How To Pick A Startup Financial Model That Will Generate Income?
Dec 20, 20217 min read
Chief Marketing Officer of Ideamotive. Travel addict and remote work advocate.
Sometimes you get this awesome startup idea and you can not wait to turn it into reality. Most businesses are too focused on creating the end product that they forget the business side of it. That is where the mess begins.
Unfortunately, having an amazing idea is not quite enough nowadays. You have to know how to financially secure your startup to be able to bring that idea to life. One of the best ways to build a sustainable business, secure funding, and avoid bankruptcy is to create a financial model.
The financial model defines how your startup will work in numbers, how it will generate revenue, and what financial goals you plan to achieve. It includes things like your revenue, expenses, probable conversion rates, etc. It will help you and your financiers understand whether it will survive complications and whether it will function in the long term. It is known that 70% of startups fail in their 2-5 year and everyone wants to avoid this type of situation. Your finance model is a chance to prove to everyone that you are not going to become a part of this sad statistic. Or you can understand what to work on to not fail quickly. You will need funding consultants and financiers to create the model.
We will guide you through the process of how to build a financial model for a startup, make an overview of common mistakes and share a checklist of main points to define before creating a financial model. We have tried to pack everything you need to know within one article, so stay tuned!
Signups are about where your customers come from - trackable channels like Google Ads or social media marketing or untrackable ones like word of mouth. Make sure that you know how much budget you plan to allocate to each source - what the most important for your target audience are and what are the most effective ones.
Step 2 – Calculate Conversion Rates
Conversion means that people gave their contact information for further marketing purposes or signed up for a free trial. Make sure to forecast how many customers you will be able to convert and from which channels.
Step 3 – Determine Your ARPA
ARPA stands for average revenue per account. It is also often called ARPU, average revenue per user. It is important to predict how much your future user will spend every month on your business and what are their peak activity months. It will help you determine whether you need to invest in finding new customers or maintaining relationships with the old ones. It will also help you understand when your profits and losses will be the biggest to evenly spread the budget throughout the year.
Step 4 – Calculate Your Revenues
If you have predicted your ARPA, you can multiply it by the number of users that you expect to have in the particular time period.
Step 5 – Figure in Your Expenses
Unfortunately, businesses are not all about profits. You should also list down your expenses to understand whether your revenue will be enough. It includes office rent and supplies, salaries for project managers, a CTO, developers, etc., and one-time startup expenses like buying computers or installing the Internet.
Step 6 – Keep It Simple
Do not go into too many numbers at once. Established businesses usually track a lot but you have nothing to track really - there is only room for assumption. Do you really need to assume your future mergers or traveling expenses?
Also, please, do remember that it is for you as well. Make sure that you can understand it and analyze it in the future to see whether your assumptions are working.
Step 7 – Review Your Assumptions
Your assumptions should not appear out of thin air. Make sure that you have data to back you up on this: analyze your market and take a closer look at your competitors and their historical data. Also do not forget to make your revenue goals actually achievable. Otherwise, you may go bankrupt in your first year.
Three Deliverables of Every Financial Model
Startups usually work out a structure that works for them so that everyone can easily understand it and the model highlights what is essential for the company. No matter how you decide to design your spreadsheet, it is important that your financial model includes these three deliverables:
Financial statements signal how well the company is performing. As a startup, you will not have the historical data but it is important to forecast. Every investor will look for financial statements projections in your model.
There are three financial statements to take care of: the profit and loss statement (P&L), the balance sheet (BS), and the cash flow statement (CF).
The profit and loss statement determines your income and expenses. You should include how much revenue you plan to get and from what and list your expenses like ads, salaries, taxes, office maintenance, hiring, etc.
The balance sheet demonstrates what you own (computers and buildings) and what you owe (debt). The forecast of a balance sheet determines what investors will get in case your startup’s assets will be liquidated and there will be a debt to be paid.
The cash flow defines where cash comes from and where it goes. It breaks down into three categories: the operational cash flow, the investment cash flow, and the financial cash flow. In the operational cash flow, you should predict how you will get or lose money from regular business operations. For example, the cash inflow will be from selling your product and the outflow will happen because of the salaries, taxes, and rent. In the investment cash flow, you should state what you plan to finance (new equipment, new offices) and what you plan to sell. Lastly, your financial cash flow will come from investors and banks and go to dividends, stock repurchases, or repayment of loans.
Operational Cash Flow Overview
We have already discussed operational cash flow in the last paragraph but it is such an important part of your financial model that it deserves a separate mention. However, it is a bit different: in the financial statement it is an overview of yearly results and in overview, it is about monthly operations. You will know what months are more demanding on cash to make sure you are prepared for them. You will also learn what months are least demanding and you can save money for later.
KPI stands for key performance indicators and measures the success of your startup. It is always paired with a business objective, what one wants to achieve. Basically, it is a way to set goals and measure whether you achieve them accurately through numbers. For example, if you want to use ads more efficiently, you have to track your clicks, click-through rates, conversion rates, customer acquisition costs, return of investment, etc.
KPIs will help you both focus on reaching goals and define what does not work and needs improvements. If you have KPIs, investors will better understand whether your business is sustainable and see that you do, in fact, have a solid plan.
You should choose KPIs based on your main business goals rather than tracking everything out there. In such a way, you will have time to track and actually analyze your results. Numbers are nothing if they are not interpreted well.
There is no one particular template that fits them all so do not try to waste your time on finding the perfect one that every investor will love. As your search criteria, use your business’s unique state of things. As a rule of thumb, you can look through numerous options and pick up what works for you from there. In the end, you will have a custom template only with the information that you need.
We also recommend looking at the different structures of templates, how their spreadsheets are divided and tables organized. You may find the inspiration for the structure that will work for you.
The structure of your financial model should be unique but mistakes are the same among all the startups. Let’s take a look at them to know what to avoid - sometimes it is the best learning starting point.
As we have mentioned, you should always have some data to back up your assumptions. If you do not have it, investors will just not take you seriously. It might end up destroying your business too if you assume that you will have too much revenue and spend money just because.
No Executive Summary
Even though finance departments love numbers, they want to read first what the numbers are about. A small explanation with key points will also do good for those who understand nothing about finance but want to know more about your startup.
Untested Formulas and Errors
Before you use the formula for a huge document, try to test it on a small number of definitions that you can actually just count yourself. Otherwise, you might get errors or incorrect numbers. Make sure to scroll through the document to check for errors as well - they look very unprofessional and lazy.
Make sure you use the same format of dates, numbers (decimals with a comma or full stop), and percentages (0,07 or 7%). It will eliminate confusion and make you look more put together.
Do not hard-code ever. It is the most common mistake. If you still decide to do so, leave a comment where this number came from for more credibility and the absence of errors. And no, you will not just keep it in mind - these things are forgotten so easily.
Too Complex Formulas
The more complex the formula, the more likely it is to go wrong. Long formulas are also too hard to follow and finance people who have to review dozens of those in a day will just give up. As a rule of thumb, do not make it longer than one formula bar.
Consider Real-Life Examples of Your Company’s Performance While Choosing Financial Model
The worst thing about assumptions is that they are rarely true - no matter how much data you have. Therefore, it is always better to be ready for both best- and worst-case scenarios. In your financial model, include a baseline - you can take it from your market research and by analyzing the performance of other similar companies that started not more than a year ago. Afterward, make the worst and best assumptions and forecast how you will live through both of them.
For example, you’ve just launched a startup in FinTech and your baseline is 20 new users per month, the best scenario will mean 30 users while the worst comes at only 10 new customers. Are you ready for such a small revenue? Are you ready to expand in the case of big growth? Well, you should be.
The financial model is a great way to prove to investors and yourself that your business will last long and that your profits and losses are perfectly balanced. It can also prepare you for the worst and best scenarios if you decide to take our advice.
Financial models are mostly based on assumptions but they definitely need to be backed up by data from the market research. Otherwise, you might get into trouble and sink in your first year. Other than that, make sure that the technical part of your model is right: check whether your formulas are working fine and if the text is formatted well.
Making a financial model is an essential part of your startup journey so it is definitely worth the effort. Remember: it is not only for the investors, it is for you in the first place. So make sure to create a model that is more than merely a nominal.
Michał is a digital marketing veteran with a growth hacking mindset and 10+ years of experience. His goal is building high-quality technological content, with particular emphasis on React and Ruby on Rails. Traveler, climber, remote work advocate.