Investing in Seed Stage Startups? Toss the Financial Model!
If you are a Seed stage tech investor, ignoring a detailed financial model may be the best move you can make as you approach your investment decisions. As contrarian as this advice may seem, there are sound reasons to do so. This article explores some of them, based on our fifteen-plus years of experience in the CFO seat, helping hundreds of venture-backed startups raise over $2.3 billion.
Do Seed stage startups need a financial model?
You may think that asking this question seems unnecessary. After all, how can you project a business without a financial model? How would you know what you’re getting into? Arguably, the right question may be: How good is a financial model for a Seed stage company at predicting how the company will actually perform?
As I wrote above, the collective experience of many of our CFOs – including mine – indicates that a financial model at Seed is pretty useless as a predictor of performance. We surveyed several of our startup clients to try to quantify what we’ve experienced.
The findings confirmed our thesis. Specifically, of a sample of roughly 70 Burkland clients, 80% had a financial model used in their Seed raise. So far so good, right? We dug deeper and found that only 25% actually used it after raising the round. Not so good. To understand the issue better, we approached the same issue from a different perspective: from the point of view of companies who made it past Series B. This time, of 10 startups we surveyed who made it past Series B, only three had used a financial model for their Seed raise. That is quite a difference and worth highlighting. In our sample, 80% of startups use a model to raise a seed, but only 30% of companies that make it past series B used a financial model to raise a seed.
These figures, although far from statistically significant, align with my anecdotal experience and that of the other CFOs at Burkland.
Should having a financial model at Seed be a warning sign for an investor?
The figures we got from our little survey are not surprising. Evidence shows that financial models at the Seed stage are often useless and, in fact, potentially destroy value, with some exceptions. Crazy? How could these Series B companies have started business operations without a financial model and made it so far?
To understand why only one in three post Series B startups had a model in the first place, and why only 75% of all those who had a model never actually used it, it helps to look at four basic building blocks that constitute most early-stage financial models. Specifically, in order to create a multi-year financial model that serves as the blueprint for a company, one needs to estimate:
- The Core Revenue Driver, which is constituted of the basic inputs which drive sales, based on the market, such as account executives, marketing spend, and the like;
- The basic Unit Economics of the business, such as the direct costs associated with each sale so that management can understand gross margins;
- Headcount; and
- Growth rate.
None of the above are rocket science for anybody with some understanding of how to build an Excel spreadsheet. However, the high level of uncertainty facing a Seed stage startup is a huge disrupter to any financial model. To understand just how big of a disruptor uncertainty can be at Seed, the following are some ways a financial model can get dramatically off-track, really fast.
Most Seed stage companies don’t have any significant revenue to speak of. With no revenue history, how can a startup, whose very nature is venturing into a new market, project revenue and revenue drivers with any accuracy? This is the fundamental underpinning for why a financial model at the Seed stage is meaningless, as everything in a model except basic headcount cash consumption flows from one’s assumptions about the timing and size of the revenue drivers.
Questions like: What will price per unit be? How many units per month can an Account Executive sell? How many units per month will a given dollar of marketing drive? How will all this ramp up based on market adoption? It is not difficult to see that this is extremely speculative when a Seed company has not even completed their product.
Even if a company already has some small revenue, the target market will likely adjust as the business learns the sales flow. Adjustments in the types of clients that a sales team targets happen frequently in the early days. These often change the revenue assumptions. Importantly, this market feedback results in changes to the Minimum Viable Product (MVP) to improve product-market fit, setting any assumptions off track for a good reason. No surprise why only one in four of the companies we surveyed used their model after raising the Seed.
Similarly, Headcount will inevitably be different than your predictions. Because of the small number of people, any loss of key staff or hiring challenges you [change of voice] encounter will shift your numbers in ways you cannot predict on a spreadsheet. Finally, Growth Rate will change simply because growth is 100% an assumed figure when a startup has no in-market experience with their product.
What should you look for in a financial model if presented with one?
A financial model at Seed may lead you in the wrong direction. You may make an investment you shouldn’t, or you may pass on a good opportunity because you found flaws with the model. Both are bad decisions.
As per our experience, having a financial model may be OK if you as a Seed investor look at it from the right perspective. Specifically, a financial model may force founders to explain tactical details regarding their business that otherwise they might gloss over. It can also show discipline in their approach to thinking about their business model. Finally, it can provide a canvas for having a conversation about the drivers for the business.
Looking at anything beyond these points on a financial model could bias you if you make a Seed investment decision based on the the story the actual numbers on it are telling, because chances are the model will be so far from reality that it will never be used – as the evidence above suggests. A detailed financial model at Seed also distracts an investor from the elements that really count for an early stage investment decision, such as team, Unique Selling Proposition, Minimum Viable Product, or Go-to-Market strategy. Furthermore, founders may believe the model at the expense of their deep understanding of the business problem they are solving and fail to adjust as they learn more during their build of product and product-market fit. There is also an opportunity cost, as the founding team spends their valuable time trying to perfect their model at the expense of focusing on solving the problem the company exists to solve. Finally, a financial model is easy to manipulate. I can create a model that shows $100 million revenue in five years on any business and make that model look reasonable.
Is any model good for a Seed Stage company?
I often hear from VCs expressions like “we funded them despite their model.” They have learned that sound Seed Stage investment decisions do not depend on the financial model presented.
There may be two insights behind this. First, at Seed, companies are pre-product and the model has very little relevance to what actually ends up becoming the product and the business model. So how could one possibly know what the economics of the business will be when one doesn’t even know the product, let alone product-market fit yet? There are very few exceptions here. A rare early, industry-disrupting, startup with a directly comparable business may be one. Take the scooters we all see on the streets. They address a very similar need as Uber and Lyft, and so they did know a lot about their business model right from the start.
At the Seed stage, founders need to spend their energy building a product based on their deep understanding of the problem and their market opportunity. For a Seed Stage startup, a good understanding of the Total Addressable Market, or TAM, is a good indicator as it can evidence that the founders understand what they’re up against and tells you if a market is big enough for disruptive investing. A simple and relevant model at Seed may be one that projects the headcount and inventory that is necessary to get to the next milestone. It ignores revenue and is a cost-only model, because the series A raise usually doesn’t require replicable revenue. This simple model assists with calculating the amount of money that needs to be raised in the Seed.
Note that not having a detailed financial model for the Seed Stage does not mean a startup will not need one, it just means that it is not the right tool to either manage the business or to make an investment decision at that stage. At later stages, when there is actual experience and data on the company’s offer, a financial model becomes more granular and accurate. It starts reflecting reality based on evidence in the market, rather than a set of assumptions that will turn out differently. This typically occurs, in my experience, around the time the company reaches Series A.
Photo courtesy of Christopher Michel.