Startup Founders, Don't Fear the Financial Model

I grew up in a time when going on a road trip required a map. This was before mobile phones and GPS devices. If you were traveling somewhere you were not familiar with, you needed a folding map, a willingness to ask strangers for help, and a decent sense of direction. Without the map though, expect to be needlessly wandering for a while.

It reminds me of one of my pet peeves when accessing APIs for any apps I’m building. I sort of know what the API should do, but I still need documentation to know how to format my API calls or what parameters to pass. When the docs are missing or unclear, all I get for my efforts are failed requests, unexpected errors, and a whole lot of frustration.

Similarly, if you are launching a startup without a financial model, you are heading for trouble. Having a financial model is your documentation and map for how you plan to get from idea to MVP to a growing and scalable business.

"Can you walk me through your financial projections,” is a common question an investor will ask that vexes some founders. In response, these founders will slap together a half-baked spreadsheet, guess at numbers, and hope it is convincing enough to get them the funding they need.

Why does the question of a financial model cause such anxiety? We have heard many reasons from founders from the belief that it’s unnecessary busy work, to questioning the value of projections early on, to a lack of experience in building a financial model.

We believe a financial model is not just a nice to have, but a critical early step that helps position your startup for success. What can happen if you have not put together a proper financial model?

• Underestimating expenses can lead to burning through cash too fast due to poor budgeting and spending control.
• Poor planning can cause you to misallocate your capital, leading you to miss key milestones like product launches, hiring, or expansion.
• Lack of visibility into your financial future makes it hard to make informed strategic decisions, spreading yourself too thin or miss out on key opportunities.
• Unrealistic or incomplete financial projections can hurt your ability to raise funding as investors want to see that you have a solid grasp of your business.

When I had my startup, a financial model was required. Most investors we pitched to had a financial background and expected founders to have a solid grasp of their startup's financial trajectory. They wanted to see that founders have thought through the business model, market size, growth strategy, key metrics, and potential business risks.

During the last decade, the question of a financial model seemed to fall out of favor. Perhaps this was to the VC funding hysteria and more investors coming from founder and operator backgrounds. As reality has come back post-funding winter, investors are once again asking about financial models.

The good news is creating a financial model is not a daunting task, even if you fear spreadsheets and financial terminology. Being a founder means learning a lot of new stuff and picking up enough of what you need to know to move ahead. So, let’s walk through what goes into an early-stage startup financial model and how to building one from scratch.

Key Elements of a Startup Financial Model

While every startup is unique, most early-stage financial models include these four core components:

1.?????? Revenue projections

a.?????? Conduct market research to understand addressable market – TAM, SAM & SOM (Total Addressable Market, Serviceable Addressable Market & Serviceable Obtainable Market)

b.?????? Analyze your pricing strategy and compare it to competitors to ensure you're positioned competitively

c.?????? Estimate your sales based on your target market, pricing, and go-to-market strategy and use that to make data-driven assumptions about your growth rate

2.?????? Expense forecasts

a.?????? Calculate your cost of goods sold (COGS) - the direct costs of producing your product or service such as materials used, labor, and shipping

b.?????? Estimate your operating expenses (salaries, rent, cloud services, marketing costs, SaaS tools, outsourced services, data & news subscriptions, etc.)

c.?????? Don't forget to factor in one-time costs and a build in a buffer for unexpected expenses

3.?????? Cash flow projections

a.?????? Project your monthly cash inflows and outflows and include all sources of cash such as revenue, investments, expenses, and loans

b.?????? Aim to always maintain a positive cash balance to ensure you have sufficient cash reserves to cover potential shortfalls

c.?????? Identify when you'll need to raise funds or become profitable by setting milestones and track your runway for when your cash will last (burn rate)

4.?????? Key metrics

a.?????? Determine the key performance indicators (KPIs) for your business

b.?????? Set targets for these metrics and measure against them regularly whether daily, weekly, or monthly depending on the business model

c.?????? Some examples include: user growth & acquisition, conversion rates at each stage of funnel, customer acquisition costs (CAC), customer lifetime value (LTV), engagement metrics like daily (DAU) or monthly active users (MAU), churn or retention rate, gross margins & profitability metrics

Tips for Building Your Model

Now that you know what goes into a startup financial model, here are a few ideas to help you as you build yours:

1. Keep it simple to start. Don't get bogged down trying to create an overly complex model right out of the gate. Begin with a high-level forecast and refine it over time as you gather more data about your business.
2. Be conservative in your assumptions. It's better to underestimate your revenue and overestimate your expenses than to paint an unrealistic picture of rocketship growth. Investors will appreciate your honesty.
3. Tie your projections to your operational metrics. Your financial projections should align with your key business drivers. For example, if you expect to double your sales team next quarter, your revenue forecast should reflect that increased capacity.
4. Stress test your model. Play with different scenarios to see how your projections hold up. What happens if your sales cycle is twice as long as anticipated? What if your COGS increase by 20%? Investors will likely ask you these types of questions, so be prepared with answers.
5. Seek feedback and advice. Don't build your model in a vacuum! Share it with your co-founders, advisors, and mentors. Consider asking a finance or accounting professional to review it for any red flags or unrealistic assumptions.

Remember, the goal is not to create a perfect model on your first attempt. This first step is to simply translate your thinking behind the startup into numbers that give you a basis for how to build a profitable business. As your startup evolves, so too will your projections. The key is to start with a solid foundation so you can iterative and refine as you go.

By taking the time to build a thoughtful financial model, you'll be better equipped to make informed decisions, avoid cash crunches, and steer your startup toward long-term success. Plus, when an investor asks to see your model, you'll be ready to showcase your capabilities as a startup founder.

How early did you put together a financial model for your startup? What tips do you have that helped you build a useful model from scratch?

Mark & Basil

This post was inspired by what became an unexpectedly controversial tweet by Jenny Fielding of Everywhere VC when she said she asks founders about their financial models:

We never thought talking about financial models could be this exciting or elicit so much passion! For the record, we do not exactly party with spreadsheets or get excited about diving into EBITA. But we do believe financial models are an important topic for startups to take seriously.

We can understand why some founders, especially founders that do not have a business background, are allergic to such things though. While building product and talking to customers is tangible, projecting into the future while staring into a vast sea of unknowns like COGS and cash flows and revenues seems overly prescriptive. That is what some founders (and investors) hear when "financial model" comes up.

But founders should have a basic sense of the economic drivers of their startup, and investors should absolutely dig in deeper to understand how founders are arriving at those drivers and the levers they will use to steer the business.

While we shared some thoughts in the essay above on how to get started, we also included some other resources on how to approach financial models:

• Roy Bahat, the Head of Bloomberg Beta, wrote a comprehensive post on building a financial model for early-stage startups.
• The accounting firm EY wrote a useful and quite thorough piece on financial models that is appropriate for startups.
• If you need a template to get started, Open VC compared twelve different financial model templates built for SaaS startups with links to each.

Lastly, we have found Reddit under r/startups to be a useful source for info and intelligent discussions about financial modeling for startups.

This week the Advocates were back out on the road! Basil attended the AWS Summit in Amsterdam and talked about AI as your co-founder! If you are in Amsterdam, we hope you checked it out that hands-on workshops, tech talks, and the startup loft.

Mark is in Florida for Miami Tech Week to meet with founders, investors, and developers. The showcase for the week is DevFest, a developer meetup during Hack Week, on Wed, April 10. Come join, and if you are around, ping Mark to meet up in person. Here is the full agenda for Hack Week here.

We also wanted to announce that AWS now has the full in-person and online events calendar for all AWS Startups events worldwide available to search for on the AWS Startups website. Visit the page and see what events are happening in your area.