial model can provide critical insights to startup leaders as they weigh the costs and benefits of various courses of action. Modeling different pricing models, cost elements, and staff hiring plans can help illustrate what the team can afford. Modeling strategic partnership terms and implications can help define the potential value and provide a financial sales pitch to show the value of the relationship. Modeling the scenarios side-by-side can illuminate the tradeoffs and implications on revenue growth, scaling challenges, runway impacts, and next-round investment requirements. The key to effective scenario modeling is to be intentional about what variables you are adjusting and rolling through some realistic implications. For example, do not just increase revenue without considering what staffing may be required to support your customers. It can be helpful to model different price points to see how that affects your revenue and use of cash; however, be sure to run experiments with actual customers to validate that your desired price points are achievable before building your whole plan around them.

One Thing We Know for Certain

It is remarkable what you can do with a spreadsheet. You can invent fantastic visions of the future. However, it is critical to always remember the one thing we know about our financial forecasts:  They are wrong 100% of the time. Think about it. Your assumptions about the future will never perfectly match reality, which means that your financial model will not match what happens, although hopefully, the results will be close enough.

So once we accept that our financial forecasts are wrong, the question to focus on is HOW might they be wrong? Stress-testing the most likely scenarios, such as delayed revenue ramp, unexpected expenses, and other possibilities, will help you understand what might happen. Then you will have to strike the right balance between conserving your cash and making strategic bets that can enable you to break through on critical business development milestones.

Startup Financial Modeling Tips

Here are some of the techniques my CFOs and I use to make our financial modeling as helpful as possible for our startup management and provide a vital tool for convincing investors that we know what we are doing so they will take a chance on our opportunity:
 

• Picking a practical level of detail is important. Sometimes it is tempting to drill deep into the details of each little expense, ranging from the cost of a screw, a Q-tip, or a lunch expense. However, getting overly detailed is not useful because it quickly results in an unwieldy model that is hard to update and brittle because it does not have enough slop to work practically. On the other hand, you want to make sure you model the critical drivers of your financials, so you will need to pay attention to significant expenses like the number and cost of various types of team members, the volume of sales, the cost of goods sold at different volumes, any scale effects, and various other elements. Do not just model the variable costs of your revenue and the cost of your products that become part of your gross margin. Be sure to include the fixed costs you must cover, such as salespeople, R&D investments, fixed facilities, and management overhead expenses. I will often try to use the level of detail that I track in the accounts in my accounting software as a base.
  
  
• Creating an extendable model is important. I use a standard format of months, quarters, and years across multiple spreadsheets so that I can easily copy and paste formulas to take the first year out to five years or more. I use color shading to distinguish between cells that are my assumptions and cells which are calculations based on those assumptions. With the columns providing a monthly timeline, I set up the various assumptions in stacked rows so that I can use formulas to calculate the monthly financial numbers based on the visible assumptions I have made (and can adjust). For example, I will have assumption rows for the number of people with a particular title, the average compensation for that title, and percentages for tax, benefit, and other rates. Once those assumptions are set, a simple set of formulas translates the assumptions above into the monthly cost that can then be built into useful summary sheets, and ultimately into forecasted financial statements like forward-looking income statements, balance sheets, and statements of cash flows. Then I update the model with actuals over time so that my forward-looking assumptions can be informed by what we have actually been experiencing.
  
  
• Modeling conservatively is important. Things like revenue traction will likely take longer and ramp slower than you hope. Ensure you do not let your hopes govern your revenue and profitability assumptions. It can be one of the most dangerous financial modeling mistakes since your revenue and cash can make up for many cash expenses. Missed revenue assumptions can create a catastrophic situation if you hire too quickly and run out of cash.
   
  
• Build in some contingency capacity. The flip side of making sure you estimate revenue ramp conservatively in your model (and then try to beat your estimates in real life!) is making sure that you build in some “extra” contingency capacity in your expenses to absorb unexpected costs that inevitably show up and to provide some flexibility to capitalize on opportunities that may emerge. I do this in a few ways. One is “rounding up” on expenses. For example, if I think my consumable costs for my service are $154.57, I will model it assuming my consumable costs are $170 (or something reasonable) to account for unexpected waste or other variations. The same round-up idea can be applied to estimating legal, consulting, and marketing costs. When in doubt, I would rather my costs be modeled a little on the high side. In addition, I do include some “other expense” that is not specifically defined every month to make sure I am accounting for those things we forgot or were too detailed to build out specifically.

When building a high-potential startup, I strongly recommend developing a solid competency in financial modeling early in the development of your startup. Someone needs to know how to develop and maintain financial models, and there needs to be a close partnership with the CEO, who is responsible for ensuring the startup does not run out of money and making strategic tradeoffs to try to create success.