Building a financial model for a startup doesn’t have to be overly complicated. If you break it down into the 5 key components it will be much more manageable.
The 5 Key Components are:
Startup expenses
These are the expenses incurred by the business before it “goes live” and starts selling, earning revenue, or begins operating. Sometimes the startup period will be considered Year 0 in the financial model. The startup period can include a due diligence period where market research is performed. It can also include costs incurred during product development and setup periods. It is common for these costs to include buying a business, its assets, and an initial working capital investment–for example, purchasing inventory. Typical other costs include people costs, both employees and consultants, professional services: legal, accounting, software licenses, and general office expenses like rent, phones, travel and entertainment, computers, etc.
Revenue
Measuring the revenue at the most basic level is price * quantity for each of the products/services offered. The selling price should be net of or after any discounts are included. So if your product is $100 and you offer a 10% discount if you buy 3 or more units, the revenue would be 3 units * $90 each = $270. The key metric that many investors will look at is Revenue Growth. Turning our attention to the quantity side of the equation, most startups show strong month over month sales growth in the early days, albeit from a small base. Depending on the nature of the business, there could be a seasonal component. For example, if you provide tax preparation services, you will be busier in March and April. There could also be a cyclical component. For example, if you are in real estate, the strength of the economy and housing market can impact the business revenue. The trend, seasonal, and cyclical components can be included in the model. Pricing should also be adjusted (up or down) at later stages in the model to reflect market maturation and other competitive pressures. It is also a good idea to perform a reality check using a top-down TAM SAM SOM analysis: TAM (Total Available Market–how big is the market?) SAM (Serviceable Available Market–how much of the market are you going after?) SOM (Serviceable Obtainable Market–how much of the market can you get?) In this way you can see if your assumptions are out of whack. You want to make sure you don’t build your bottom-up model so you have 110% of your SOM!
Cost of Goods Sold/Cost of Sales
You will need to include the cost of making or buying what you are selling and the cost of bringing the product to the customer. Here again, you will use cost * quantity for each of the products/services offered. This includes logistics costs like delivery and shipping. As an alternative, you can model Cost of Sales as a percentage of revenue. If you are setting your pricing so that you have a 10% markup this will work well. Just remember that different products can have different margins, especially if you are discounting. And don’t forget the difference between markup and margin. If the cost is $40 and the selling price is $50, the markup is 25% ($10/$40) and the margin is 20% ($10/$50). The Gross Profit formula is subtracting Cost of Sales from Revenue. Hopefully, it is positive. The remaining costs will need to be funded out of the Gross Profit.
Customer Acquisition
The next component to include in your model is the cost of obtaining customers. These could be advertising and marketing expenses. They can also be affiliate fees, commissions, and any other cost of generating sales. The key metric that many investors will look at is the Customer Acquisition Cost (CAC) which is the cost of obtaining an additional customer. You will also want to consider the order frequency and Lifetime Value (LTV) of the customer. The trick is to correctly link sales to customer acquisition cost and lifetime value. As you spend more on marketing you will generate more sales (hopefully!) assuming you have available cash to do so. But you have to make sure the sales growth trend doesn’t get out of whack and the lifetime value is reasonable. In an ideal world, you will see revenue increasing and customer acquisition cost decreasing over time.
Operating Expenses
These are all the other daily expenses the business incurs. At this stage of the game, you shouldn’t focus on the accounting. The model is ultimately a cashflow model so things like depreciation aren’t important. Typical operating expenses are people costs, consultants and professional services, rent, software licenses, travel and entertainment, and misc office expenses. The people costs are particularly important because you will need to show your headcount is inline with the company’s growth plans and budget. It will also inform on the employee stock option pool that will need to be set aside.
Other Assumptions
For purposes of this exercise, we won’t include depreciation or amortization. They are non-cash expenses so they won’t impact your financial model. There is a net-positive tax impact as they lower taxable income. However, for a startup, at least in the first couple of years while the business is acquiring its first customers and the customer acquisition cost is higher than the gross profit there won’t be a material impact. Similarly, we will assume there is no debt financing as this is not typical in early-stage startups, so we won’t consider interest expense.
Final Thoughts
It isn’t so important to be 100% accurate on everything. In the real world, things never pan out as planned so there is little sense beating yourself up over every detail. What is important is understanding what your assumptions are, why you made them, documenting them, and being able to defend them. A well-defended set of assumptions will win out over a supposedly more accurate model any day.
When you are comfortable with the basic inputs, the information can be used to generate a profit and loss statement (P&L). You can check your margins and key performance indicators (KPIs) like profit margin and cost per unit. And then noting the timing of cash inflow and outflow a statement of cash flow can be created. If you have to pay for your inventory 30 days before it is produced and sold and you get paid by your customers 15 days after the sale, you will have to have enough cash to cover 45 days of operations and cover the growth of the business over that time period. This can be very useful to determine how much cash you need to raise to keep the business on track. Or if you are bootstrapping, you can see how much you will be able to grow the business without outside investors.
You can also do a discounted cash flow (DCF) analysis to see what the value of the business is. And you can integrate a cap table to show how the amount of money raised at different stages impacts the investors.
