You are about to go see investors and raise funds for your startup and the questions start flowing. How much should you be raising? What is your business worth? How much equity shoufld you leave on the table?
All these questions need answers before you meet investors. The more prepared you are ahead of fundraising, the more likely you will get a fairer deal. In order to answer these questions, you need to build a solid financial plan.
In this article, we go through all the reasons why you need solid financial projections for your fundraising.
What is a financial model?
A financial model is a projection of a business’s financial statements: namely the income statement, the balance sheet, and the cash flow statement.
Typically, we forecast financials over a period of 3 to 5 years by using assumptions (“drivers”) that allows us to estimate the revenue and expenses that a business may have in the future.
Although the document is built using a spreadsheet (Excel or Google Sheets), we usually include the output of a financial model in a business plan or a pitch deck by using charts and tables instead of attaching the spreadsheet itself.
Yet, because a lot of businesses share the same business model, entrepreneurs often use financial model templates to create projections for their businesses, instead of building them from scratch.
What’s inside a financial model?
A financial model should include at a minimum the following components:
- Income statement: a summary of the revenues and expenses
- Balance sheet: the assets and liabilities of a company at a specific point in time in the future (at the end of a fiscal year-end like December 31st for example)
- Cash flow statement: the cash flow movements (cash inflows and outflows)
All these financial statements are intricately related and one minor change in any of them will impact the other 2.
Whilst the balance sheet represents the financial position of a company at a point in time, the income statement (or “P&L”) and cash flow statement give an overview of a company’s financial performance over a period of time (a year for example). That’s why the income statement and cash flow undeniably are the most important components of a financial model.
In addition to these financial statements, a financial model should ideally include all the calculations and assumptions used to create these projections. For example, you could forecast the revenue of an online store by multiplying a conversion rate by your website’s visitor traffic.
What do we use a financial model for?
We create financial models for a number of reasons.
To raise capital
When a business owner needs to raise funding from investors or a bank, for example, she or he usually needs to prepare a business plan. A business plan is a 20 to 40 pages document where you showcase your business, strategy, and future plans. Within these future plans, we include financial projections to show investors (or the bank) the feasibility and potential of your business.
To manage a business’s finances
Preparing a financial model shouldn’t be limited to raising funds. You can also use a financial model to make better decisions.
For example, preparing financial forecasts can help you decide which pricing strategy you should adopt for your products to break even.
Another common example is to calculate how much you should theoretically spend on customer acquisition costs (CAC) so your marketing strategy is profitable.
Finally, a financial model will allow you to assess your runway: how many months can your business survive if you raise $100,000 today? Indeed, most businesses are unprofitable at the outset, and raising funds allow you to cover these losses until your business turns profitable.
Why should you prepare a financial model for your business?
Preparing a financial model for your business isn’t just about raising funds or making better decisions. Here are 3 important reasons you might not have thought of why you should prepare solid financial projections for your business.
You understand your business and your market
When you prepare solid financial and industry trends forecasts for your business, it gives investors (or the bank) more confidence in your business and also in you as an entrepreneur.
You show people you understand how your business makes money, what the costs involved to run it are, and the potential financial risks.
As such, investors will appreciate entrepreneurs well-versed in finance topics, as they are more likely to make better decisions with their finance. A common example, as explained earlier, is CAC: you would be careful to monitor your return on ad spend (ROAC) to acquire customers via paid acquisition campaigns.
Investors will also give credit to financial projections that clearly state their assumptions. For example, you would forecast revenue using assumptions like market size, conversion rates, adoption rates, etc. The more assumptions you can back up your financial projections with, the better.
You have a good idea of your business’s valuation
Preparing a financial model will also make sure you’re best prepared for negotiations with investors when it comes to your business valuation.
Indeed, if you raise funds from investors you will have to give up ownership of your business. That’s why you must come up with a valuation for your business, agreed with the investors coming in.
That’s where your financial model comes into play: investors use a number of methodologies to calculate a business valuation, and they use your financial projections as a basis for their analysis.
Although investors will very likely make some adjustments to your financial plan, it will be their starting point. Therefore, you must have a solid plan with clear assumptions to be able to back up all your estimates. This will allow you to defend your financial projections and obtain a higher valuation for your business.