Financial Modelling (Part 2 Income)

In our last discussion, we discussed how to calculate startup costs. Today, we'll focus on revenue. Some financial models use a growth formula to predict the number of units sold in the upcoming 36-60 months. This growth formula is either linear (every month, 10 new extra units are sold) or exponential (every month, 5% more units are sold). However, this approach is both too detailed and not detailed enough.

A good financial model should provide relevant information to internal and external users. A detailed pipeline will give a good understanding of the type of customers and their average spending, while the market size gives an idea of the long-term potential. A formula does not say anything about the 12-month pipeline or the market size.

The Pipeline

We can create a weighted pipeline by listing potential customers in the coming 12 to 24 months, including their expected spend and a chance of successfully onboarding them as customers. This weighted pipeline provides extra information for investors as it helps them understand average order size and conversion time.

Total Addressable Market (Long Term Revenue)

After 12-24 months, we can use a percentage of the Total Addressable Market to estimate revenue. We can estimate market size in different ways. The top-down approach uses various industry/government/analyst reports that estimate the size of the markets. Most of these reports need to be bought, but an excellent free source of market size data is the analyst updates from listed companies in the sector.

Another way is to add the sales of the suppliers in the market. For instance, the combined yearly revenue of the 64 largest car producers is $2.7 trillion. This is easy to calculate for some sectors with a limited number of suppliers. This is more difficult to estimate for markets with many suppliers or new markets.

The best way to calculate for a start-up is bottom-up. We can determine how many potential clients and how much they can spend a year. For instance, there are over 25,000 universities worldwide, all potential clients for a ￡10,000 a year software product. The Total addressable market is then 25,000 * ￡10,000 = ￡250 million. For physical products, we have to adjust for lifespan. For example, a ￡10k product with a 5-year lifespan is ￡2k yearly.

Once the bottom-up market size is calculated, you can sanity-check this with Top-down and/or Supply-side Market size calculations.

Market share

Once you have computed Market size, you need to estimate your market share. You can say you aim to own 1% of the market in ?5 years. A better way to calculate is to make it more tangible without being super precise. ?For instance, the aim is to have 100 American, 100 European, 50 British and ?40 Asian universities as customers in year 5. 290*￡10k =￡2.9 mln, which is 1.16% of the Market.?

Once you know the Market Size and Market shares, you can calculate the revenue.

If we combine this with the margins discussed in part 1, we can calculate the Free Cash Flow available for the shareholders. This will allow us to sanity-check the valuation in two steps.

Step 1 IRR calculation:

To calculate the Internal Rate of Return on an investment, we need to know three things:

1. Valuation upon Investment

2. Exit price (based on similar exits and/or Peer Group analysis)

3. Time to exit

For instance, if an investor invests at a post-money valuation of ￡905,000 and the estimated exit is in 6 years at ￡12 million, the IRR is 41%. If an investor estimates that 2/3 of investments do not return an investment, the expected return is 13.6%, just enough for a risky, illiquid asset class like startup investing.

Step 2 Exit price sanity check

If we estimate a ￡12 million exit based on similar exits, we have to sanity check this with the FCF Yield (FCF/Exit valuation). We can create a table of different outcomes using different FCF Margins and market shares. For instance, if our estimated FCF/Sales is 2%, we might add (-20%, 10%, 10%, 20%) to create five different margins. . In the example below, 40 different FCFs are calculated based on 5 different FCF margins and eight different market shares.

The higher the Free Cash Flow yield, the better. If it's below 7%, it's likely not a good investment. In our case, the estimated ￡12mln exit price might be too high if the company predicts a 2% FCF yield and 10% of the market long term.

In recent years, many start-ups failed one or both sanity checks but were still funded. With funding getting more scarce, I expect investors to be more critical.