Five Ways Your Approach to Financial Modeling is Probably Wrong
Proper financial modeling is critical, but not for the faint of heart.
Work with enough early stage companies, and you’ll inevitably hear reference to a financial model. Depending on the company in question, the model will be either a mysterious topic discussed only in hushed tones, or something casually mentioned on a Friday afternoon as a box to check in the start-up’s sure-to-be rapid ascent to riches. Neither is correct; in my experience, entrepreneurs at early-stage companies almost always approach financial modeling from the wrong angle (if at all), resulting in incorrect expectations and potentially costly decisions down the road.
Here’s a quick list of the five most common misconceptions and mistakes that early-stage management teams make when it comes to modeling.
- Yes, you need to do a model…and a good one. It is staggering how many young companies try to raise capital around a business plan containing only the most basic of financial projections. It is not enough to list revenues, expenses, and net profits – you have to build out a model that accurately shows the moving parts of the business you want to build. No matter how astute an entrepreneur may be in his or her field, superficial financial projections scream amateur, and won’t help the conversation.
- No, the model’s estimates are not cast in stone. It’s a model, after all, not a guarantee. Many entrepreneurs are justifiably wary about overpromising, but being too conservative isn’t great either – better to actually build out what you reasonably hope will happen, and back it up with logical assumptions and arguments. Institutional investors know that reality and projections will differ, and a good model can be adjusted to reflect what is actually going on as your company makes progress. That's what models are for - they are living documents.
- It’s the Journey, not the Destination. Any idiot can type numbers into a spreadsheet, so don’t think fancy formulas and complicated pivot tables will impress anyone. What matters much more is the level of detailed thought you have put into how all the moving parts of the business fit together under different scenarios. Investors will generally discount your projections anyway; what they really care about is whether you have actually done the work to think through all the expected revenues and expenses in the business over the model’s time horizon, and what assumptions you’ve made to ramp them. Important: Everything is connected, so don’t model, say, 5x sales growth without thinking carefully about what it means for the rest of the business. What will it cost? At what point to do you need to add staff? And what happens when you do? Does rent go up? How about insurance? All elements of the business have to reflect what you are predicting, not just sales, clients, users, etc.
- Models Are Not Fire-and-Forget. A proper business model is built in a way that allows key elements of the company’s economics to be adjusted going forward. This provides a mechanism for management to not only adjust core metrics to reflect real-world experience, but also a sandbox in which different scenarios and combinations can be tested to measure what happens to your company. Many entrepreneurs make a model during a fundraising round and never look at it again; this is like installing a GPS app on your phone and never turning it on. Use the model as a tool to better inform how and when you will be impacted by various developments, and what you can do to react. Done properly, they’re particularly good at predicting when cash will run low (which helps manage fundraising activities well in advance of a pinch) and can be a tremendous resource for learning which inputs and assumptions ultimately drive the business. Operationally, this helps you focus your time and energy - and that of your senior personnel - on the areas that ultimately have the biggest impact on the business.
- One Size Fits All. Don’t fall into the trap of building different versions of the model to suit the different conversations you’re having, display a certain pre-conceived result, or garner a higher valuation. It’s just not a good idea. You’re crafting the question to suit the answer, which leads to merely plugging in numbers into excel (remember the idiot mentioned in #3?). Build a model that is a legit depiction of what you think might happen if all goes well – no more, no less.
Proper financial modeling is not for the faint of heart, and it’s one of the areas in which Burkland’s on-demand CFOs excel. It requires an interesting mix of accounting knowledge and good, old-fashioned operating experience to do well, which means modeling is often the very last thing an entrepreneur wants to tackle. But it’s critical to not only understanding and managing the inner workings of your company at a granular level, but also to raising outside capital, and most importantly, to understand all the moving parts that affect your own business. Take the time to do the modeling right; your company, your investors and you will be thankful you did.
Photo courtesy of Christopher Michel.