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Ethan is the founder of SMB Finance, a fractional CFO service for early-stage tech startups.
I have been a fractional CFO for several startups in the past couple of years, helping them prepare financially for the uphill battle they’re fighting. In my investing career, I’ve seen many startups fail simply because of inadequate planning and poor execution. However, planning and execution should not be rocket science to startups. It should be simple and elegant.
So, how do we do that? The answer is creating financial models. Founders often overlook startup finance because they’re so focused on building products and finding market fits. But startup finance is the heart of building a successful startup. Let me explain.
What Are Startup Financial Models?
Financial models are the numerical expressions of your startup business plan. Creating financial models should start with the key metrics and assumptions you will test while executing your business plan. Let’s put it this way — you use financial models to navigate your business and hold yourself accountable through the process. Moreover, financial models are an easy way to communicate business strategies with the board and investors and avoid miscommunications.
Why is it critical to have financial models for your startup? First, financial models allow you to propel the company forward with key performance metrics and accountability. Also, financial models enable you to quantify and compare different parts of your business, such as operations, marketing and human resources, all in one place. Essentially, you’re using financial measurement as the standard measurement for your entire business.
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How To Build A Financial Model
The first step in building any financial model is to map out all the key drivers and assumptions. Then, you have to figure out the numerical relationships between these variables, such as the conversion rate from one part of the customer acquisition to another or the churn rate of a subscription offer. Once you have all of these figured out, it’s time to start building your financial models.
The content of your financial model should be based on the questions about your business you’re trying to answer. So, start by putting the key metrics and assumptions down. For example, you might want to see returns on different advertisement spend so you can double down on the top channels and retire the underperforming ones. In this case, we know the lifetime value, and we calculated our customer acquisition cost. Thus, we can get the metrics we’re looking for.
Once you’re done building a financial model, the work doesn’t stop there. You have to keep refining the accuracy by drilling down on the drivers and assumptions you have and seeing if more variables can be derived from those. Keep in mind there’s a trade-off between accuracy and overfitting the model. There’s a saying that, “No model is ever 100% accurate, but some are more useful than others.”
Examples Of Startup Financial Models
The top financial models for startups include the customer acquisition model, profit and loss (P&L) forecast and runway analysis. I’ll walk you through each of them below:
• Customer acquisition model: A customer acquisition model can provide startups with insights into their customer acquisition channel to maximize customer acquisition effort. When you’re a startup, the best competitive advantage you have against incumbents is the skill of allocating resources.
• Profit and loss forecast: Once you have the customer acquisition model ready, it’s time to forecast your revenue based on those metrics. P&L forecasts are a great way to set company-wide goals. As a founder, you can also think through the economics of your business model and plan for the bigger picture by constructing a P&L forecast.
• Runway analysis: This is probably the most critical financial model a startup should have. After you have your profit and loss forecast, you know exactly how much money you’ll be burning per month. From there, you can see how many more months of the runway you have. And with runway analysis, you can set up fundraising goals and milestones. Managing a startup’s runway is a craft; you’re constantly adjusting the lever between spending more to grow faster and not running out of money.
Financial models are the mission control for your startup. Before you even start your business, financial models are a great way to tell you if you have a sustainable business model and can help you determine how to take your product to the market and drive adoption. You also gain better visibility into your entire business.
When you’re building a startup, speed is everything. And financial models help drive your business forward with quantitative metrics.