How to create a financial model for fundraising? Do’s and Dont’s
Founders love building breath-taking products which have the potential to disrupt the world around them. What they don’t like is to get stuck up in the messy yet important world of spreadsheets and assumptions even though how so ever important it is. To help these entrepreneurs we have come up with this small guide to help them understand the basics in’s and out’s of a good financial model.
Every entrepreneur has a dream of building a sustainable business which is both feasible and efficient. A good financial model will allow you to do that or if we put it more specifically, following a good financial model will ensure that your business is on the correct path to become sustainable, efficient and feasible.
Financial models can be used for whatever purposes that you put them into, financial obviously but there are 3 main uses of the financial model:
a) To build an economically viable business: Financial model is nothing but the quantified version of your business model & business plan, assumptions and vision. By quantifying and validating these inputs you are able to reach to the conclusion that whether the business is viable or not. Adding in scenario and sensitivity analysis will allow you to incorporate those situations which are pertinently not normal, the Black Swans.
b) You need one to raise funds: Investors will always ask you for a financial model whenever you engage with them to raise funds. Investors here is a broad term denoting Angels, VC’s, PE’s, Banks and Regulators or Bodies providing grants or subsidies for e.g. The model answers the tricky question that an investor has whenever they evaluate your business model.
c) To create benchmarks & milestones: Financial models allow you to create benchmarks and milestones that can be used as targets to achieve. In this form the model becomes nothing but an input output exercise driven by all the assumptions around the business model.
Now you know the 3 most important reasons why you need a financial model for, we will look at some technical methods to reach to the numbers and forecasts. There are 3 major ways to forecast future numbers:
a) Top Down: Using a top down perspective you work from a macro view towards a micro view i.e. you start with assumptions on the economy level and get down the level of your firm/startup. The top down method allows you to create a forecast based upon the market size that you would like to capture in a given timeframe.
b) Bottom Up: Completely opposite of top down methodology is the bottom up methodology. Top down methodology can be too optimistic at times, as you start looking at bigger numbers right away. Bottom up allows you to sensibly craft assumptions around your startups capabilities and reach to holistic forecasts which are both realistic and reliable. In a top down method, you begin with a micro view and build up towards a macro view. This allows you to capture the forecasts based on the key value drivers of your company whether revenue or costs.
c) Hybrid: Hybrid is nothing but the cross section of the top down approach and the bottom up approach. This is the least used method around and is complex to create and justify.
Now we know the 3 methods to build your financial model, we can look at some best practices to ensure that your model has the desired impact:
a) Validate your assumptions: As a startup you don’t have the historical data or the amount of data is so small that the sample is not reliable, hence your historicals are incomplete to create the assumptions around. The best way in this scenario is to validate your assumptions through ample of research.
b) Be clear & concise with your presentations: Try to keep your model simple as possible, don’t try to use many complex logics or formulas until and unless they are necessary. This allows the investor to get on grips with the model very quickly and build up his decision in a systematic manner.
c) How long should you forecast for: You don’t want to forecast for a very short period nor you would like to forecast for a very long period. We would suggest you to keep your forecast period somewhere in between 3 to 5 years.
d) Monthly, Quarterly or Yearly: We would suggest you to go with a monthly presentation. This will allow the investor to look at the model from an granular level and he or she will be able to capture all the changes as they come about.
e) Create schedules for key drivers: You should always create different schedules for different key drivers, whether costs or revenue. For e.g. if you are a SaaS platform then ideally you should have schedules for Opex, Capex, Tech Costs, Man Power Costs, Marketing Costs, Revenue and a separate sheet for Assumptions.
f) Graphs are great but do you really know which ones to use: Graphs are great, visualisations make everything easy to understand but you really need to know which visuals are best for the type of data you have.
g) Be through with your Financial Statements: One of the outputs of the whole financial modelling exercise are the financial statements, P&L, Balance Sheet and the Cash Flow Statement. We would suggest you to have a combined schedule for P&L and Cash Flow Statement and a separate schedule for Balance Sheet. Create two separate schedules for monthly P&L and Cash Flow Statement and a summary yearly P&L and Cash Flow Statement. Balance Sheet can be kept as a single schedule on a yearly basis.
h) Calculating your cost of capital: One of the end goals of the financial model is to reach to a tentative valuation number for your venture using the DCF valuation methodology. Calculating the WACC on a separate cost of capital schedule would make things easier for both the founder and the investor.
i) Comprehensive DCF Valuation sheet: Create a separate sheet for DCF valuation of your financial model.
j) Create a separate Cap Table and Scenario Analysis schedule.
k) Create a summary sheet: A summary sheet is like an overview of the model and involves you showcasing the key aspects of the model and few KPI’s which are important from the point of view of business model evaluation.
l) Create a top sheet: A top sheet with business summary and other inputs is desirable but not necessary in building up a successful financial model.
In addition to that be consistent with your fonts, use bold and other editing judiciously and always cross check your formulas and methods.
Financial models are dynamic in nature and should always be changed as your startup moves ahead on the growth curves. Always keep in mind that a move towards profitability is the only way that a business will survive in the harsh world of business and is a factor which a prospective investor would always like to see in a financial model.
We hope this blog post of ours will help you to create perfect and streamlined financial models which will help you to achieve the desired success.
Written by: Ayush Dadhich & Manas Vashistha
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