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5 things to know about creating a financial model for your business

When pitching your business to venture investors, sharing a well designed financial model is very important!  Why?  Because how a financial model is designed helps investors learn some things about you and your business:  it provides insights into how you think about your business, helps clarify what are the main assumptions that drive it and also implicitly sends messages about how you are approaching the business.  Is this obvious?  Not if you look at the inconsistent quality of financial models we see every day.  For some entrepreneurs, it is almost like an afterthought.   So I thought about creating a list of things that entrepreneurs and managers need to keep in mind as they design a model for their business.  This advice applies to young startups as well as established or even public companies.

1. Keep it simple.  This is most important.  You are into all the details of your business.  You really like to be on top of everything.  And might be tempted to create a model that covers every eventuality and every variable.  Don’t.  The purpose of a financial model to be shared with investors is to get them excited about your business.  You may have budget spreadsheets that go into a lot of detail.  But the place for that complexity is in your back office, not the model you share with investors.  Think of the model as a way to tell the story of your business.  It should be easy for someone to follow and understand.  Tthis requires effort and time and you need to put in the effort.  Examples?: make sure you use a format that is easy to follow, don’t have too many unecessary sheets in your file, clearly state and label the assumptions vs the calculations, don’t create too many assumptions/variables if they are not consequential to the business; emphasize the appropriate time period for your business (mothly, quartrely, yearly).

2. Build bottoms-up/ validate top-down. This is especially important for startups or early stage businesses.  I have seen projections that start with a huge market and then a revenue plan that is driven by an assumption of market share: “The market for this service will be $2BN in 2011 and if we get 2% of that market, which I think we can, we will be a $40MM business.”  That is an instant loss of credibility.  You need to build a revenue and cost plan based on actionable assumptions that you control and can demostrate.  That is what I mean by bottoms-up.  You then need to revisit it and ask yourself whether the numbers, esp. the later year numbers make sense top-down, i.e. Is the market penetration by number of customers believable?

3. Altitude is important. This is closely related to the 1st point.  Make sure you can see the forest and not just the trees.  You need to know what level of detail is important to your audience.  Understanding how much ink toner you are going to use is not relevant unless you are in the publishing industry.  The level of detail has to be relevant to what your investor is trying to understand.  Most likely whether the business has potential, can it grow fast, be profitable or require too much capital; not whether you can predict the travel budget of your salesperson in year 5.  You model also needs to be relevant to the stage of your business.  At the stage of an idea, you should only have general assumptions around key items.  Not things you can’t predict that are irrelevant.  Creating too much detail not only makes it hard to understand your business; it also says you are not in touch with reality, so make sure you “fly” at the right level.

4. Find the key drivers. Your financial model is not a crystal ball into the future.  And investors are not asking you to predict the future.  What they want to understand is what drives your business.  What will accelerate or slow down your business, what will make it more profitable or less capital intensive?  In every business there are a few numbers that business performance is most sensitive to.  The most important thing you can do with your model is help identify those things that drive your business: the key drivers.  Is it sales conversion, number of customer calls per sales person, cost per widget by volume, growth in demand, etc?  Understanding and clearly explaining what those are has a double bonus: it helps investors understand your business and also sends the message that your are on top of your business.  Both build trust and confidence in investing.

5. Well spaced bread crumbs. My partner Scott wrote a blog entry about this so I will just point to it here. You need to help investors understand the story of your business.  You need to guide them so that they stay engaged and interested.  You need to make it easy.  Here is a practical example: create a powerpoint presentation to explain your business model.  One of the companies we looked at recently came prepared with a presentation that highlighted all their main assumptions, compared those key assumptions to other competitors and highlighted why they thought they were conservative and reasonable in their projections.  That made it a lot easier to follow and significantly shortened the amount of time we would have to spend on due diligence.