Startup Finance: Build an Investor Ready Financial Model

We at Hammock recently hosted an evening workshop to help educate founders and individuals on the fundamentals of crafting a funding strategy and building a financial model from scratch (You can find more info about our event here).

I’ll start by acknowledging that there are plenty of free templates available online at startup communities and sites. Some are decent but most are either too specific to a vertical or too broad. No matter which template you start with, be ready to spend hours tailoring it to make it specific to your business and encompass the key information and metrics that are critical for your company. In the book Venture Deals by Brad Feld (a must-read for anyone going through fundraising), it emphasizes that if there’s one thing to know about model is that it’s always wrong. True, but building a model will help you understand the impact of certain internal decisions and external factors on possible futures. As an adviser to tech start-ups, I consider the financial model as a persuasive tool and logical framework that enables founders to communicate their growth plans to others and tie operational activities to key metrics.

This blog is organized into 4 sections and covers the following

1. Why do I need a financial model?

2. Principles of an investor ready model

3. Basic structure of an excel worksheet

4. Sample excel revenue and cost templates

Why do I need a financial model?

If you’re reading this blog, my guess is that you probably already have a pretty good idea why. Let me give you my reasons. I believe the exercise of building a model is critical when you’re ready to fundraise. It takes the traction you have established in the prior months or years and projects it out over the next 3 to 5 years. Even if you’re pre-revenue, the exercise helps you answer questions with greater detail — which channels will get you traction? How much are you spending on each channel? How will you get users to convert?

A model is even more critical in later fundraising cycles and will have greater implications to valuation. I advise founders to maintain a simple model even for pre-revenue products. During the diligence process, investors will use your model to review your historical data and test assumptions. They’ll look to the model to answer questions such as “How will you capture the market? What are the growth trends across channels? How much value are created to customers across their lifetime?”. It’s important to tie this to the right channels and sales initiatives. While this can become more of an art than a science, the more historical data you have, the more credible your story.

Principles of an investor ready model

What makes a model investor ready? The model should be robust enough to calculate key metrics and answer questions that your investors may have about the assumptions. Regardless of your industry, the model typically covers 4 key areas:

• Growth & Revenue Strategy. Model should demonstrate how the injected capital ties back to your target milestone and illustrate a monetization strategy that indicates a strong path to user growth, revenue growth, or profitability.

• Operating Budget includes a detailed breakdown of marketing & sales and operating spend.

• Resource build-up for the next 12 to 18 mo. (sales, engineers, products) and the time-frame and cost of each resource.

• Cash balance is typically incorporated once the funding is received. This helps founders stay on top of their monthly burn rate.

Basic structure of an excel workbook

The most basic financial model should have at a minimum 3 to 4 tabs. Don’t try to put too much into one tab — its far better to have a consistent structure in one tab than to cover too much. For a basic model, I recommend organizing the excel workbook in this way:

Sample excel revenue templates -> download here

To keep things simple, I’ve only enclosed the revenue and cost models. I suggest starting in excel but Google Sheets works as well for very simple models. The reason I didn’t include any other tabs is because it should be designed to align with your pitch deck and story. Each founder brings his/her own tone to the story and the model should be consistent to that tone.

Templates includes instructions and footnotes on how to complete. The workbook has three sample revenue templates that uses different unit economics:

• SAAS subscription
• Sales team
• Product-based sales

Basic revenue metrics are also incorporates but you should absolutely adjust and incorporate metrics specific to your business (ie.g. user growth, conversion, churn)

Most investors are focused less on cost, but it’s still important to model as it enables you to understand the levers to profitability.

Costs are organized into a larger income statement, but feel free to tailor to your company.

• Team payroll (salary, benefits, and bonus)

• Operating costs (travel, software, overhead)

Paychex: cloud accounting give start-ups a competitive edge

Paychex: cloud accounting give start-ups a competitive edge

Startup companies are constantly on the lookout for ways to gain a competitive edge. To manage a young business and find new investors, entrepreneurs know that reliable financial information must be readily available. Informational requests can pop up at any time. Rather than formulating responses with quick number crunching on paper, cloud accounting systems allow users to immediately access financial data in a variety of customized formats. With online accounting software, startups find the competitive edge they need to keep up with the fast pace of the business world.

“Mobilize” Accounting

Cloud accounting can “mobilize” data by providing real-time monitoring of income and expenses, even when small business owners are away from the office. Compatible iPad and iPhone apps can be downloaded and installed on a smart device, giving users the ability to view year-to-date sales, generate new invoices, and scan in expense receipts. The apps provide synced data at users’ fingertips in meetings, on conference calls, and at trade shows. 

Manage Cash Flow

Cash is vitally important, especially in the early stages of a business when significant startup expenses are required. Cash balances must be frequently reviewed and future expenses prioritized. For companies without an online accounting system, constructing a cash flow statement can be daunting. Using a cloud accounting system, cash flow is continuously updated once a starting balance is entered. As income and expense items are reported by individual users, cash flow is automatically adjusted. Management can monitor the current balance of the cash account and take comfort in the knowledge of just how much liquidity is available for immediate investment in business opportunities.

Produce Professional Reports

The day-to-day operational demands of running a small business keep many owners busy. Sitting down to create professional financial reports for individual customers and investors is a time-consuming task that is frequently pushed off. Yet, when financial information is requested, or a business plan is needed, it is essential for management to put their best foot forward and produce quality financials. Online accounting software is designed to easily help startups produce accurate financial reports which look great and can be customized to meet a variety of requests. Invoices may also be generated for customers both in the office or using the iPad app while on a job site.

Enhanced Data Security and Availability

Few startups can afford the high-tech data security measures employed by larger companies utilizing full-time IT staff and internally built systems. One of the many benefits of today’s online accounting systems is that cloud data storage helps level the playing field for smaller companies. Cloud accounting systems feature high-level safeguards with dedicated firewalls to ensure that accounting records are safe and secure at all times. Servers are housed in special data centers built using redundant Internet connections, routers, and power generators to guarantee uptime. These data centers also provide startups with offsite file backup. Should the home office or company headquarters ever become inaccessible, remote access to financial data is always available.

https://www.paychex.com/articles/finance/cloud-accounting-gives-startups-competitive-edge

Metrics that are useful for startups

Metrics that are useful for startups

Startups that are searching for a business model need to keep score differently than large companies that are executing a known business model.

Yet most entrepreneurs and their VC’s make startups use financial models and spreadsheets that actually hinder their success.

Here’s why.

Managing the Business
When I ran my startups our venture investors scheduled board meetings each month for the first year or two, going to every six weeks a bit later, and then moving to quarterly after we found a profitable business model.

One of the ways our VC’s kept track of our progress was by taking a monthly look at three financial documents: Income Statement, Balance Sheet and Cash Flow Statement.

If I knew what I knew now, I never would have let that happen.  These financial documents were worse than useless for helping us understand how well we were (or weren’t) doing.  They were an indicator of “I went to business school but don’t really know what to tell you to measure so I’ll have you do these.”

To be clear – Income Statements, Balance Sheets and Cash Flow Statements are really important at two points in your startup.  First, when you pitch your idea to VC’s, you need a financial model showing VC’s what your company will look like after you are no longer a startup and you’re executing the profitable model you’ve found.  If this sounds like you’re guessing – you’re right – you are.  But don’t dismiss the exercise.  Putting together a financial model and having the founders understand the interrelationships of the variables that can make or break a business is a worthwhile exercise.

The second time you’ll need to know about Income Statements, Balance Sheets and Cash Flow Statements is after you’ve found your repeatable and profitable business model.  You’ll then use these documents to run your business and monitor your company’s financial health as you execute your business model.

The problem is that using Income Statement, Balance Sheets and Cash Flow Statements any other time, particularly in a startup board meeting, has the founding team focused on the wrong numbers.  I had been confused for years why I had to update an income statement each board meeting that said zero for 18 months before we had any revenue.

But What Does a Business Model Have to Do With Accounting in My Startup?
A startup is a search for a repeatable and scalable business model.  As a founder you are testing a series of hypotheses about all the pieces of the business model: Who are the customers/users? What’s the distribution channel? How do we price and position the product? How do we create end user demand? Who are our partners? Where/how do we build the product? How do we finance the company, etc.

An early indication that you’ve found the right business model is when you believe the cost of getting customers will be less than the revenues the customers will generate. For web startups, this is when the cost of customer acquisition is less than the lifetime value of that customer.  For biotech startups, it’s when the cost of the R&D required to find and clinically test a drug is less than the market demand for that drug.  These measures are vastly different from those captured in balance sheets and income statements especially in the near term.

What should you be talking about in your board meeting? If you are following Customer Development, the answer is easy.  Board meetings are about measuring progress measured against the hypotheses in Customer Discovery and Validation. Do the metrics show that the business model you’re creating will support the company you’re trying to become?

Startup Metrics
Startups need different metrics than large companies.  They need metrics to tell how well the search for the business model is going, and whether at the end of that search is the business model you picked worth scaling into a company. Or is it time to pivot and look for a different business model?

Essentially startups need to “instrument” all parts of their business model to measure how well their hypotheses in Customer Discovery and Validation are faring in the real world.

For example, at a minimum, a web based startup needs to understand the Customer Lifecycle, Customer Acquisition Cost, Marketing Cost, Viral Coefficient, Customer Lifetime Value, etc.  Dave McClure’s AARRR Model is one illustration of the web sales pipeline.

At a web startup, our board meetings were discussions of the real world results of testing our hypotheses from Customer Discovery.  We had made some guesses about the customer pipeline and now we had a live web site.  So we put together a spreadsheet that tracked these actual customer numbers every month.  Every month we reported to our board progress on registrations, activations, retained users, etc. They looked like this:

User Base

• Registrations (Customers who completed the registration process during the month)
• Activations (Customers who had activity 3 to 10 days after they registered.  Measures only customers that registered during that month)
• Activation/Registrations %
• Retained 30+ Days
• Retained 30+/ Total Actives %
• Retained 90+ Days
• Retained 90+/Total Actives %
• Paying Customers (How many customers made $ purchases that month)
• Paying/(Activations + Retained 30+)

Financials

• Revenue
• Contribution Margin

Cash

• Burn Rate
• Months of cash left

Customer Acquisition

• Cost Per Acquisition Paid
• Cost Per Acquisition Net
• Advertising Expenses
• Viral Acquisition Ratio

Web Metrics

• Total Unique Visitors
• Total Page Views
• Total Visits
• PV/visit

A startup selling via a direct sales force will want to understand: average order size, Customer Lifetime Value, average time to first order, average time to follow-on orders, revenue per sales person, time to salesperson becomes effective.

Regardless of your type of business model you should be tracking cash burn rate, months of cash left, time to cash flow breakeven.

Tell Them No
If you have venture investors, work with them to agree what metrics matter.  What numbers are life and death for the success of your startup?  (These numbers ought to be the hypotheses you’re testing in Customer Discovery and Validation.) Agree that these will be the numbers that you’ll talk about in your board meeting.  Agree that there will come times that the numbers show that the business model you picked is not worth scaling into a company. Then you’ll all agree it’s time to pivot and look for a different business model.

You’ll all feel like you’re focused on what’s important.

https://steveblank.com/2010/02/22/no-accounting-for-startups/

Forbes: Accounting for start-ups

Forbes: Accounting for start-ups

When you first bring a newborn home from the hospital and want reassurance the baby is doing ok, you’ll probably listen periodically for breathing sounds. It’s unlikely that you’ll track the number of breaths per minute and compare it to the average for all newborns. Of course, as the child grows, you’ll incorporate additional ways to monitor whether physical, mental and emotional development are on the right track.

In the same way, your need for accounting services as you’re starting a business is going to be quite different from your needs once the business has, with a lot of hard work, grown to, say, $20 million a year in revenue. According to Brian Hamilton, chairman of financial information company Sageworks, a lot of inexperienced entrepreneurs may be confused about whether they need to hire an accountant early on,  or even before they’ve started operating.

“Most businesses are very simple, and the vast majority of them are sole proprietorships,” Hamilton says. As a result, all of the owners’ energy goes toward getting revenue and getting customers. “In most cases, you don’t need an accountant on day one. If I’m going to start, for example, a landscaping company, I’m not going to count money until I make money.”

Numerous accounting systems, such as QuickBooks, Peachtree and Xero, can help new-business owners track the key metrics such as sales and expenses in the early stages. And tax-return software makers like Intuit make it easier for these sole proprietors to file their Form 1040 with a Schedule C attached.

Sageworks Stats

We write about private-company financial data and managing a business. 

Opinions expressed by Forbes Contributors are their own.

Mary Ellen Biery, Contributor

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• inexperienced entrepreneurs may be confused about whether they need to hire an accountant early on,

When you first bring a newborn home from the hospital and want reassurance the baby is doing ok, you’ll probably listen periodically for breathing sounds. It’s unlikely that you’ll track the number of breaths per minute and compare it to the average for all newborns. Of course, as the child grows, you’ll incorporate additional ways to monitor whether physical, mental and emotional development are on the right track.

In the same way, your need for accounting services as you’re starting a business is going to be quite different from your needs once the business has, with a lot of hard work, grown to, say, $20 million a year in revenue. According to Brian Hamilton, chairman of financial information company Sageworks, a lot of inexperienced entrepreneurs may be confused about whether they need to hire an accountant early on,  or even before they’ve started operating.

“Most businesses are very simple, and the vast majority of them are sole proprietorships,” Hamilton says. As a result, all of the owners’ energy goes toward getting revenue and getting customers. “In most cases, you don’t need an accountant on day one. If I’m going to start, for example, a landscaping company, I’m not going to count money until I make money.”

Numerous accounting systems, such as QuickBooks, Peachtree and Xero, can help new-business owners track the key metrics such as sales and expenses in the early stages. And tax-return software makers like Intuit make it easier for these sole proprietors to file their Form 1040 with a Schedule C attached.

“If you’re running a fairly simple business, why do you need an accountant on the first day? You might need an accountant for advice, because you usually need advice once you get going,” he said. Accountants can provide financial and strategic advice for your business, and they can help with services like estate planning or getting a loan. A startup tech company raising money might also need an accountant in some cases, he said.

But the need for an accountant is mostly dependent on the type of business you’re starting and where the business is in its life cycle. And most of the time, people are starting a simple business and simply need to jump on the task of getting customers.

“A lot of the time, entrepreneurs and others seem to have a kind of checklist in their head about what ‘real’ businesses do and have. They think that all businesses ‘need’ an accountant, a lawyer, a business plan, to be incorporated. All they’re doing is setting big obstacles to getting the first customer,” he said. “My advice would be to go get a customer and then get an accountant.”

In the meantime, private-company owners do well to focus on a couple of key financial metrics. Most will closely track sales for obvious reasons. And unless the business is project-based or you offer credit to customers, tracking sales should be pretty straightforward. Aside from that, logging your expenses meticulously (both your direct costs for materials and supplies and your indirect costs for advertising or that accounting software), will help you keep tabs on whether or not your business is turning a profit.

Two key ratios that can help you track your profitability

• Gross margin: This is a company’s revenue minus total costs directly involved in producing the product or delivering the service, divided by revenue. This shows what percentage of sales is left over after direct costs, and it’s an important measure of efficiency. Examining this can guide you on when you need to adjust prices or volume in order to keep more of what you sell.

Net margin: This is a company’s net profit measured against sales and takes into account all expenses related to the business (such as bank fees and other general overhead). This margin tells you how much of every dollar in sales your firm is keeping after all expenses are paid.

Other metrics become more important to understand and track as the business grows, Hamilton said. Again, when exactly the business begins tracking these metrics will vary depending on the type and life stage of a company. But at the earliest stage – when many individuals are developing the idea for and launching their business – the most critical metric is sales.

“I’m not saying you don’t need an accountant at some point,” he said. “It’s got to be time sequenced.”

“Most businesses in the early stages are very simple, and all of your energy should be channeled into getting revenue and getting customers,” Hamilton said. “Then once you get those, maybe you get an accountant.”

http://www.forbes.com/sites/sageworks/2014/11/02/accounting-for-startups/#19f88bf1432f

Standard GSB: Smart start-ups don’t wait to set up accounting system

Smart Startups Don't Wait to Set Up Accounting Systems

A study shows that those with early financial monitoring systems grow faster in revenues and head count.

The question of when to set up management control systems such as financial planning and monitoring tools haunts most entrepreneurs involved in startup operations. Until recently, there was little research on the topic, but a new study by Antonio Davila, assistant professor of accounting, and George Foster, the Paul L. and Phyllis Wattis Professor of Management, explores this area.

Davila and Foster studied 78 companies in a variety of technical and non-technical industries, each less than 10 years old. They found firms that acted quickly to institute formal mechanisms such as operation budgets, cash budgets, and financial monitoring systems (tools that measure profitability, customer acquisition costs, variance from actual budget, and so forth) had higher growth rates in terms of revenues and head count. They also had greater and more rapid increases in valuation at successive rounds of venture capital funding.

"Control systems are critical for providing executives with data they can use for their managerial decision making," says Foster. "We can't prove whether growth pushes the adoption of management systems, or whether the adoption of management systems pushes growth, but clearly both are occurring. Larger companies are more complex and need the discipline that such systems can bring. At the same time, it's generally true that managers of early-stage companies are unlikely to predict accurately exactly when growth will occur. Therefore, because significant growth does tend to happen within a year of their establishing management accounting systems, it's likely that these systems anticipate and fuel growth, as well."

Because information about internal decision making regarding management systems generally is not available publicly, the researchers used questionnaires and interviews to glean valuable data about company practices from some 200 startup executives. They found that young companies begin with few management systems in place. These firms tend to institute financial planning systems such as operational budgets on average 1.48 years after the company founding, with cash budgets following quickly. Financial monitoring systems come much later — on average three or more years after founding. Still other systems, such as product development, partnership, and marketing control, come even later.

"Management systems are the foundation for growth," says Davila. "As an executive in one of the companies we worked with described it, 'management by personality' only works up to a certain point. After that, you need to put systems in place."

One key factor driving the timing of when financial management systems are adopted is when a chief financial officer is hired, according to Davila and Foster. "We call this the 'import-in' approach to establishing control systems," says Foster. "Companies look for what's missing in their organization and hire people who have skills in those areas. Bringing on a senior financial officer typically fast tracks establishing financial planning and monitoring systems. It's generally more effective and economical than trying to create something from scratch within an organization."

The study also reveals that venture capital-backed companies tend to establish operating and cash budgets sooner than individually funded startups. "Often managers want to be sure that the funding will not be abused, so they are eager to set up controls as soon as they can," Foster says. "VCs also understand the importance of good financial management and encourage the use of these systems." Companies with more experienced CEOs adopt planning systems earlier than those with greener leaders at the helm, as well. "More experienced executives recognize the importance of formalized decision-making mechanisms and are quicker to implement them," he says.

The study, which was funded by Stanford's Center for Entrepreneurial Studies, is an important step toward helping future entrepreneurs learn from the experience of others about making wise management systems decisions. Davila and Foster are now exploring in more depth not only managerial accounting decisions, but also decisions concerning other systems such as strategy planning, human resources planning and compensation, marketing and sales, product development, and partnership. "We are finding that how these various systems complement each other to support growth," Davila notes.

Moreover, the researchers are globalizing the investigation, extending it to include early-stage companies in Europe. "Preliminary findings indicate that Germans, for example, have a greater propensity for establishing systems at an earlier stage than U.S. companies," Foster reports.

https://www.gsb.stanford.edu/insights/smart-startups-dont-wait-set-accounting-systems