Preparing to raise a round of funding is one of the most important tasks every founder goes through. Compiling a deck, teaser, and executive summary requires a thorough understanding of a startup’s story and the market in which it operates. But for many founders, the most challenging item required is often the most crucial: building a financial model.
A sound financial model not only helps founders understand their own business and how much capital to raise, but is usually required by an investor, who will comb through the model during due diligence.
Your model is your financial roadmap. As a founder, it’s your responsibility to never lose sight of your “runway” – how long before you run out of cash – which is calculated by dividing your cash-on-hand by your monthly burn rate. Your model should reflect a runway that is long enough to get you to your next round of financing or break-even cash flow under a more conservative set of revenue assumptions. What do the next twelve to eighteen months look like from a cash flow perspective? For example, does the business have enough runway, even if you only achieve half of your expected revenue – or no revenue?
Here’s your model’s end goal: to cohesively demonstrate to a potential investor how your business will grow from both a revenue and expenses perspective and to indicate how much money you should raise. While it may feel unfamiliar, as a founder there are a few key things to keep in mind that will ensure that your financial model is both a powerful tool for you and is also investor ready.
As a founder, it’s your responsibility to never lose sight of your “runway” – how long before you run out of cash – which is calculated by dividing your cash-on-hand by your monthly burn rate.
Build a model that covers the next five years
No one can predict the future, but you need to tell an investable story that demonstrates your company’s potential to grow. It usually takes five years to show how a business scales, and if you are not realistic in presenting how your business will do that, the model may be discounted by an investor. Most investors will want to see a three-year projection at a minimum – but five years provides for a more reasonable ramp up in revenue and profitability.
A financial model will often include a few different statements: income statement (profit and loss statement), cash flow statement, and a balance sheet. For early-stage companies, with limited assets and liabilities, a balance sheet will often not be as relevant as it would be for a later-stage company. The focus is, therefore, on the income statement, and some version of a cash flow statement. Your income statement may be broken down into revenue, cost of goods sold, gross profit, fixed costs, and EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA can serve as a proxy for cash flow, or you can prepare a more formal cash flow statement.
Design a “bottom up” financial model
There are two ways to build a financial model: top down and bottom up. In a top-down approach, you estimate the size of the market and calculate your percentage of that total market revenue each year. A bottom-up model is more powerful, detailed, and comprehensive. In this model, you start with granular assumptions that drive revenue and build on each other.
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