Preparing for a funding round is one of the most important tasks for any founder. Crafting a presentation, teaser, and executive summary requires a thorough understanding of the company's history and the market in which it operates. But for many founders, the hardest task is often the most crucial: Create a financial model.
A solid financial model not only helps founders understand their own business and how much capital they need to raise, but it is also often necessary for an investor, who will look at it during due diligence.
Your blueprint is your financial roadmap. As a founder, it's your responsibility to never lose sight of your “headroom”—that is, how long it will take to run out of cash, calculated by dividing your available cash by your monthly consumption rate. Your model should reflect a margin long enough to reach the next round of funding or break even with a more conservative set of revenue assumptions. What will the next 12-18 months look like from a cash flow standpoint? For example, does the company have enough leeway even if it only makes half of the expected revenue, or no revenue at all?
This is the ultimate goal of your model: to consistently demonstrate to a potential investor how your business will grow from a revenue and expense standpoint, and indicate how much money you should raise. Although it may seem unfamiliar to you, as a founder you need to keep in mind a few key aspects that will ensure that your financial model is a powerful tool for you and ready for investors.
Build a model covering the next five years
No one can predict the future, but you have to tell a investable story that demonstrates your company's growth potential. Typically, it takes five years to demonstrate how a business scales, and if you are unrealistic in presenting how your business will do so, the model may be dismissed by an investor. Most investors will want to see at least a three-year projection, but five years allows for a more reasonable increase in income and profitability.
A financial model usually includes several statements: income statement, treasury statement and balance sheet. For early-stage companies, with limited assets and liabilities, the balance sheet is typically not as important as it is for a late-stage company. Attention is therefore focused on the income statement and some version of the cash flow statement. The income statement can 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.
Designing a bottom-up financial model
There are two ways to build a financial model: top down and bottom up. In a top-down approach, the market size is estimated and the percentage of total market revenue is calculated each year. A bottom-up model is more powerful, detailed, and comprehensive. In this model, you make granular assumptions that drive revenue and build on each other.
A bottom-up model of revenue, cost of goods sold and gross profit, fixed expenses, and EBITDA must be calculated monthly for 60 months. The monthly model must be rolled into a five-year annual summary, which is what an investor will initially be presented with. During due diligence, many investors will dig into the more detailed monthly model and review all of their assumptions.
Here's an example of revenue assumptions in a bottom-up model: Take the expected number of leads generated in a month and multiply it by the conversion rate of one lead to unit sold and revenue per unit sold. So if we have 100 leads in March 2023 and multiply that by a 20% conversion rate and again by $1.000 per unit sold, we'll get $20.000 in revenue in March.
Remember, the goal here is to demonstrate a thorough understanding of your market and how your business scales, which is then reflected through the various assumptions you use to build the model. Investors realize that it is very difficult to project total revenue each year, but they will spend time understanding your assumptions, so be prepared.
The bottom-up approach is almost always the best option to achieve this. As you gain actual market data, over time you can continue to effectively refine your model by updating your assumptions with this data, thus adjusting the entire model accordingly. As more market data is collected, the model improves in accuracy and reliability.
Make sure the fixed expenses for the first 12-18 months of your model are accurate
Projected fixed expenses for the first 12 to 18 months (research and development, marketing and sales, and general and administrative expenses) should be as precise and detailed as possible. You need to know exactly how many people you will hire and how much each will cost in salaries, benefits and employment taxes (full cost), as well as how much you plan to spend on marketing and sales, research and development, and general and administrative expenses, such as rent, legal services , accounting and insurance.
This detail allows you and investors to more accurately assess your rate of consumption for the next 12-18 months, which is essential for cash flow management.
Perform a sensitivity analysis
A sensitivity analysis evaluates the possible variations of each assumption and the level of impact each variation is expected to have on revenues and cash flow. In addition to the projected scenario (sometimes called the "base case"), you should model scenarios for when things go much better than the base case, and when things don't go as well as the base case. Analyzing how these scenarios will affect revenue and cash flow will be invaluable. For your “downside” model, you need to run the model at 50% and 25% of your base case forecast revenue or even zero your revenue in order to properly determine how much capital needs to be raised. This financial year will benefit you and your investors.
Understand the exact moment when you run out of money
Perhaps the most important step is to predict when your leeway will run out. Using a conservative version of your financial model will help ensure that, in the worst case, you won't run out of money sooner than expected.
For example, if your projected fixed expenses (consumption rate) are $100.000 per month, you've raised $1 million to start with, and your base case shows a monthly gross profit (revenue minus cost of goods sold) of $20.000, will run out of liquidity after 12 months. If you need 18 months to reach the next set of critical milestones and close the next round of funding, then you know that raising $1 million isn't enough and you'll need to raise at least $1,5 million. However, this does not provide any cushion if the anticipated income is not achieved. A sensitivity analysis holding revenue at zero would indicate a collection of $1,8 million to remove the pressure to meet revenue targets, which is difficult to do up front.
Generally speaking, an early-stage investor will want to understand their team, the market opportunity (for example, is it a $100 million market opportunity or a $1.000 billion?), how the business is scaling, and What drives the business model? A detailed, bottom-up, five-year financial model will be an important component of your fundraising process, both for you as the founder and for investors looking to invest in your new company.
