Of the companies that pitched us in Q1 of 2018, more than half came in without a well thought out financial model. Some brought no model at all, expecting to focus the conversation on narrative and vision. Others presented models that were shallow or incomplete. They missed an opportunity.
Financial models do not predict success. At early-stage companies in particular, models are often completely scrapped and rebuilt several times over as the business grows.
But believing that models play no role in the investment decisions of early-stage investors is a costly misconception. Part of the disconnect stems from the fact that VCs and (sophisticated) angels use models very differently from the average late-stage investor. Where private equity investors look carefully at multiples and cash flows in order to help them figure out how to value a company, it’s just not accurate to do the same for startups.
A valuation model is only as good as the quality of its inputs, and seemingly innocuous assumptions can have a huge impact on a model’s outputs. That is true in late-stage companies but even more amplified in early-stage companies, where assumptions have to be made without the benefit of historical precedent. To put it plainly, when we look at an early-stage financial model, the one thing we know for sure is that it is wrong.
But just because we don’t rely on financial models to determine valuation in early stage companies doesn’t mean that they aren’t incredibly useful in assessing a company. A well-developed financial plan reveals both the business’ fundamentals and the entrepreneur’s thought process. It illustrates how you get from here to there and how you will realize your vision.
And though we’ve never invested in a company solely because it had a good financial model, it has been a significant hurdle for us when companies have had poorly thought-out or incomplete ones.
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Here are five (more) reasons why we believe financial models are still important, and five mistakes to avoid when building yours:
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So yes, financial models are important, even for early stage companies. But how does an entrepreneur put together a model that showcases his or her quality of thought, communicates the fundamentals of the business to investors, and lays the groundwork for planning a capital raise? There isn’t any one set recipe for how to build a great financial model—what works well for one company might not work well for another. However, there are common mistakes that companies make.
Mistake #1: The financial shows income or EBITDA but not cash flow. A good financial model needs to go further than simply breaking out revenue, overhead, and expenses. As mentioned above, cash is the oxygen and lifeblood of a company. As such, it's critical that entrepreneurs and their prospective investors have a clear understanding of the cash flow dynamics of the business. That means breaking down the nuances of not just how much money is flowing in and out, but also when. Using EBITDA or net income as a proxy for cash flow can often be a dangerous oversimplification that misrepresents the actual cash needs of the business or the consequences of different growth scenarios. A financial model should take into account factors like how long it takes to collect payments from customers, how quickly the business pays its vendors, whether or not there is spending on capital equipment, and so on. To illustrate this further, let’s look at an example of an overly simplistic model from a fictional “Company X”:
We often come across models that are more or less like the figure above—an income statement without much else. Sometimes they are even less detailed than that. Companies with this kind of financial model will often point to the summation of EBITDA or Net Income as their forecasted cash needs (negative 70 in the example above). In a small minority of businesses this might be a close enough approximation to use for forecasting, but for the vast majority of businesses it is necessary to go beyond just building an income statement when building a financial model. The timing of cash flows in and out of the business can have massive impact on the overall cash needs for the business. To understand why this is, let’s look at a financial model for Company X that takes into account its cash flow:
This more detailed model includes a few assumptions that would be important to potential investors: it takes 45 days for Company X to collect money from customers (AR days outstanding), 30 days on average for it to pay its invoices/suppliers (AP days outstanding), and 15 days to sell its inventory (inventory days outstanding). In other words, it takes the company longer to receive money than pay it out, and the company needs to build inventory ahead of growing sales. Because of this, the company actually requires much more capital to grow than a simple proxy like EBITDA would imply, and the model in Figure 1 greatly underestimates the amount they need to raise.
This is an important dynamic for startups to understand, because higher sales growth can actually make this delta much larger. We can see this dynamic play out by keeping all of the assumptions we added to Figure 2, but changing the revenue growth from 10% MoM to 25% MoM in Figure 3.
As you can see, the higher rate of revenue growth with no change to the Gross Margin or Operating Expense assumptions means this company reaches positive EBITDA quicker and the sum of the negative periods of EBITDA goes down to 38 from 70. But because this is a positive net working capital business, the higher rate of growth means that the company actually needs more, not less, capital to reach these sales figures.
Mistake #2: The financial model is overly complicated or overly simple. There is a delicate balance to strike here. Because one of the central purposes of the financial model is to facilitate swift knowledge transfer between the entrepreneur and an investor, the document needs to be clear and easy to understand. However, it also needs to be rich enough with detail that we can use it to begin to assess the entrepreneur’s thought process and their thinking about their business. A spreadsheet with more than ten tabs is probably too much; at the other end of the spectrum, a model that lacks the nuances mentioned under Mistake #1 is probably too little.
Growth projections are another place we often see financial models oversimplify. When we look at revenue we want to see a nuanced explanation of how it was calculated and from what data—a simple average or fixed growth rate is not enough. With revenue growth, think about breaking down unit price and volume by customer segment. Large enterprise clients will have different lead times, churn rates, and pricing than small business ones, for example. On the expenses side, when we click through on an estimate of salary spend, we want to see how many people’s salaries the numbers represent, when they will be brought on, and so on. The same goes for other expenditures like marketing. When this detail is lacking, we are left to assume that not a lot of thought was put into the estimates, which is never a good sign.
Mistake #3: The financial model is outdated. For early stage companies, both expectations for the future and current business realities can change quite rapidly. Fundraising processes can often stretch out longer than the entrepreneur initially expected or hoped, so it’s relatively easy for a financial model created at the beginning of that process to become out of date. The updates necessary may be small, but if an entrepreneur fails to carry them out, it can raise unwanted questions and potentially jeopardize the process.
For example, it’s fairly common for us to see a model that has projections instead of actuals for months that have already happened, and more often than not, those actuals fall short of the initial projections. We have also encountered models that show an assumption for how much capital the entrepreneur wants to raise that is no longer the number they are presenting to investors (e.g., the model shows raising $15m but we are told that the round is $10m). Problems like these may seem innocuous and inconsequential, and ultimately they probably should be—I don’t think anyone would argue these are strong indicators of future success. But in a process where the odds are stacked against you and you are trying to build excitement for your business, you want to eliminate any downside surprises. And this is something that is in your control and easy to fix.
Mistake #4: The financial model and capital raise are out of sync. Often, we see models that forecast financial needs far smaller or far greater than what the entrepreneur is asking for in a raise. Both these scenarios can be a red flag for us.
Raising more money than you need is, in a sense, a misuse of investors’ funds: we provide capital to accelerate the growth of a business, not to sit in a bank account. But it can be particularly costly to the entrepreneur. The early rounds of capital are always the most expensive, so raising more seed or Series A money than you need will likely lead to unnecessary dilution. By contrast, raising less money than the company needs leads to a bridge to nowhere scenario, where it doesn’t have enough cash to reach profitability or its next milestone.
Successful entrepreneurs need to have visibility into the cash flow needs of their business, and financial planning should guide strategic decision-making from the earliest days of the company. An entrepreneur who isn’t really sure how much money his or her business needs can create major problems for both their company and their investors. Besides the pitfalls described above, they run the risk of raising the next round too late, when existing funds are about to run dry. Such a situation gives investors increased leverage, so it’s much more likely entrepreneurs are going to get stuck with terms that aren’t advantageous to them. It’s not good for the company, and it’s not good for those of us who invested in earlier rounds, either.
Mistake #5: The financial model contains hard-coded numbers, hidden sheets, and/or references to other spreadsheets.
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In closing, here’s just one more thing to consider. As an entrepreneur, it’s in your interest to make sure your investors come to a detailed understanding of how your business operates as quickly as possible. If your financials are strong, you want to put time and effort into communicating that clearly and efficiently, even if it won’t be the most important factor in the investor’s decision making. On the other hand, if there is a concern that your financials will cause some investors to pass, it’s better to get to that understanding as quickly as possible so that you can move on and hopefully find an investor that sees your business through a different lens. There is simply no reason to obscure your company’s inner workings behind an incomplete, poorly thought out, or otherwise ineffective financial model.
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