How to build an investor-ready financial model

Robust financial models are imperative for business owners who want to raise funds for growth from external investors, but what goes into making an effective one that will bring the results you want?

As a business owner preparing to raise funds, an ‘investor-ready’ financial model is essential. But for many entrepreneurs, writing a financial model that meets investor expectations can be daunting. You may wonder what investors seek in a financial model, which areas require more attention, and whether you might unknowingly generate any red flags.

In this article, I will guide you through the essential elements of producing an investor-ready financial model and provide insights on how to build it effectively for a successful fundraising campaign.

Purpose of a financial model

The primary reason for a financial model is to enable investors to assess the financial performance of your business. This includes historic numbers supporting your company's narrative to date and future projections demonstrating how it is expected to perform. The financial model helps investors calculate their potential returns based on factors such as revenue or EBITDA growth (see here if this term is new to you - https://www.investopedia.com/terms/e/ebitda.asp ).

Core financial statements

To build a comprehensive financial model, you must include the three core financial statements: profit and loss, balance sheet, and cash flow. A working capital statement will also be advantageous if your business involves products or inventory. It is crucial to present each of these statements monthly to provide a clear and detailed picture of your business.

These core statements reveal valuable insights about your business, and investors pay close attention to them. Therefore, it is essential to ensure that the information presented is accurate.

Timeframe?

When determining the timeframe to cover in your financial model, it is important to consider the typical holding period for early-stage investors, usually three to five years. Therefore, a four-year projection from the point of investment is often recommended for most businesses.

It is important to note that as young companies evolve rapidly, deviations from the original plan are expected. Investors understand this and anticipate adjustments. However, a well-defined and detailed plan for the first 12 months post-investment is essential. This period should be carefully mapped out, with solid assumptions and specific data points to support projected performance.

Building the financial model

There are various ways that a financial model can be put together, but for early-stage institutional fundraises, the bottom-up methodology is often the most suitable. This involves starting with underlying assumptions, data points, and metrics available to you, preferably from internal sources. These inputs drive the forecasts and determine the output in the core statements, such as the profit and loss.

Having a justifiable case for every assumption used in the financial model is crucial. Investors can scrutinise each assumption, comparing them to historical performance to guide future forecasts. Note that if some assumptions deviate significantly from historical data, this will raise red flags for potential investors.

To ensure flexibility and ease of analysis, your financial model should be built in a structured format. The ideal workbook comprises tabs for data assumptions, calculation sheets (revenue, cost of sales, operational costs, etc.), and an output sheet (profit and loss, balance sheet, cash flow, and key performance indicators (KPIs)). This allows for easy updating and modifying assumptions, making it dynamic and adaptable.

Key considerations for investors

Investors can thoroughly analyse the entire financial model, but certain areas often receive particular attention. To prepare for investor questions, consider the following key considerations:

Revenue?

• Is the projected growth rate achievable, and what factors underpin this growth?
• Are there any fluctuations in revenue? If so, what are the reasons behind them? Are they related to seasonality or other factors?
• If your business has multiple revenue streams, how does the mix change over time? What drives these changes?
• What is the story behind your historic revenue performance? Do you have confirmed pipeline or current conversion rates to support imminent revenue claims?

Cost of sales/gross margin

• Is the gross margin consistent, or does it exhibit fluctuations? If so, why?
• How does your gross margin compare to similar companies in your sector?
• Are there expected improvements in gross margin over time? If yes, what are the reasons behind these improvements?
• If your business has multiple revenue streams, do specific streams have better margins than others? How does this impact the sales mix weighting?

Operational costs

• Does your operational expenditure scale to support the projected growth of your business?
• Have you adequately planned for the scaling of headcount to meet the growth demands?
• Is your research and development (R&D) investment sufficient to drive innovation throughout the plan?
• What is the breakdown of marketing costs? Are they sufficient to execute the growth plan effectively?

Ensuring the financial model reflects realistic operational costs is crucial to support rapid sales growth. Marketing and R&D spend should not decline rapidly as a percentage of revenue in the later years of the plan. Investors expect businesses to continue investing in marketing and R&D to sustain growth and maximise potential returns.

Importance of a robust financial model

Creating an ‘investor-ready’ financial model is a significant undertaking. But it is essential to get it right, as it plays a crucial role in the fundraising process. A well-constructed financial model provides comprehensive information, speeds up the fundraising process, identifies possible bottlenecks, and helps you assign KPIs to your plan.

Conclusion

Hopefully, this article has given you a clear appreciation of an investor-ready financial model's content, structure, and composition. While some businesses may be able to complete this task in-house, others may require external assistance. Numerous options are available, including professional teams specialising in supporting businesses during fundraising.

The team at ISQ support business leaders to plan, prepare, and deliver highly successful investment rounds on leading equity crowdfunding platforms and with the support of leading legal partners. We’ve helped hundreds of clients to raise tens of millions - click here to learn more