Entrepreneurs hear over and over again that they need a robust financial model in order to raise capital and get the attention from investors else they risk that an investor would say, “You haven’t thought through”, which is the entrepreneur’s nightmare.
Yet, a robust financial model does not necessarily mean a super complex and cumbersome financial model. Sometimes, investors “fade away” because they just don’t get the financial model quickly and they move on!
Yes, financial models need to be robust. But they need to be robust relative to the stage of the business and attuned to what we know about the product, the customer and the business today.
In this series of two articles, I describe three financial model types for different business phases (or stages). The first phase is the startup, or I sometimes call it the Unit-economic and Capital-efficiency Stage. In part 2 of the article, I’ll cover the second phase, the Initial Traction Model, and the third phase, the Operating Model. (A link to part 2 is at the end of this article.)
Based on the companies I see, the Startup Model is used in roughly years one and two. Companies in years two, three and four typically run the Initial Traction Model, and after year four is when you start getting into Operational Models. But that’s just a general representation of the life of a startup.
Let’s look at the first phase in more detail.
Strong Doesn’t Mean Complex
It’s funny how investors, bloggers, venture capitalists and other folks use so many different words for the growth phases: startup, seed, early, MVP, first-revenue and cash-flow positive. There’s also product market fit, scaling and operating.
While the language can be fun, this same group of people is giving founders a strong message: “To get funding, you need a strong financial model to help others understand your business.”
“Strong” is then immediately misinterpreted by founders and, often, young MBA finance people as a granular, super-detailed, we’ve-thought-of-absolutely-everything financial model.
But the truth is, you don’t need an operational model in a pitch deck. And it might hurt you. As a company grows, so should its financial models, starting from very simple.
I was recently introduced to a pre-revenue tech startup. The founder had shared his financial model with some investors to get a seed or angel round in place. But nobody was biting. And he had no idea why.
Here’s what we noticed in the revenue build of this model. He showed four client sizes (small, medium, large and extra-large). To each of those clients, he offered a suite of 16 different products. Then across those 16 products, he could provide three different service levels, like silver, gold and platinum.
Multiply that out. Here is a pre-revenue company with 192 product and service configurations in their financial model, each of which required a different look at cost and COGS! And each of those 192 configurations were detailed through the entire model.
Investors want to know: What margins are going to be driving this business? In this model, nobody could tell. And investors with deal fatigue will just move on to the next one. It was also hard for investors to understand customer acquisition costs because they were mixed across a plethora of different assumptions based on customer size and sales cycle assumptions.
In the very early stages, your financial model doesn’t have to be that complex. Not only does it not help, but too much complexity can actually hinder your pitch.
When Accuracy Is Low, Models Must Be Simpler
To make my point to the tech startup founder, I referenced some beginner math rules around “the law of significant figures.” When you multiply a single decimal number times a single decimal, your answer can’t be more accurate than your inputs. So 1.3 x 1.7 is 2.21, but because of the inputs, you can only credibly report accuracy to one significant figure, or 2.2.
The same thing applies here in financial modeling. An assumption times an assumption times an assumption really doesn’t give you a more credible level of accuracy, especially when you’re talking to an outside party.
So let’s look at how you should present your numbers.
Phase #1: The Startup or Early-Phase Model for Getting Funding and Getting Going
That pre-revenue tech startup should have been using more of a Startup Model. Your objective is attracting capital investment by clearly articulating to an investor the key things you believe to be true that make this an attractive business model.
You want to make this statement, with great clarity: “Here are the 10 things that are true and really drive our business model; so this is how we will make money and returns for our investors.” Your model should prove that message out in a simple way.
Let’s say your model shows you can sell $1,000 a week and attract customers for $X price and get this done and have that margin, at this level of scalability. When those key assumptions are presented clearly and the basis of those assumptions have merit, then it communicates a strong, clear financial model.
When investors are interested, the next part of your conversation becomes, “And here’s how we’re going to use capital to prove out that our assumptions are correct.” You will use historical examples and comparative examples at this point. Investors are very good at sniffing out reasonable assumptions or asking about a challenge built into other assumptions. They are wary of unreasonable or too many assumptions.
The Startup Model gets you ready to battle for your key assumptions. It’s not a pie-in-the-sky, back-of-the-napkin picture. Your model needs to be representative of what you’re trying to build.
In the pre-revenue stage, you have a few serious hurdles to leap. You cannot tell me that you know your customer yet. You do not yet know how they buy. You do not know how long they’re going to stick around. You’re trying to create a core assumption around who your target (early) customer is and how long they’re going to stay.
Nor do you really know your acquisition cost yet. Sure, you probably have some insights as to why that cost will be what it will be. Maybe you’ve run some tests. Maybe you’ve done a beta test with a fake product with Facebook ads. But you don’t truly know, in terms of growing this business, your acquisition cost.
Your information around price and margin, too, is quite limited. You don’t know the elasticity of this market for price. You get the picture.
With limited data at this point, you only — and clearly — want to build a unit economic hypothesis with your model. Your message to investors needs to be, “We can set this price, build it at this cost and scale in this limited way so the unit economics look quite good. Let’s start to prove that out with $500,000.”
That kind of simpler financial model, demonstrating your understanding of your current uncertainties as well as your goals and research to date, should make it easier for interested investors to start writing checks.
Once your business starts growing and you see you were right, or maybe have to make a few tweaks, then you’ll need a phase two or Initial Traction Model before shifting into a full-blown Operational Model. See you in the next article.