Financial Models for Startups

Planning is an essential function that the founder of a startup company needs to perform. However, this planning is often done informally. If a startup founder is not reaching out to investors to raise funds, there is a very low chance that they will have a well-documented financial model in place. However, empirical data shows that companies that have financial models in place have a significantly higher chance of succeeding as compared to other companies.

In this article, we will understand the basics of financial models as well as why they are important for startup firms.

What is a Startup Financial Model?

A financial model is a way to clearly and unambiguously describe the goals of the startup enterprise. Startup models are mechanisms to create what-if financial statements which help in understanding how the company will serve its customers and what will be the cost of providing this service. The main purpose of a financial model is to allow the startup founders to check how the financial prospects of a company are impacted if any of the underlying assumptions are changed. This helps founders to foresee several possible scenarios and then be prepared for managing them.

Types of Financial Models

There are two common methods that are used to create the financial model for a startup company. The details about these models have been listed below:

  1. Top-Down Financial Model: A top-down financial model uses aggregate financial data available at the industry level as the starting point for making financial forecasts. The analysis starts with industry data and then based on certain assumptions the forecasts are made at the company level. It is common for companies to aim to capture a certain amount of market share within a certain time frame. Hence, they forecast their future revenue based on this market share assumption.

    There is a model called the TAM SAM SOM model which is widely used for creating top-down financial models. Total Available Market (TAM) is the total worldwide market for a product. This is considered to be the starting point of the analysis. The next step is to determine the market which the company can serve given its geographical and regulatory constraints. This is called the Serviceable Available Market (SAM). The last step is to find out the amount of market which can be realistically captured based on the competitive position of the company. This is called Serviceable Obtainable Market (SOM). Once the top line is available using this method, other details such as cost of goods sold as well as overheads need to be calculated in order to derive a financial forecast.

  2. Bottoms Up Financial Model: The problem with the top-down approach is that it tends to make the founders much more optimistic. Capturing small market percentages seems to be easily achievable on paper. However, in real life, obtaining even a 5% market share in any market can be a very difficult task for a startup company. This is because startup companies are generally unknown and face limitations of resources as well. The bottoms-up data tries to remove this flaw. This is because the bottom-up approach begins the analysis by looking at the company’s own past data or looking at the publically available data of similar companies.

    The bottom-up approach to forecasting helps companies identify the key value drivers which lead to the growth of the company. The bottoms-up approach errs on the side of caution. It may not be the appropriate approach to make an investment pitch to potential investors who are very interested in the ability of the startup to quickly gain market share.

Advantages of a Financial Model

There are some distinct advantages of having a ready financial model. Some of these advantages have been listed below:

  • Financial models are very useful since they help business owners create a viable business model. Financial models help companies validate their individual assumptions. This helps them forecast several different possible scenarios and be prepared.

  • Financial models are indispensable for startup companies if they want to raise funds from investors. This is because of the fact that financial models help the founder to understand the cash burn rate that the company will have under different scenarios. This is an important starting point that is used to determine the amount of funds that need to be raised

  • A financial model serves the purpose of being a benchmark. The actual results of the company are compared with the projected results in the model. This helps the founders and the investors compare whether the financial success of the startup is in line with the expectations. However, it is important to ensure that the model is not too optimistic, to begin with. Otherwise, the employees and the management will be under constant pressure.

The bottom line is that a financial model is an important part of a startup’s overall plan. It helps the entrepreneurs gain a lot of insight since it leads them to question the validity of their assumptions.

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Startup Finance