The following Insights post is contributed by Keith Davidson, Principal at Silverbridge Consulting.
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Financial models have a personality. That may seem strange to the non-finance professional, but it’s true. Not only does it have a personality, but it tends to mirror the organization it represents. Large public company financial models and forecasts tend to be rigid, mechanical, and highly biased towards prior period data. Like the overall culture at most large companies, making changes to this model is typically met with consternation (the model itself will likely automatically schedule meetings to stop you). Conversely, startup and small-cap financial models are usually (or at least should be) dynamic, balancing both art and science, and able to adjust to a changing environment. Those type of models fit startup companies like a glove. Until they don’t. With the proliferation of startup companies in today’s world, unfortunately the same has occurred for financial models, and unlike startup companies, not in a good way.
Due to the oversupply of models and methods out there, too many startup financial models have become watered down and unable to meet the needs of their startup. That gap results in a lack of information and overall insight for both the leadership team and investors. Fortunately, the differences between a good and bad financial model are not impossible to fix. Below are the top 7 problems errors in startup financial models today.
Failing to internalize the business
The first problem is directed at the actual finance person or team performing the work, whether it’s someone internal to the company, a fractional CFO, or a consultant. A financial model may seem like a strictly mechanical function, but for startups, truly understanding the commercial and monetization model and strategy of the business is the first step in creating the type of interactive and assumption driven model required.
Not all financial models have the same goal. A financial model for a quarterly forecast is different than a model for an annual budget, which is different than a 5–7 year model needed for a fundraising round. Even for fundraising rounds, a long-term model for internal use for the board or the founders will have different nuances and assumptions than one meant for a VC firm. Failing to understand that goal could result in overkill or a model that is too thin.
A pet peeve in both modeling and in finance overall is false precision. Applied to financial modeling, false precision occurs when assumptions or data is included in a model beyond what is actually reasonable or possible to know, especially in situations where the outcome is not worth the time. It is extraordinary that large companies with billion-dollar revenue budgets spend as much time trying to figure out a miscellaneous $50K expense as they do the actual billion-dollar revenue budget, but that happens all over the corporate world. Startups are guilty of this too, but in the case of startups it is important to remember that investors are much more worried about your handle of the assumptions and your vision for the business plan than they are about whether your G&A budget in 5 years is accurate to the nearest thousand.
Focusing on point estimates only
Slightly related to false precision, financial models can be too focused on point estimates and not the range of possibilities or sensitivities to the business. While point estimates are needed to produce complete pro-forma financial statements, ranges and sensitivities are more helpful to the startup leadership team. After all, one of the reasons you have a financial model or a finance team in general is to provide leadership with enough information and insight to make better decisions and to understand the impact of those decisions. Understanding the possibilities and sensitivities to different assumptions and business decisions drive that process. It also impacts the investor conversation as well, since they want to focus their understanding on the business model and strategy as a whole, as opposed to focusing on exact estimates.
Neglecting key metrics in favor of financial statements only
Financial statements are important, but better business decisions and even investor inquiries are driven by performance metrics, not by a simple income statement or balance sheet. When an investor asks you about your MRR, CAC, deal win rate, manufacturing speed, or staff utilization, a spreadsheet of an income statement is the wrong answer (you would be surprised how often it’s submitted as an answer). Ensuring the financial model consists of key performance metrics will help you tell the story of the business and help you focus on problem areas once the financial forecast is not measuring up to the original forecast.
Unrealistic expense growth and scale assumptions
Startups should and will typically achieve some degree of scale over time. However, even the most challenging investor will expect reasonable expense growth in the short-term. Unfortunately, many financial models think the opposite. Doubling sales in one year? That could be possible given a groundbreaking product, but typically impossible at only a 5% increase in sales and marketing spend (especially with sales teams and commissions involved). Increasing manufacturing production due to increased sales? Great progress, but it is unreasonable to assume manufacturing is increasing by 50% over two years with no increases in fixed overhead costs. Investors will lose confidence in these types of financial models very quickly, not only because the projections will be inaccurate, but also because you can easily lose the credibility that you have a firm grasp of what it takes to grow the business. Remember, as the financial model takes on the personality of its business, that personality cannot afford to be naïve and simply hopeful.
Pouring the model in concrete
A financial model, especially for a startup, is a living document. Too many models today are frozen in time and painful to update in later years or in later fundraising rounds. Ensure you have a financial model that is easily updated and full of key assumptions. One of the marks of a good financial model is the ability for non-finance professionals to update it in real time.
Startup companies are too difficult, and the team is too busy building the company to let a poor financial model cause challenges in making decisions or fundraising. Startups are successful when there is a perfect storm of a solid team and a winning idea. Ensure you have a financial model that is worthy of that storm and capable of the journey.