How to build a practical financial model for your startup
Apart from being a good resource to take to potential venture capitalists and investors, a sound financial model for your startup can help you assess:
Your assumptions and key drivers of your business
Different business choices, like pricing models (example: subscription vs pay-as-you-go)
Actual capital required for your startup
Burn rate and expenses
User growth
Before you start building your model, you should have a very good idea of the overall structure and the flow you’re creating. Some of the modelling best practices that we follow include:
Always start with the end goal in mind
When modelling, the hardest thing is to understand where to start. Do you start with revenue projections or costs? In order to make this easier, you should build a list of questions. For example:
What are the key drivers of revenue for your business?
Which business model is better?
What pricing model should you use? (Example: subscription, freemium, pay-as-you-go, etc.)
How would revenues look if you did X vs. Y vs. Z?
How quickly do you need to grow in order to hit the profit goals?
Why are you making the model?
List out all the questions and prioritize them based on their importance to you. Anytime you put something into the model, it should be done to answer your questions.
Make the model as clear as possible for an external user to read
The end goal should be to make the financial model easy to navigate and read, so that if you show it to anyone, they can figure out what you’re doing and what your assumptions are. Remember to:
Use color codes to differentiate calculations from assumptions
Add labels that are self-explanatory
Make a logical flow of sections – for instance, have the first sheet with instructions on how to read the model, followed by the financial statements, schedules and calculation sheets
Always do sanity checks
While building a model, there is a good chance that you may make errors such as incorrect formulas, illogical assumptions or wrong linkages. There are two types of errors that you should look out for:
Logical error – you make an assumption that is not realistic
Technical error – you put in wrong formulas or link to the wrong cells
In order to spot logical errors, do sanity checks. Pause and ask yourself – is it really possible to achieve what you have assumed? For instance, is it possible to onboard 1,000 users on to your platform if you have budgeted in for only one person on the sales team?
To spot technical errors, look closely at the numbers on your model and see if they are similar to what you would expect? If not, check for formulas and cell linkages. For instance, why is the profit for 2023 lower than that in 2021?
Start small and simple
Do not tackle the complicated aspects of your model until you have modeled out the easy stuff. For instance, you can start with one product in your business, one location, one revenue model or one channel for reaching customers. Doing it this way makes it easier to spot mistakes and fix them immediately.
Define constraints clearly
You have to set the limits of what your model needs to do. The most common mistake entrepreneurs do when trying to build a model is, they try to make the model do too many things.
Ask yourself, what is the purpose of building the model? Is it to arrive at a valuation? Is it to project financial position of the company in 5 years from now? Is it to make a decision on leasing vs buying? If the purpose is too broad, it gets more difficult to build.
Setting clear constraints can make your model process more efficient.
Don’t shy away from utilizing google!
There are a lot of websites and blogs that have financial model templates, similar businesses’ valuations, growth assumptions, etc. that you can utilize to validate and compare your assumptions. You can also find information such as risk-free returns, beta of your industry, market risk premium, etc. to do more complicated calculations such as cost of capital. One of the websites that beginners can use is Aswath Damodaran’s blog.
You do not need to be a financial expert to build a financial model. You also do not have to make it too complicated. The best way to approach financial modelling is to start small and simple, and then slowly add more complexity.