Financial Modeling for Startups: An Introduction
Financial Modeling for Startups: An Introduction
Founders and executives of new companies, particularly those seeking to raise capital, will inevitably be confronted with the prospect of building a financial model. The goal of this guide is to give you an idea of what a financial model is, why you might want one, and how to go about building one.
For the sake of simplicity, we're going to ignore all the usual accounting nuances involved in modeling a company and just focus on keeping track of the cash. (Most of the complexities involved in accounting just arise from differences in timing of cash flows vs when certain items were "earned" or "incurred").
A financial model is basically a simulation of the future financial performance of a company.
A typical user of a model is:
- A founder or executive who uses it to manage the company, or
- An investor who uses it to evaluate the potential risks and rewards that an investment in the company might entail
A financial model has many uses, including to:
Validate the economics of your business. Are you sure you can make more money than you spend in the long run?
Find out when you expect to run out of cash, and how much cash you will need until your business is self-sustaining. After entering assumptions about income, expenses, and capital raised, you will start to have a clear picture about how cash flows in and out of your business.
Serve as a key piece of the pitch to an investor. A well-crafted model shows how you will make money, how much money you will need to build the business, what the expected timeline is, and who you will need to hire to get there. It also helps quantify potential return on investment.
Show investors that you are rigorous about managing your business. A thoughtful model can drive confidence that you are going to be effectively deploying their capital.
Test key assumptions. How does the timing of hires affect how much cash you need to raise? What is the impact of a 6 month delay in product launch?
Clarify your thinking about the business. In order to build a model, you are forced to concretely write down all of your assumptions about the business that may have just been floating around in your mind until now. For example, will you be able to charge customers $500 for your product, or $5,000? Where that number ends up being will have a drastic impact on your company.
Track your performance over time. A model can help enforce some discipline. Are you where you expected to be 3 months ago? Why or why not?
If you're quantitatively-minded and care a lot about the future of the company you're working on, I think you'll find that having a financial model will be both fascinating and enlightening.
Love it or hate it, even at the highest levels of finance, these models are almost always built in Microsoft Excel.
If you'd like to follow along in Excel, here's the file we'll be walking through (though you'll still be able to follow along without it):
Download the Example Model
In this guide, we'll walk through building a model for an example company. Here's what the end result will look like, which is a summary view of the forecast we're about to build:
The sections shown on this summary page include:
- Income Statement. Shows how much money we expect to make, how much we expect to spend, and our Net Income (by simply subtracting Expenses from Revenue).
- Operating Metrics. Summarizes some of the interesting metrics from our projections, which were used to produce the Income Statement (which we'll see shortly).
- Cash Summary. Shows how much cash we expect to have on hand at the end of each period, along with how much investment capital we expect to raise.
Everything on this summary page simply links to other places in the model where each of the items are forecast (which again, we'll see shortly). This view is just meant to pull the most interesting pieces into a single dashboard.
In a model, the columns represents time, with each column typically representing a month, quarter, or year.
Each row represents either:
A cash inflow or outflow over time, which is summed over the indicated period. For example, cell G8 above shows the sum of Revenue earned from Jan 1, 2019, through Dec 31, 2019, or
A snapshot of some metric as it stands at the end of the indicated period. For example, cell G23 above shows what the cash balance was on Dec 31, 2019 (but gives us no information about what the balance was throughout the year)
In this model, we're going to have 3 sheets:
The Model tab, where we'll forecast our revenue and most of our expenses
The Personnel tab, where we'll forecast our personnel expenses (which the Model tab then links to), and
The Summary tab, which provides an overview of the model's most interesting components (which links to the other two tabs)
The steps we're going to go through to construct this model are:
Forecast our Revenue
Forecast our Expenses
Calculate our Net Income
Forecast our Cash Balance (assuming we don't raise outside capital). This will tell us if we need to raise additional capital, and if so, how much, and
- Forecast Investment Capital raised (if required)
Revenue is simply cash that the company receives from customers.
There are many ways to forecast the revenue of a company, and the method you choose should be tailored to the business in question. Examples of the more common possibilities include:
Price * Units. The most basic and general of the methods. Apple sells X number of iPhones at an average of $Y each, and Revenue = X * Y.
Subscription. Once you sign up a customer, by default they will continue paying you money every so often, and a certain percentage of them unsubscribe (churn) each period. This is the method we'll walk through below.
Service Contracts. Many B2B companies have contracts with given clients where the client agrees to pay a certain amount of money on a given date (or dates). These might be recurring, they might not.
Our example company sells subscriptions to use its software:
Note that some of the math may look funny here because the quarterly detail is hidden. Full detail can be found in the excel file linked above.
In this example, we're forecasting revenue for the company by:
Forecasting New Subscriptions (line 10). We've just entered hardcodes here for simplicity, but these could be the result of calculations related to a marketing / sales funnel
Forecasting Subscriber Attrition (line 11). We've input assumptions about the quarterly attrition rate over time on line 14, and use that to calculate this line
Forecasting # of Subscriptions (line 12), which starts with existing subscriptions, adds new subscriptions, and subtracts subscriber attrition
Forecasting Revenue per Active Subscription (line 16), which is hardcoded and assumed to stay flat
Forecasting Total Revenue (lines 17 and 19) by multiplying # of Subscriptions by Revenue per Subscription. Note that we only receive revenue from subscriptions, so Subscription Revenue also equals Total Revenue.
The biggest expense category for most startups is personnel.
Many companies spend 80%+ of their cash on personnel
Until you have at least 100 employees, I recommend forecasting out your personnel expense by individual position. Don't forget to count bounuses, benefits, payroll taxes, sales commissions, and onboarding expenses for each employee.
Beyond personnel, you should take time to itemize everything you can possibly imagine spending money on and make sure you budget for them all accordingly.
There are no hard and fast rules on how to categorize your expenses - every company will be a little different - but some common expense categories can be found in the following example:
Your categories will likely vary
As mentioned above, Net Income = Revenue - Expenses
. In this context, Net Income tells us how much cash the operations of our business generated (or burned) in the given period.
The quarterly detail is hidden in this view, but if we look at 2021 on a quarterly basis we can see that we reach profitability in Q3:
2021 quarterly net income
Net Income dips down again in Q4, but that's just because we're forecasting a lot of bonuses being paid that quarter. Assuming our revenue continues to grow faster than our expenses, we should be in good shape moving forward in terms of profitability.
Note that things get more complicated in the real world if the timing of when you "earn" revenue or "incur" expenses gets out of alignment with when the actual cash changes hands (for example, if your customers take a while to pay you even if you've already delivered product), but we're ignoring those differences for now and just looking at the cash.
Now that we know what our Net Income is, we can use it to forecast our Cash Balance.
If our forecasted cash balance ever turns negative, we essentially have three options to rectify the situation. We can:
- Increase our Revenue projections (i.e. make more money)
- Decrease our Expense projections (i.e. spend less money)
- Get money from investors
In our example below, based on our current forecast, we find ourselves in a negative cash situation:
Note that in cell G53, we're assuming that we're starting 2019 with $1mm in the bank. Line 54 links to the Net Income calculation we just did, which captures all of our income and expenses.
Notice that the "Investment Capital" line (line 55) is blank at the moment, and the "Ending Balance" line (line 56) eventually turns negative, meaning we're currently forecasting that we'll go bankrupt!
Assuming we're already being realistic about our revenue and expense forecasts, the option we're left with is to raise investment capital. Our "Ending Balance" line tells us how much cash we need to raise to get the business to self-sufficiency (our quarterly model shows that we reach a trough of ~$7.2mm in 2Q21 before reaching profitability). Building in some cushion, let's assume we raise $10mm in 1Q19 and forecast that investment capital coming in on line 55:
Cash including investment
According to our model, after raising capital we should be on track to reach profitability and have a self-sustaining business in 2021.
There's a lot of detail that we haven't touched in this example (like forecasting the Balance Sheet and Statement of Cash Flows, or integrating the projections with our historical financials), but hopefully this gives you some good guidance on how to get started building your model. A model certainly isn't a silver bullet, but it can serve as a useful quantitative framework for managing and analyzing a company.
Want help building your model? We at Fivecast Financial have built models for hundred of companies to help them successfully raise capital and understand their businesses better. I'd love to hear from you at firstname.lastname@example.org.