Startup Financial Models

You want your model to easily change assumptions for each year, and you want to include a waterfall throughout the entire sales funnel, that’s going to include conversion rates and unit economics.

This is a best practice that the best CEOs do, because it provides an understanding of resources and effort required to close a sale. You also want to remember to include delays due to sales cycle and customer collections. This is going to affect your cash flows.

Next, you want to stress test your model, conversion rates, growth rates and see what the impacts are. When these start to go sideways, you’re going to be prepared. If not, it can kill your cash. Next, your model should include a balance sheet, income statement, and cash flows. Finally, be honest with yourself in building your model.

We've outlined the steps to creating a financial model for your startup. 

1. Determine the goal of the model
2. Determine the KPIs for your company
3. Get a financial model template
4. Merge actual results into the template
5. Start with revenue
6. Project headcount needs
7. Estimate other expenses
8. Model working capital
9. Review your projections

Step 1. Determine the goal of the model. This is so you can decide how complicated to make the project. In general, if you are market sizing or doing back of the envelope estimates, less complicated is better. The next level of complication is if you are raising capital - too detailed, and your conversations with investors will get bogged down in minutiae. But have enough detail to show that you understand the market. Finally, for a detailed cash flow model for an operating business, it is typical to have very detailed analysis. 

Step 2. Determine your KPIs. Ideally these are numerical factors and assumptions that you will be able to track - KPIs in a model a useless if you can’t track how you perform against them! Use industry standard KPIs as a starting point.

Step 3. Get a financial model template. Don’t start from nothing; building a working piece of Excel is time consuming and a waste of time. Use one of the many free templates - like the ones on this page. 

Step 4. If you have an operating business, merge your actual results into your projections. It’s best to start with reality, so you can level set. Strange ‘kinks’ in the model where actual results meet projections is a sign that there is something off with your projections. 

Step 5. Work your way down the income statement, starting with revenue. When  you think about how much revenue you’ll have, make sure you understand what’s driving that revenue. Is there a particular number of customers or sales people or marketing spend/activities that will cause that revenue growth? You’ll also want to think about your cost of goods sold as you project your revenue. Note that this does NOT make sense if you are projecting a hardware or biotech company with a long time to revenue. Instead, for those, map out the effort you'll need to reach critical product development milestones. 

Step 6. For most startups, headcount is the biggest expense (at least until marketing kicks in!) How many people will you need to achieve your goals, and how much will each cost? Don’t forget recruiting costs; even if you have a deep network, you’ll will likely need to hire in the out years. 

Step 7. Estimate other expenses. You can use examples from other successful companies to see how they’ve scaled their expenses. Remember to add in additional expenses as the company grows - this should also apply to your headcount expenses. Very few companies have over a 50% pre-tax profit margin, so make sure you are adding in expenses!

Step 8. Working capital matters. Read our section below. Basically, understand when your clients will pay you, and when you’ll need to pay big vendors. 

Step 9. Review your projections. Take a look at the summary. Does it make sense? Is the model telling the story that you envisioned? A sanity check is always a good idea. 

In the early days of a startup, projecting cash flow is relatively simple, because it’s a one-way street. Payroll, rent, R&D and maybe some legal costs equal the cash out the door, with no revenue yet to offset the cash burn. Modeling this out in a spreadsheet is easy for most entrepreneurs. 

Understanding cash flow gets a lot more complicated when an early-stage company starts servicing clients - and this is where we see super-basic, back of the envelope financial models start to breakdown. There are a few places where revenue-generating clients can “mess up” a nice cash flow model. At this point of your company's life/growth, understanding and being able to model working capital comes into play.

What is Working Capital?

Working Capital = the difference between current assets and current liabilities on a company’s balance sheet. What this really means for most startups is the difference between when a startup gets paid by clients vs. how long it has to pay your expenses. 

The timing of payments from clients usually starts pretty simple but can get complicated quickly. Super easy SaaS companies may collect a Stripe bill each month from their clients. Unfortunately, not all billing platforms wire revenue quickly. Some of the app store billing systems wait up to 60 days to share the cash with their app developers. It doesn’t take long before a simple SaaS business has a variety of receivables to wait on from a variety of billing platforms. Fast growth may mean that customer count is spiking (and costs along with it), but with lagging cash collection, even a gross margin positive customer can drain cash for a while.

Purchase orders make selling into the enterprise even harder. Just because a new Fortune 500 client signs a contract does not mean that payment is on the way. Many larger companies have a Purchase Order system that can add on months to the actual receipt of payment. And if different enterprise clients are requesting different invoices or purchase orders, payment can take a long time to show up.

On the positive side, companies that sell annual subscriptions can get large payments upfront. This can really boost cash flow but does create some modeling issues vis a vis deferred revenue and revenue recognition. (We’ve got a whole video on deferred revenue here).

Expenses that companies incurred as they grow sometimes are automatically paid every month (like your monthly bookkeeping cost)- but others may be paid “manually” - as in when the executive in charge of bill pay decides to pay them. Stretching bill payment does have a positive impact on cash flow, but may not be worth the manual effort. Plus, it may annoy your vendors to the point where they stop providing their service, so this is not a great game to play if you are a startup founder.

Thinking through your startup’s working capital will help you have better projections.