If you are building any sizable business you are going to need to figure out how to scale and the resources required to get there in a profitable manner. This means building a solid financial model but there are a few things you should know before you dive in.
Financial Models are Not Fun but Necessary
Yes, I know, you are dreading doing this and the thought of it makes you happy to do yard work or clean out the garage. There is an ongoing debate between entrepreneurs whether they should spend tons of time on this and my personal opinion is that investors will study this more than your business plan at first. If you have a house of cards or full of magical growth projections that you can’t back up, the financial model will reveal it fast.
Yes, I know you are busy “running your business”, however if you want any kind of investment you need to build a detailed 3-5 year model. True, your business will probably not like it does in 3-5 years but you need to demonstrate on the information you have now and the current business model you have that it will be profitable.
Financial Models actually make you a better entrepreneur
Spending this kind of time on a business model and working out the variables and various good to great scenarios you end up understanding your business better and becoming a better entrepreneur. Some of the reasons that investors require a financial model are obvious. They want to see how big a business is possible, potential margins and cash flow, and the long term funding requirements to project how much additional cash may have to go into the company. A financial model will give them a starting point on how they should think about valuing your business.
What they also see is how you, the entrepreneur, think about your own business. Your financial model will be a detailed discussion guide to walk potential investors through the intricacies of the business.
What Do Investors Care About in a Financial Model?
Investors will want to see how you’ve thought about growing your revenue base. Does it grow as a step function or along a smooth growth curve? How does pricing change over time? What is the impact of competitors in the market? They’ll have you walk through customer acquisition methodology, using the model as a backdrop on how you think about marketing to your customer base. They’ll want to see a detailed hiring plan and how you think about staffing the company to support your projected growth.
The financial model walk-through is often the center of the fundraising process. At the end of the discussion, the potential investor has probably made up his/her mind on whether you have a fundable business and whether you, as an entrepreneur, are qualified to take the company through its next phase of growth.
How Much is Required by Investors?
In the first presentation to investors, you don’t need to show everything, just the top-line summary with emphasis on revenues, profit margins, and cash requirements.They will playing too much with their Blackberry or iPhone to notice at this point. Present the summary as a table, showing quarterly projections for the first 24 months, with year three summarized in a single column.
You won’t dive into the details until probably third meeting (if they ask you back) and they will bring in junior people to tear the model apart and come up with questions you need to answer. This is the beginning of the due diligence process and if you are at this point with them it your opportunity to blow.
Financial Models Give You a Roadmap Even if You Don’t Raise Capital?
The outcome of all this work isn’t just a satisfied investor. You will walk away with a much better understanding of your business and quite possibly awareness of key decisions that need to be made immediately if you are going to hit your numbers. Take this example – you want to be on track to drive $2.5 million in revenue in 2010 but in order to meet these numbers you get a hard realization that you’ll have to have your customers numbers up and at a specific level by Q2 2009. This can make you take a hard look at product development to ask what is most important to customers so you release in time and attract new customers. You should also get some great insight into the key drivers of your business and what assumptions in the model are most sensitive. Overall you can set reasonable, objective and achievable goals that your company can meet. This prevents everyone from working 100 hour weeks and still feeling like a failure.
Final thoughts and tips from another expert:
Stu over at Momentum Venture Partners has some great extra tips that should be included in this post.
While it may sound counter-intuitive, it is better to be too conservative rather than too aggressive. If there is one thing that turns investors off it is “hockey stick” projections that they simply cannot believe.
One way to test how reasonable your model is is to look at the growth of other companies you can research: What’s the strongest performance that’s ever been achieved in a related company? What are the average sales per year / per employee for other companies in your market? What is the best EBITDA margin of potential competitors? If you feel you will set new records with your performance you should be prepared to deal with skeptical investors.
Take the time to build the model yourself. Handing it off to a friend or team member may ensure that a model gets built, but you’re doing yourself a disservice by not understanding every assumption upon which it is built. Your lack of understanding will come out in the investor conversations and more importantly, in how you run the business.
There are a lot of ways to build a financial model – we suggest you start with a template. Recently, Guy Kawasaki posted a good example model for an early stage company; you can download that model at his site.
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