Startups: How to build a financial model and breathe life into it
Considering embarking on the road to entrepreneurship? Clueless about financial modeling? In this post we aim to provide a basic explanation of financial modeling and its importance for startups. We begin by asking the following questions:
- Should you focus on the best case or worst case scenario for your financial statements?
- How deep should you go in your analysis?
- What is credibility and how is it achieved?
- How do footfall and ticket size apply to financial modelling?
- What are top-down and bottom-up approaches to financial modelling?
- What is the Break-Even level?
- What should your final financial statements look like?
For a start up, financial modeling is essentially developing financial statements for the future business which you wish to undertake. It is much more than just juggling with numbers to form profit, expense, capital and revenue statements. Before drafting any document or statement for an investor or venture capitalist it is paramount to understand their psychology. Potential investors are interested in your credibility and will not write that first cheque until they are convinced of it. Your credibility is defined by conveying how well you understand the nature of your business and knowledge of various aspects of it. Having a solid business idea and an effective way of making it a reality is what the investors will actually be looking for when assessing your credibility.
Your projected financial statements will help to convey this to them to a large extent. The first step in drafting your projected financial statements is to determine the expected footfall and conversion rate, i.e. the number of customers expected and those who will convert. There are two approaches to do this. First is a top-down approach. Suppose you are selling clothes for children. The client-base is 3 million households in the region of the city you are planning to operate in. Assuming each household has only one child and that only one out of every three households will actually buy an item of clothing within a suitable time period, e.g. 3 months. Assume additional filters that could impact your client base such as competition as well as how much you would actually be able to cater for, etc. In this manner you arrive at the footfall; the number of customers expected at your doorstep. What remains next is to convert them into effective sales. Not all those who arrive at your outlet will purchase clothes.
For example, you may assume that out of all those who come to your shop, only 0.5% of them may actually convert into sales. The second approach is the bottoms-up approach. With this approach you begin with how much you need to make to achieve your objectives. For instance, you are planning on opening a restaurant and daily costs work out to $5000 per day. If you sell 100 meals at $50 per meal your sales revenue would equal your cost. This is your breakeven level. The breakeven level is the output at which costs equals revenues resulting in a net profit of zero. Out of the two approaches, the bottom-down approach is more credible because it is more realistic and based less on assumptions than the top-down approach. The second part of credibility is to communicate your plans to enable conversion as well as what will be the size of your ticket sales. Online forum sites such as Quora have discussed conversion rates for a number of real world businesses including retail stores where rates have ranged from 1% to 10%. Ticket size applied to the conversion rate gives sales revenue. Ticket size is the amount generated in an average transaction. The next step is to match ticket size with costs (fixed and variable) per transaction to arrive at the net profit margin. To determine the cost break down a transaction into various components. What procedures/ items are required to make a single piece of clothing? What is the cost of each procedure/ item? Determine the steps from raw material to production to inventory to sale. Add value at each step to cover costs and profit margin. In your projections cover both best case and worst case scenarios. However, what investors really look for is a realistic case. The greater the degree of realism in your business plans the more serious you appear to a potential investor. Set realistic benchmarks that can be met. For instance, if you will be starting in the retail clothing business it may be wise to set cost benchmarks that are comparable with the local clothing market.
Your financial model should be linked to your understanding of your business. Target a particular customer segment; see their price tolerance or appetite and purchasing frequency to arrive at the profit margin you would be able to generate.
After determining the average market transaction you need to define your capital needs. This depends on the nature of your business. Also, the investment capital that you will be asking for should cover a period of one year for support so that your business can be functional and liquid. This one year is a period of experimentation – a period to see how your initial assumptions fare in the real world. The capital needs should be divided into startup capital and working capital. Will you be making a profit after 18 months? Not necessarily. The time-to-breakeven and how sustainable the break even position is, needs to be determined. It is import to determine the time-to-breakeven on a cash basis; not on an accrual basis. Time-to-breakeven on a cash basis is the time taken for net cash-flows to turn positive, whereas on an accrual basis costs and revenues are assigned to a stated period whether actual payments were received or not.
For a startup liquidity is very important and it is also very important to the investor therefore determining time-to-breakeven on a cash basis is crucial. This involves making a month-by-month or quarter-by-quarter analysis of how close you are to approaching breakeven. Investors are keen to know what the payback period is for your business. This is the time required by the business to pay off investments and achieve self sufficiency. Investors like a moderate payback time depending on the nature of the business. Also the mode of payment is important. Will the investor be paid in cash or will he be given shares in the company or will be continue as a partner in your firm, etc.
Credibility comes from this; determining the market size and explaining it coherently in front of the investors. Time for presenting your case is limited therefore you need to be succinct and precise. The projections of the financial statements should be for a number of years. Investors are interested in how you plan to increase revenues over time. To effectively communicate this you need to understand the nature of the market and how it interacts with your business. Market research and asking potential customers will help you be more aware. However, the projections and commentary should be brief avoiding unnecessary details to keep potential investors interested and engaged. For the model you can start off with a simple spreadsheet containing a separate section for assumptions (e.g. discount rate, inflation rate, revenue growth, etc), a revenue model and an expense model. The latter two are transaction based. Project the revenues and expenses to determine the net profit or loss for a number of years.
Next you can make a more detailed model but note that this increases the complexity so only include details if you have sufficient data to back it up. Your final model that you will present however should be easy to understand. What is more important than the actual numbers used is that these figures reflect your vision. Credibility requires more than just a presentation of numbers; you must be able to defend your figures. This requires an insight into the nature of the business and a depth of understanding of the projected figures.
What happens next once the business has started
It is imperative to know that investors will pay you survival money not your market value. Suppose you are a lawyer and your market worth is a salary of $10,000 per month. However, if you open your own legal consultancy service, an investor will pay the money to keep your business surviving which may not include your salary. This is one of the drawbacks of starting up a business. There can be no returns made without risk and compromise. Adopt the 3 month milestone framework if you are serious about entrepreneurship. Set a 3-month target to obtain a customer or small number of initial ‘break-through’ customers. Keep reflecting and revisiting your assumptions based on real market experience. If assumptions are not being met obtain feedback and investigate the reasons why they are not materializing.
For example if the growth assumption is not being met obtain feedback from customers as to their reasons for not buying. The first year of business is precisely the time for such experimentations because this is when your assumptions face stark reality and need to be adjusted if needed. It is important to understand that investors will cover your experiences not your assumptions. Reflect continuously every 3 months or so on all your targets and goals based on real world experience. Initiate a $100 experiment – spend $100 on your business and see where it goes and where it leads you. Investors look for realistic answers which show that you have done your homework. Based upon your experience, see the trend in your sales. Does it show signs of customer loyalty? If so, understand that it is important to lock-in customers. Loyalty informs you of your core competencies which need to be strengthened and built on.