A guide to financial modelling—and why it's key to your company's success
A guide to financial modelling—and why it's key to your company's success
Words Camila Zattar
June 23rd 2022 / 10 min read
An early stage founder’s most scarce resource is time. Between developing a product and strategy, acquiring customers, and hiring a stellar team, there’s barely time to breathe—even less to think. And yet structured thinking and a clear strategic vision are critical to a founder’s success, and as such, are demanded by investors, partners, and customers alike.
What does any of this have to do with financial modelling? Building a model is a critical exercise in business structuring. You can think of it as taking the time to draw a roadmap for your startup’s success. A well-built model is a powerful tool to enable financial tracking and capital efficiency. It’s also the clearest way to articulate vision and execution in an accessible format to stakeholders.
Every founder should invest time and effort into building a financial model for their business. Here’s our essential guide to financial modelling—what it is, how to build one, and why it’s vital for your business.
Founders should be hands-on with modelling, as it will aid your understanding of the business
A guide to each part of your financial model
The do’s and don’ts of modelling—including automation, labelling, colour coding
Our advice for forecasting for investors
What are financial models, and why are they so important?
The best way to think of a financial model is as a numbers-driven roadmap:
It’s a simplification. It won’t (and shouldn’t) show every detail of your business, just like a map won’t show every leaf and stone.
A model should reflect the company, not vice versa. If you found a road on a map that didn't exist, you wouldn’t start paving it. A model should never restrict your strategy and vision: it should be adapted to accurately reflect them.
To be useful, it must be readable/accessible. It should follow certain conventions (basic accounting rules), but also should fit a cohesive narrative that resonates with stakeholders. If you propose certain milestones, benchmarks, and performance indicators, these should appear in the model within their respective timeframes.
Four reasons why financial models are so important:
1. It’ll help you understand the key levers of your business
This is key for swift, efficient decision making.
For example—increasing pricing will generally lead to more revenue. But while some customers will accept higher prices, others will leave if there is a price increase. Should you price down at first to capture the market, or will that erode your future profitability?
Maybe hiring software developers will help you perfect the product, but investors will want to know if you have an effective go-to-market plan, for which you need sales personnel. Which should you prioritise, or do you have enough capital to do both?
2. It’ll help you keep track of your company’s financial achievements and health
Two key questions you’ll have to answer pretty much every day:
“Am I growing enough?” Properly recording historical volumes, revenue, and growth metrics will help establish a track record to assess your strategy and guide future initiatives.
“Do I have enough cash?” Accurately tracking costs (or “burn”) and external cash inflow will help you assess and control your runway, prioritise capital investments into strategy venues, efficiently time your fundraises and optimise your capital structure.
3. It’ll help you test and iterate on key assumptions
Unless you’re Paul the Octopus, trying to predict the future is a fool’s errand. So being aware of and preparing for different scenarios is critical to any decision-making exercise. A well-built, flexible model will allow you to quickly shift between scenarios and modify assumptions, adding a new layer of information to in-depth strategy discussions.
4. It’ll help you effectively communicate with key stakeholders
Among other uses, financial models are also powerful sales documents, which speaks volumes about a founders’ business acumen and commercial capabilities. Assumptions should be well-backed, but ambitious; growth expectations should be sensible, but compelling; and strategy points should be purposeful and well-timed. Little is more compelling to investors (and partners & future employees) than a founder who can show, not only qualitatively but concretely, why their success is inevitable.
How to build a financial model
Let’s get to it: how do you actually build a simple financial model? The easiest way is to split it into three core components, and add onto them as needed based on the rising complexity of your business over time. These components are:
The Cockpit aka the Assumptions Sheet
This is where all your core model assumptions should live, and this is where you will be spending nearly all your time once the model is completed. Taking time to properly format and structure the assumptions sheet will make your life significantly easier.
Residents of the assumptions sheet include:
1. Revenue assumptions
a) Volume assumptions - number of customers or items sold, and expected monthly growth rate
If you’re calculating your number of customers from a marketing funnel (e.g. website impressions > sign-up rate > conversion to paying customers), as in the template model, funnel assumptions should sit with volume assumptions.
e.g. I have onboarded 20 clients on my SaaS platform so far and expect to grow that number by 10% every month (next month I will have 22, then 24, 26, and so on).
b) Pricing assumptions - how much you charge for your product
This could be as simple as a unit price (e.g. £20 per item) or as complicated as a tiered SaaS subscription model (e.g., £10/month for a personal subscription, £1,000/month for a small enterprise subscription, £5,000/month for a large enterprise subscription). It can also be a commission rate (e.g., 15% commission on a purchase made through the platform).
2. Cost assumptions
This includes direct costs (such as cost of materials per unit produced) and indirect costs, or “overhead” (sales & marketing, general & administrative and others).
e.g. £5 of materials + £2 of shipping per item sold; 15% of monthly revenue on marketing costs; £300 per employee on office space; £150 / month flat rate for insurance; etc.
3. Cash flow assumptions
This includes your current cash balance and your expected fundraising round amounts.
e.g. I currently have £150k of cash in the bank; I expect to close a £1m pre-seed round in December 2021; then a £3m seed round in December 2022
4. Personnel assumptions
Though they are technically part of the cost assumptions, personnel costs (i.e., salaries) are usually by far the largest cost component at this stage of a business. It’s handy to keep them in a separate sheet to help keep track of headcount and strategise around future hiring decisions.
The Engines (aka ‘Where the Maths Happen’)
The engine sheets are where you work the assumption numbers into monthly financial results. It’s an exercise of logic and basic accounting, backed by a core understanding of your business model. Thankfully, google can supply several examples of best calculation practices, usage of excel formulas and typical model structures.
The key is to take your time to automate things properly - so once you are done, you will only come back to these sheets for structural additions.
Meet the engines:
1. The Revenue Sheet
Volume and price can take multiple formats. You can also have multiple segments and/or revenue streams—one-time purchases, subscriptions, commission—meaning in the same model you can have a few different forms of Volume x Price. Think through each of them separately, add them together at the end.
2. The Costs Sheet
COGS are direct costs related to the physical products you are selling (such as the cost of fabric for making a piece of clothing) and are calculated on a per unit sold basis. Service companies (such as SaaS businesses) rarely have COGS.
For overheads, in general, you can have the following cost “categories”:
Fixed rates (e.g. insurance, rent) - anything that is charged as a fixed contractual amount on a monthly or yearly basis
Growing costs (e.g. hosting services, , direct marketing) - you will usually have an initial fixed value for these, accompanied by a “growth rate” which you assume is needed to support the future scaling of the business
Variable costs based on revenue (e.g. COGS, certain advertising costs) - anything that is estimated as a % of your achieved revenue
Variable costs based on personnel (e.g. travel, entertainment, hybrid workspaces) - assume a cost per employee, and multiply by headcount
3. Cash flow modelling
Cash flows should be modelled as simply as possible (see below). Starting from the current cash position of the company:
1. Add any incoming investment cash and operating profit
2. Subtract any cash operating losses and capital expenditures
Note: because cash flow modelling at this stage is so simple, you can include these calculations directly in the summary page, right underneath the financial summary (as in the template provided).
The Summary Sheet
This effectively paints a picture of your company development for the next 1-to-3 years. In its simplest form, a summary sheet should show two things:
1. Total Revenues – Total Costs = Operating Profit / Loss
2. Existing Cash + Incoming Investment (+/-) Operating Profit / Loss = Cash Position
It’s worth having a more detailed summary sheet, so that you don’t have to sift through your engines to find additional information. This should include:
Volume (by segment or by type, if applicable) - while pricing is internally defined, volume varies based on external reception of various strategic choices. Looking at volumes separately can give you tons of insight on how recent strategies have been performing
Revenue (by segment or stream, if applicable) - this is the key metric for any early-stage business. Looking at it by segment/stream provides insight into how each chosen vertical is performing separately
Personnel expenses - should always be listed separately, given they are almost always the largest cost. As your team develops, it can be useful to split personnel expenses by function/team
Expenses (broken down by size/importance) - it is not critical to break down expenses (apart from personnel), unless one of them is significantly larger than the others or provides meaningful insight into the workings of the business
Top tips for building financial models
Only hardcodes (pure number cells) in a model should be in the assumptions tab. Everything else, particularly in the engines tab, should run automatically. It takes time to set up formulas and check all the links, but it will save you tons of time (and reduce errors) should you need to change any assumptions or run scenarios.
The best guideline to go by: once the model is done, the only thing you should be touching is the assumptions tab (aka the cockpit). You will only touch the engines to modify the model structure (e.g. add new revenue or cost lines).
Use number tying
All documents (teaser, pitch deck, any appendices, model, data room docs) should “speak” to each other and tell a cohesive story—which includes showcasing the same numbers. Once you’ve finalised your fundraising documents, look through them together in detail and make sure all numbers and metrics mentioned are accurately depicted in the model within the correct timeline.
Look out for…
Any GMV, ARR, MRR, customer volume or other metrics cited as milestones
Any specific hiring timelines explicitly mentioned
Any significant inflow / outflow of cash (e.g. fundraises, runway, etc)
Label, label, label!
You might know what that 43.7% on cell D45 means, but that doesn’t mean anyone else will.
Get in the habit of putting any hardcodes in a separate cell in the assumptions page, and labelling them. It can be something as obvious as “Months to a year = 12” or as critical as “Premium Commission Rate (per user) = 15%”.
Use comments to your advantage
The comment box (Shift+F2) on cells is a great place to jot down any implicit assumptions, comments on the formula used, or anything else that may be helpful (to you and others) in understanding your modelling decisions and assumption choices.
Colour-code your cells
Do the following as you go along:
1) Format all your hardcodes (pure numbers) BLUE
2) All in-sheet formulas BLACK
3) All links to other sheets GREEN
4) Anything suspicious (mixed hardcode/formula, links to other workbooks) RED
This colour code is widely known among people in the financial markets, and it works to indicate which cells you can safely modify (blues), which you shouldn’t touch (blacks and greens), which are simple formulas (blacks), which have a detailed calculation elsewhere (greens) and which may cause some confusion (reds).
Tips for forecasting
The general rule of forecasting: the closer you are to the present, the more “proven” your expected numbers need to be.
Up to 18 months (or up to your next funding round) - make reasonable assumptions based on existing or imminent revenue lines. Investors will want to know what their capital will be used for, and milestones before the next fundraise.
18 months to 3 years (aka the “Realm of Healthy Scepticism”) - investors may question or discount projections here, because of the higher degree of uncertainty. With that in mind, show vision and ambition - indicating the high growth prospects, innovative new business verticals (and revenue streams) and strategic advantages you plan to achieve.
Beyond 3 years - long-term business plans at this horizon risk being judged as either a) unexciting for being too conservative or b) unrealistic for being too ambitious. It’s incredibly difficult, especially at pre-seed / seed stages, to tell what the business will look like that far ahead. If investors ask for this length of forecasting, you should try to gauge any specific long-run concerns through strategy conversations.
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Cami is a Venture Associate at Founders Factory, part of the Venture Team who support startups in business and fundraising strategies. She previously worked in investment banking at Stirling Square Capital Partners and Credit Suisse. 15% of her brain is still occupied by modelling and Excel shortcuts (hence the article) - the remaining 85% is split between cheerleading FF startups and obsessing over sports, wellness, and mental health. She received a B.A. in Economics and a B.S. in Business Administration from the University of California, Berkeley.
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