Three tests to ensure a credible financial model for your start-up
TechnologyBuilding a good financial model is not easy, but it is very important to raise capital for your business. Many companies spend many hours trying to get their financial model right. The reason – – – to provide potential investors with information about the projected financial performance of the company in the hope of obtaining an investment and demonstrating that the strategy (that is, using dollars for things like marketing, inventory or personnel) is translates into financial gain in a reasonable period of time for that particular industry.
The model should provide the details of the big picture that the company presents. The key assumptions that are driving the financial model are critical to fully understand and communicate to potential investors. Also, if your key drivers don’t make sense to investors, your proposal won’t be considered credible. To ensure that your presentation is credible and, in essence, your financial model makes sense, be sure to test the following items when your model is complete BEFORE submitting it to someone outside.
First test: make sure the cash flow makes sense
In your cash flow model, you need to make sure to account for when cash is actually received from sales rather than when it is earned and when money is paid for expenses. Many models assume that when a sale occurs, the business receives the money at the same time. However, this may be the scenario for a consumer-oriented brick and mortar retail store, but not the case for an online retail store that uses a third-party sales portal to hoard their products. The third party can wait 30 days or more to pay the money for the sales. Meanwhile, while you wait for those funds, employees are due to receive payment and other bills are arriving in the mail. Your cash flow statement and balance sheet should take into account these cash inflows and outflows. By including this information, you show potential investors that you understand cash flow and that you are not a complete idiot.
Second test: does not take into account income taxes
Most early-stage or start-up business models show significant losses during the first few years of business operations. For the years that there were losses, there is no tax liability. However, when you start to make a profit, there may or may not be a tax liability for the first few years, depending on past losses. Be sure to factor in your net operating losses for the first few years when calculating future tax liabilities in profitable years.
Tax can be complicated, so be sure to speak with a tax professional to understand your state and federal tax obligations, as well as the standard tax rate for your industry.
Third test: sales forecasts are based on reliable data, not on a percentage of the market.
From an investor presentation point of view, it makes sense to present your business as if you were getting a certain percentage of the market for a specific period of time so that the investor understands the size of the opportunity. However, you should not base your business model on a percentage of the market assumption.
Sales must be calculated from a bottom-up approach. This means calculating your sales based on your sales cycle and process. If you did a good job developing the key drivers (that is, the assumptions) of your business model, this shouldn’t be difficult to do. Examples of key drivers include:
- How long does it take to close a sale?
- What is the capacity per salesperson to reach potential customers?
- What is the percentage of leads that convert to sales?
- What percentage of online referrals convert to paying customers?
The list can go on and on, but it depends on knowing your sales process and cycle to be credible.
At the end of the day, it is you who sell yourself and the company to investors. You must understand the key drivers of your business model and explain them both strategically and financially. If you need help with the financial part, get help. You want to be credible to potential investors.