Why is Financial Modeling Important to Startups?
Starting up a business is EXCITING! If you’ve ever started a business, or plan to do so, pat yourself on the back because you’ve got gumption. Startup entrepreneurs have so much passion for developing their products and using them to change the world for the better! It would be devastating to not see those ideas come to fruition as a result of limited understanding of their business’s financial components. Because I want to help you find success, I’m going to share a statistic. 50% of startups fail in the first five years (#scaretactics). Yes, that is a scary number, but if we dig into why this failure occurs, probably 80% of these businesses could be saved with sound financial planning and business model brainstorming.
So, what are you waiting for? There is a way to build a much more sustainable business and that is through sound financial management including KPI tracking, metric based decision making, cash management, and much more. Which brings us to the importance of financial modeling.
Three Reasons to Build a Startup Financial Model
Financial modeling allows you to best (better) prepare for “balancing the books” and managing the timing of inflows and outflows for your business. Essentially it provides a crystal ball, of sorts, so you have a business roadmap to work from.
Reason 1: Awareness
Stemming from the many awesome conversations I’ve had with entrepreneurs, I’ve come to a major conclusion – surprises in business are unwelcome! This leads me to believe that any way a business owner can better understand their business, their industry, and their numbers is a good thing. So our first reason to build a financial model for your startup is because it creates a higher level of awareness and will open your eyes to new considerations.
Beyond just having the actual model, the process you go through to develop a financial model is hugely educational. Building a financial model forces you to ask questions of yourself and of your business, so you can ultimately become a better leader, a better manager and build a better company. How devastating would it be if your business failed simply because you didn’t know what to look for?
Reason 2: Plan, Execute & Monitor
Now that you have a higher level of awareness, let’s talk about the second reason which is all about your action items: plan, execute and monitor. Now you have the opportunity to enter your initial assumptions into a financial model and reforecast them based on the exciting new considerations you learned from being more aware. This will allow you to solidify your initial plans based on market data and to go out and test them!
Here’s the hitch though, you HAVE TO monitor your progress. It’s okay to fail fast and make a quick pivot however without monitoring the financial plan that comes from your financial modeling, you still aren’t letting the data drive your decisions.
Reason 3: Learn, Modify & Grow
Above all, the process of developing your startup financial model gives you the opportunity for growth and improvement. So, our third reason is to learn, modify and grow. You get to distill everything you’ve learned from reason two and build on what is working and then keep improving your business plan which will ultimately help you grow a stronger business.
With deep knowledge of your business, its numbers and how it should perform you can:
- Answer challenging questions about your business for yourself (#stayingsane);
- Prepare for conversations with colleagues, customers, advisors, lenders and investors about your business;
- And finally turn these otherwise challenging questions into ones that are now a walk in the park (#personaldevelopment).
The process of building a financial model allows you to crystallize what your plan of attack is and the true value of your organization. Which in the fullness of time feeds back to our initial reason for building a financial model, which is achieving a greater awareness of yourself and your business so you can be a better leader and a better manager all in the name of building a better company.
Building a financial model helps you achieve three things:
- Awareness. You know the right questions to ask and have the right information to shape your business plan.
- Plan, Execute & Monitor. Now that you know what to look for you can reshape your business plan for the better and create a cycle of monitoring and improvement.
- Learn, Modify & Grow. You have a true foundation of understanding of your business to make awesome decisions, show its value and encapsulate its value for others.
Do You Have to Build a Financial Model?
If you’re still unsure of the value of a business model, I can keep going. I see far too many companies building financial projections solely to raise capital and, honestly, you’re basically cutting off your nose to spite your face. Both investors and employees will flock to a kickass company and a kickass company is one that understands its future and has a clear and believable game plan to get there.
To know your future is synonymous with building a financial model. If you’re only building a model to raise capital, people will see right through that and without a model you’ll be navigating blindly based on whatever strategy you feel is important on any given day. So do you have to build a financial model and continually reforecast it? YES!
The Top Down Versus the Bottom Up Approach
There are two approaches to startup financial modeling, the top down approach and the bottom up approach. Before we go further, a quick side note, if you’re unfamiliar with the term total addressable market (TAM), it is the total market demand for a product or service and represents the most amount of revenue a business can generate by selling their product or service in a specific market.
The Top Down Approach
In the top down approach, you evaluate your expected revenue by looking at the larger market, determining the percentage of the market that is your customers, and calculating the potential revenue you can achieve within this addressable market. You can then further break down the data to achieve a top down revenue model.
The Bottom Up Approach (our preference)
As you can imagine, the bottom up approach is the opposite of the top down approach and starts with all the components that influence your business’s revenue (and cost) drivers and uses these assumptions to calculate a “bottom up” financial model. In the example of a consumer packaged goods (CPG) company revenue drivers may be:
- The number of products you have to sell
- The price of these products
- The average velocity (fancy name of speed they move off the shelf) of these products
- The number of stores these products are sold
At Simple Startup, we prefer this method because it gives us more of an actionable path for the changes we can make to achieve a certain level of revenue.
Which is the Better Approach?
The top down approach is faster to create and concentrates on the bigger picture of market availability. However, it doesn’t provide a clear path to execute and hence achieve your forecast. With this approach alone it will be difficult to ascertain if your business is on the right path.
The bottom up approach, though it takes a lot more effort, is good for understanding the many assumptions of your forecast. Knowing your assumptions gives you a higher level of clarity and shows you actions that can be taken.
We have a saying at Simple Startup – build bottom up but also sanity check top down – because even though we prefer the bottom up approach for the granular data it provides, the top down approach also provides value by ensuring you’re in line with your addressable market. In other words, if your model is projecting revenue greater than the addressable market, then it is flawed to begin with – we therefore need to be aware of this and make appropriate adjustments.
Use the Crystal Ball
Entrepreneurs are daring – that is one thing, I believe, they all have in common. BUT they can often differ in their approach to business, some go by gut feel, and some like financial models. If you’re the type of entrepreneur who wants a tool they can rely on to inform their business decisions, then starting with a financial model is an absolute must. AND since we’re here to ensure you succeed, we want to share our Fill-In-the-Blanks Financial Modeling Course that will help you build the closest thing to a crystal ball for your business that you can get!