The Ultimate Guide to Financial Modelling for Start-ups
Financial modelling for a start-up business is usually a crucial step in validating the success of a business. It is a process which aims to forecast various success factors such as revenue streams, expenses, the cost of capital and potential customers just to mention a few.
By modelling these success factors, start-up companies are more likely to establish financial stability in the short and long term. With that said, what are some key guidelines that founders should follow when developing a financial model for a start-up business?
Develop a model for the short term
Short term modelling is especially crucial for start-up businesses. This is an excellent way to get started before deciding to develop a financial model for the long term – sometimes less complicated is better. There is no point in forecasting for the long term when you do not have enough data or information from the short term. A short term model can thus be quite useful and serve as an input into developing a longer term financial model.
Establish the objective of the model
Identifying the objective of the model is as important as developing a short term model. In most cases, as mentioned before, the overarching goal of the financial model is to estimate or forecast the financial success of a business. This single overarching objective can be broken down into smaller working pieces.
For example, the model could take into account a detailed summary of the start-ups cash flow and expenses. It could also include a breakdown of the existing capital held by the business. With a clear and well established objective, the financial model should be able to tell a high level story to various stakeholders, including the founders and even the investors of a newly found start-up business.
Identify key performance indicators
Key performance indicators (KPIs) tend to be an excellent way to determine the performance of organisations. KPIs are quantifiable measures of performance over a period of time to determine the success of a business.
For start-up environments in the infancy phase it’s worthwhile tracking KPIs. It enables start-up businesses to identify the activities that are likely to improve the longevity of the business over a longer period of time.
When one considers the use of a financial model, examples of KPIs may include the cost of marketing in relation to the amount of newly on boarded customers or the cost of employee salaries in relation to the amount of revenue generated on a monthly basis.
Document the financial model
Critically thinking about a suitable financial model for a start-up business is a hard enough task as is. At some point being able to document a financial model should be the gradual next step.
Fortunately, given the amount of digital templates available on the internet, it has become a lot easier and more affordable to access existing templates that might suit the needs of the financial model that you have in mind.
Documenting a financial model is therefore a great way to visualise the road map of how a start-up business plans to navigate its way through generating revenue and managing expenses.
Also Read: How to take control of your finances and plan for the future
Develop an estimation of your revenue
One of the most important aspects of any financial model is to have a well-developed forecast of potential revenue. These projected figures are most likely going to be the first thing that potential investors will have a look at.
Projecting revenue is no easy task, especially for a start-up that has not made any sales yet. One way to approach this is by doing market research on existing businesses with a similar business model and offerings as the start-up you have in mind. This is an excellent way to formulate realistic revenue projections.
Apart from researching potential competitors, you could expand your research to the entire market or a specific industry. This will provide you with a macro view of how well a specific industry is doing overall. It also strengthens the validity of your estimations and allows you to confidently make assumptions about the figures that you have projected where your revenue is concerned.
Fortunately, with the availability of the internet, there are many market research companies that publish their data on various metrics, including revenue growth across a large number of industries.
Determine your core expenses
Much like determining the revenue stream, it is equally important to estimate core expenses. In most cases, salary expenses tend to be the largest portion of overall expenses.
This can vary between different start-ups depending on the business model in question. For example, a start-up that is quite labour intensive will likely have much more expenses attributed to salaries.
On the other hand, a start-up that is more technology driven with many automated processes might be less labour intensive. In the case of the latter example, technology driven start-ups are more likely to allocate their expenses to infrastructure and software.
Top down and bottom up forecasting
Generally speaking, there are two popular approaches to forecasting, the top down approach assumes that you work from a macro towards a micro perspective. This usually involves drafting industry estimates as a starting point which is then filtered into meaningful targets that may suit your specific start-up business model.
Top down forecasting also allows you to establish the market share you aim to capture within a sensible timeframe. It is therefore important to account for existing competition in the market as this too will determine the available market share to capture.
One major drawback of top down forecasting is that it may result in being too overly optimistic thus causing your model to fall short of the goals that you have envisioned.
Instead of taking into account external factors, such as the market, the bottom up approach focuses on internal factors. Bottom up forecasting thus lends itself to leveraging internal business information and the capacity of the start-up. Unlike top down forecasting, bottom up forecasting works from a micro perspective towards a macro perspective.
Regardless of the approach used to build a start-up financial model, it is imperative that you are able to provide evidence for the assumptions you make where your figures are concerned. This is especially true when you are dealing with a start-up that lacks historical data as evidence.
Assumptions are also important for investors and given the lack of concrete historical data, assumptions must be carefully thought out. This often requires you to be realistic in terms of the figures you are projecting. Keep in mind that investors are potentially willing to fund your start-up, so while remaining optimistic it is crucial to ground your assumptions in a realistic manner.