What is a startup financial model and why is it needed. How to plan income and expenses. Examples and templates in Excel.
Financial modeling is an important startup planning tool that allows you to determine the feasibility of launching a project and attracting investments, the efficiency of the company, and the correctness of the development strategy. The absence of an economic model of a business is fraught with negative consequences of varying severity – from unreasonable and unreasonable costs to the complete failure of the idea.
The financial model shows the current state of the company and the expected course of its development. I understand that there may be resistance: how can I know the future. And it’s true, no one can predict what will happen tomorrow. But building a financial model will give you a tool to understand the strengths and weaknesses of the company, ways to optimize costs and increase profits.
And for potential investors, the financial model will help determine how much the founder understands his business and what goals he pursues.
Startup financial model: concept and types
For planning purposes, two forms of the financial model are commonly used:
- Financial plan for income and expenses (Profit and losses – P&L) – forms a startup development strategy, is built on an accrual basis (that is, accounting is not related to the actual movement of funds, but to the date the service is provided, the transfer of products, and so on).
- Cash flow statement (CF) is used for operational management and planning of cash flows. The construction is carried out on a cash basis: in order to attribute amounts to income or expenses, the actual movement of money is required (when they entered or left the account, from the cash desk).
Most often, at the initial stage, it is enough for a startup to have a cash flow statement and plan based on it. This report serves as a good indicator of business performance, and also helps the founder to avoid cash gaps and predict the moment of attracting investments. Based on the predicted CF, the investment indicators of the project (NPV, ROI, IRR) are calculated. I won’t say that it is without exception, but there are investors who use these indicators as criteria for making a decision. The calculation of these indicators is not the topic of this article, but if you want to figure it out, the planned CF will be a good basis for these calculations.
As the company grows, the founder will need to expand the reporting and planning system. Then P&L will appear with the ability to calculate revenue, net profit, break-even point and payback of the project.
If you have a long time lag between the moment of providing the service / shipment of goods and receiving funds, it is recommended to immediately build a financial model based on two reports – CF and PL.
Why else do you need a financial model
Startup financial modeling is used to:
- Justification of the company’s concept – the layout clearly demonstrates the sources of income and costs, market size and other indicators of the organization’s activities. The model allows a deeper understanding of internal and external business processes.
- Attracting investments – based on the business plan and financial model, investors evaluate the value of the company, a decision is made on the appropriateness and amount of investments.
- Development of the company’s strategy – the layout shows the strengths and weaknesses of the company, the main economic factors affecting business growth, focuses on KPI. Analytics allows you to optimize and increase the efficiency of activities, quickly respond to market changes.
- Benchmarking – comparing the results of the company with the indicators of successful competing organizations to improve their own performance.
- Forecasting – analysis of the income and expenditure part gives an understanding at what volumes the business will start to make a profit, that is, the break-even point will be passed. The plan shows how quickly a startup spends money, whether these costs are justified when it is necessary to conduct an investment round.
Once again, the goal of the financial model is not to guess the future of the company, but to understand the business processes of a startup and the factors that affect its growth. Since the layout is based on hypotheses, it needs to be updated regularly (when actual sales figures, revenues, costs, and so on) appear. In this case, the model serves as the basis for determining the correctness of the chosen strategy and, if necessary, its revision.
Rules and features of building a model for a startup
The financial model of a startup is based on a business model, that is, initially a description of the target audience, customer acquisition processes, product features, and its receipt is required. Already on the basis of a quantitative assessment of production, customers, promotion, conversion, the financial performance of the company is determined.
When building a startup model, it is recommended to follow the rules:
- Be as flexible as possible – indicators that require changes should be listed on a separate line (for example, the price of a product). A feature of the financial model for a startup is the regularity of deviations from the plan, while the assumptions made are easy to correct. As a result, related layout elements will also change due to the action of formulas. It is important in the course of current activities to replace assumptions with the received actual data.
- At the initial stage of startup development, it is recommended to focus on key indicators, limit the number of metrics to the most important ones. Your financial model should be as simple and understandable as possible for you.
- To build a model that is close to reality, it is useful to study the average indicators for the market. Such an analysis of the industry will help the founder prove to investors the objectivity of the created layout.
- Thinking about reserves – a common mistake startupers make when creating a financial model is the desire to present an ideal picture of the company’s development. However, in practice this leads to significant deviations from the plan. When building, it is important to take into account different scenarios (pessimistic and optimistic) and provide for reserves. For example, it makes sense to allow 5-10% more for operating expenses, and consider an additional option in the sales report if they are half as planned.
How to start building a startup financial model
You need to build a startup financial model gradually – “from simple to complex”. Initially, you should create a basic business layout, establish links between its elements. Then, as the startup grows, supplement the model with indicators corresponding to the stage of development.
The main stages of building an economic prototype of a business:
- Analytics and structuring of income.
- Compilation of expenses.
- Analysis of operating activities (production and sales of products, efficiency of personnel use, fixed assets).
- Adding additional indicators based on the characteristics of the startup and the stage of development (taxes, loan interest, and so on).
You can build a model yourself or entrust the analysis to professionals. The choice is made based on the financial literacy of the startup, the budget, the reasonableness of the time spent.
At the initial stages of the company’s development, the founder is quite capable of doing it himself – create a table with the necessary economic indicators in Excel or use ready-made templates. This will allow the founder to delve deeply into business processes, control and effectively manage a startup, and show investors an “understanding” of their project and development strategy.
If the model is built by professionals, it must be adapted to a specific business, taking into account its characteristics. However, in any case, the founder will need to understand each figure, since the layout is a flexible system that needs to be constantly worked on and adjusted, be able to present it to investors, and justify each point.
In our opinion, the best option for a startup is to create a model on their own, thoroughly delving into business processes, and give it to a professional for audit.
The prerequisites are the foundation of the financial model, their change affects the final result of the company’s activities (profitability, payback, and so on). They allow you to predict different options for the development of a startup, refine the layout.
Prerequisites can include product timelines, sales funnel, marketing tools, contractual terms (such as prepaid or postpaid work), discount rate, loan rate, dollar exchange rate, markup, inflation, and so on. The financial model is a constructor – it clearly demonstrates how the entire layout changes when the above indicators are adjusted.
How to evaluate income
The model reflects:
- all sources of startup income;
- sales plan;
- sales market analysis;
- total incoming cash flow;
- cost of sales.
The end result is the definition of operating profit – it should be positive, at least in the forecast scenario. In the first months of launching a startup, negative values are allowed – when the profit does not cover the costs. But in the long term, the company must go into positive operating activity, otherwise it will become bankrupt or require new investment rounds.
When determining income, it is important to take into account the features of the product. For example, if an online service is being developed, it makes sense to break down the number of subscribers by rates. For example, set the premium to 10%, on the regular plan – 90%. Seasonality can also be attributed to the features of the product.
That is, the income statement in the financial model contains both real numbers and planned ones. At the initial stages of startup development, the layout can only consist of a forecast. The following methods are used to determine income:
- “Top down” – a startup needs to take an estimate of the size of the target market and multiply it by its estimated share in it (which the company will be able to take). For example, a niche has 7 main competitors who have occupied 70% of the market. Then the startup can indicate that he plans to own 10% in 5 years (70% / 7). To determine the profitability, the share is multiplied by the assessment of the target market.
- “Bottom up” – in this case, you should multiply the average revenue per customer by the expected number of customers. For example, if a business provides for a subscription fee, its average value can be taken as the average profit.
To determine the income, you can choose one of the methods, but it is better to use both – display the total value if there are discrepancies (at the same time, it is better to adjust the indicators in which the startupper is less confident).
When building a financial model, all real and projected startup costs are taken into account:
- for the production of a product, including capital – for the acquisition, modernization of fixed assets (equipment, technology, real estate, and so on);
- related to the promotion and sale of the product;
- permanent – salary to the state, rent, payment of utility bills and so on.
It is advisable in this part of the model to determine the gross profit – the difference between revenue and the cost of the product sold. When making forecasts for the expenditure side, a detailed analysis of the market will be required. Estimating most of the costs is not difficult – just call landlords, check the average salary of specialists on recruitment sites, collect data on advertising and marketing prices, find out from suppliers the cost of the necessary equipment, raw materials, and so on.
When compiling the expenditure part of the model, it is important to take into account the features of costs. For example, when determining the amounts for the salaries of employees, additionally include insurance premiums and other expenses in them, if they are provided by the company (payment for cellular communications, coffee, and so on). When developing a model for several years (usually 3-5 years), inflation-driven growth should also be taken into account.
The more precisely the plan is drawn up, the higher the probability of choosing the right startup strategy. Detailed cost analytics significantly reduces the risk of a cash gap that is typical for startups, when there is a temporary shortage of funds needed to pay off costs.
Examples + Templates in Excel
If a startup has not yet launched or is just starting its journey, the financial model looks as simple as possible and includes only basic elements (revenues, expenses, their ratio).
For example, Start is planning to launch an educational mobile app. Before the creation of the MVP (Minimum Viable Product) and the first sales, the founders formed a simple financial model to determine the feasibility of developing an idea.
For the first 3 months, the founders are busy creating the product, for which they attract IT specialists, which is reflected in the expenditure side. Marketing costs are minimal – the founders use free or low-cost demand analysis tools and promotion methods. Investments are made to cover the costs.
Large sales are planned in six months, when a fully functional version of the application enters the market. At this time, various channels for promoting the product, including expensive ones, are actively used.
Despite the fact that the company’s operating profit in the first months of operation is negative, investments allow to stabilize the situation. According to the plans of the founders, the break-even point will be reached after 6 months due to the growth in sales of the full-featured version of the application.
It should be understood that it is impossible to be limited to the original plan: as real data (sales, spending, interest on a loan, and so on) becomes available, the economic layout is updated and, if necessary, supplemented. Use a template of a similar financial model – fill in only the colored cells, the colorless ones contain formulas for automatically calculating indicators. For correct calculations, enter the costs in the table with a “-” sign.
After entering the market, receiving the first income, the economics of the project becomes more complicated, respectively, it is advisable to supplement the financial model. The degree of expansion depends on the stage of development of the company, the activity of its activities, the amount of resources involved and other factors and features. In this case, we suggest downloading another template of the financial model – more complicated, but it will suit startups both at the very beginning of the journey (before entering the market) and at later stages.
The first sheet of the layout contains basic questions about the startup concept, product features, its value for the consumer, competitive advantages (business model), key performance indicators (unit economics). The second sheet shows the dynamics of the company’s development over a certain period.
Summing up – life after the financial model
The main task of tabular structuring of startup performance indicators is to determine how profitable the conceived project is in the future. If the economy does not converge even on paper, the implementation of the idea should be abandoned. If the project appears profitable, the layout will help determine the target values that are needed to reach the break-even point and further growth.
However, the model should not be taken as fundamental financial analytics – it is a simplified version that provides answers to basic questions and demonstrates a startup development strategy and understanding of business processes. Since the economic layout is based on hypotheses, it is natural to ask what life is like after its formation, and whether it exists at all.
Let’s say you have ideally developed a startup model, established the profitability of the idea and the direction of development, substantiated each point to investors, and even received money. But as you do business, sales channels, promotions, production technology, contractual terms with suppliers and other factors and prerequisites that affect the company’s activities suddenly change. As a result, the financial model becomes biased and requires intervention.
Does it really need to be redesigned? Not certainly in that way. Remember the flexibility of the financial model – if the automation of calculations (using formulas) is initially provided, and the startupper understands how it works, there will be no difficulties with editing. If the layout is worked out in detail with a deep analysis of the market, competitors, own opportunities, risks, the probability of an unfavorable outcome for the company due to the changes that have occurred is significantly reduced.
A startup should always be ready for change – this is one of its characteristic features. As a result, the financial model needs to be updated accordingly. At the same time, the layout must be built in such a way that the adjustment takes a minimum of time, because the task of a startup is still to make a profit, and not to create tables.