Financial models: finding meaning in the numbers
Whilst financial models are often seen as an academic practice, when used properly they can act as a window into how you can make your business work.
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Financial models are not just numbers in an excel designed to show revenue growth over a period.
They are an insight into how you think about your business. What drives your revenue growth? How do you expect to spend? What is the relationship between spend and growth?
And whilst financial models are often seen as an academic practice, when used properly they can act as a window into how you can make your business work.
Why Financial Models Matter?
A model is a framework that helps tell the story of your business’s potential. It can help you test varying strategies to find one that is economically viable, and it will help you to raise money from investors.
In its simplest form, a financial model should indicate whether you are building something that works. Is the plan economically viable? What can you afford to spend? How many people do you need to hire? And what growth rates should you be aiming for?
A model acts as a sandbox where you can test the impact of various scenarios, such as adjusted pricing, scaling your team or entering a new market. You can simulate what happens to your cash flow if customer acquisition costs increase by 20%, or if revenue slows down. By doing this you can be proactive in identifying risks, planning contingencies and making more informed decisions.
How do we create meaningful models?
There are three things we must consider to ensure that our financial models are meaningful – and not just numbers on a sheet. They must be built and driven on clear and realistic assumptions, they must be structured clearly showing key elements and finally they must display levers of control.
Pro Tip
When pitching to investors you will get challenged on a variety of things, product, market, your ability as a founder. What’s guaranteed is that in almost every institution you approach, there will be someone whose battleground is an excel spreadsheet. They will review your model in detail, test scenarios and challenge on your numbers top to bottom. A good financial model will make these conversations immediately easier.
How do we create meaningful models?
There are three things we must consider to ensure that our financial models are meaningful – and not just numbers on a sheet. They must be built and driven on clear and realistic assumptions, they must be structured clearly showing key elements and finally they must display levers of control.
The Foundation: Clear and Realistic Assumptions🔗
Good modelers will attest that you can make an excel spreadsheet say any number you want. Do not be fooled into thinking this is a good way to impress potential funders. Analysts will roll their eyes when seeing a model that shows 1000x growth every month.
What’s truly valuable in your model is the assumptions that drive the growth. Examples of these include your expected customer acquisition rates, average order values and pricing. The assumptions form the basis of your model and tell the story of how you think about your business.
The importance of Realism
Investors and stakeholders are quick to spot overly optimistic or vague assumptions. To make your financial model meaningful, assumptions must be grounded in data or reasonable projections. For instance, even the best SaaS companies in the world don’t hit 100% conversion rates.
Use reliable data sources to back your assumptions. Industry benchmarks will help you compare metrics such as customer acquisition costs, churn rates and average revenue per user for similar start-ups.
Unrealistic assumptions tell investors that you aren’t thinking about your business in the correct way and will raise flags around your ability to manage cashflow or judge your funding needs.
Levers of Control🔗
Levers are the key variables that you can adjust within your business to help manoeuvre changes in the market. A meaningful financial model will clearly show where these levers exist within your business, and at what points in time they may need to be pulled.
Some examples of revenue levers and cost levers include pricing, marketing spend and hiring rate. How does increasing or decreasing your price affect revenue and customer retention? What’s the impact of doubling your marketing budget on customer acquisition? How does delaying new hires affect your runway?
Another important lever to display in your financial model is your funding lever.
Do you have a supportive cap table who could fund the business should cash become an issue? Do you need to secure a credit facility that you can drawdown in an emergency? If the answer is no, when do you need to go out to market to raise additional capital?
Once you understand where your levers are within the business, it’s good practice to create multiple scenarios which show how you will use these levers to improve growth or reduce cash burn.
Conclusion🔗
A meaningful financial model is not just about the numbers. And a model should not be viewed as a document you need to prepare just because VCs ask for one. It is a critical resource for guiding your business’s journey and is an insight into how you think about your business.
Basing your model on clear and realistic assumptions and understanding your levers of control will allow you to test strategies, adapt to challenges and plan for sustainable growth.
