Your Financial Model is Wrong. Congrats - You’re On Your Way!
I’ve built well over 100 financial models in my career, and I can tell you with 100% certainty that every one of them was wrong. But I can also tell you that 100% of the time they were absolutely essential to the process.
So if your financial model is guaranteed to be wrong, why do you need one at all?
Here are 8 reasons why a financial model is one of the first things your startup must have (in no particular order):
Communicate with investors. Your financial model is your business plan in number format. Experienced VCs will often prefer Excel over Word and are able to jump right into the “numbers” to understand your business better and faster than if they read through a verbose written business plan. A good model shows them that you take their investment seriously and have a good handle on the levers that drive your business. It shows that you know your stuff - that you have thought through a defensible plan and understand your business from a bottom-up perspective. It helps investors get comfortable with the risk while showing a real map to ROI.
Tell you how much you need to raise. How did you come up with the amount you think you need for your seed round or your series A? How much do you really need to make the next milestone? Raise too little, miss your milestones, and you’re in big trouble. It’s going to be costly to extend that runway. Raise too much, give away too much equity, and perhaps risk a down round for the next raise. Either way, ouch. A good financial model, with a great deal of thought and effort, will get you comfortable with the right amount to raise.
Help transform your idea or product into a real business. So you have a great idea or product, but do you have a real business here? There is a big difference. Businesses make money. Investors are under a great deal of pressure to maximize returns for their own investors and partners. Show them the money. If you are an engineer unexcited at the prospect of spreadsheets and numbers, think of it as a challenging engineering problem and design a business that will make real money and lasting value.
Find holes, test your assumptions, and explore some what-ifs. Your model can produce multiple sets of projections based on different assumptions or inputs you provide. What happens if we land this big partnership with Company X next month? What happens if we double the number of salespeople? What market share would be required to hit our numbers? Your model allows you to explore extreme scenarios and test your projections with healthy sanity checks.
Establish your KPIs. A great model should clearly show you which Key Performance Indicators are the most important to focus on. Which levers should you pull to achieve maximum growth? Which switches should you switch to optimize margins? KPI measurements indicate the health of your startup compared with industry standards and provide real-time feedback on your performance.
Provide the structure for ongoing reporting and measurement. Speaking of KPIs… they should provide you with a dashboard that you monitor constantly to steer the ship. Investors and board members love KPIs. Know yours inside and out. Your financial model is not just a one-time planning document; it becomes a living document helping you measure and make adjustments each month. At Keating, each month we take the financial model, replace the projections with the actuals, account for the deltas (what went right, what went wrong?), report the findings, and adjust as necessary. It’s a crucial part of our process.
Serve as the reference point for sound decision-making. In the hectic and emotional world of a startup, it is easy to get distracted or thrown off track. Shiny objects, competitive threats, product issues, people issues - 100 things will conspire to distract you and kill progress. At some point, you decided that if you could reach the milestones outlined in your financial model, your company would be successful. Fall back on that as needed. Revisit your model frequently as a way to find "center" and remind yourself what to accomplish this month, this week, and today.
Check your runway. Cash is the lifeblood of your startup, and at some point, you will discover that cash flow management is the trickiest and scariest part of your job as founder - especially as you ease up to that next fundraising round. How much money do we have and how many months of runway are we looking at? If we add that new VP of Sales to the payroll, book that trade show in New York, and take care of all of the pending AP, how does that affect the runway? Cash flow is complicated, and your financial model is not necessarily detailed enough to ideally manage cash flow by itself, but it can help you get a high-level view of just how comfortable or uncomfortable you should be. Don’t run out of runway.
A good financial model should serve as the centerpiece for your startup. It will be a tool your executive team will use every month (at least) to serve as True North and keep things on track. So even though your financial model is naive, oversimplified, and/or flat wrong, you won’t raise money without one.