Navigating Complexities: Advanced Financial Modeling Techniques for Early-Stage Startups

Weighing the Pros and Cons of different advanced financial modeling techniques

Photo by Scott Graham on Unsplash

As a startup founder, one of the most important things you’ll need to do is create a financial model for your business — whether it’s for closing a funding round, receiving public grants or applying for a loan.

However, creating a financial model can be a daunting task, especially if you’re not familiar with the advanced techniques used by experienced financial analysts.

We have already covered the basic steps for creating a financial model for early-stage startups in the following blogpost:

Financial Modeling 101 for Early-Stage Startups: A 6 Step Guide to Forecasting Your Company’s…

One of the most important things to understand about financial modeling is that it’s not a one-size-fits-all process. Different startups will require different types of financial models depending on their stage of development, industry, and business model. That being said, there are a few advanced techniques that can be applied to most financial models to help you better understand and demonstrate the (projected) performance of your business.

However, it is important to understand the pros and cons of each technique, in order to understand whether it is applicable for your startup. Therefore, this blogpost shares insights into three different advanced financial modeling techniques.

Scenario Analysis

A scenario analysis is a process that allows you to create different versions of your financial model to see how it would perform under different circumstances. For example, you could create a scenario where your revenue grows at a faster rate than you expect, and another scenario where it grows more slowly. This allows you to see how your business would perform under different conditions and make better-informed decisions about how to grow.

Pros:

• Allows you to see how your business would perform under different conditions, enabling you to make better-informed decisions about how to grow.
• Helps you identify potential risks and opportunities in your business model.

Cons:

• Scenario analysis are always limited by the information and data, which you are feeding the scenarios with. And the amount of possible scenarios that your business may go through is pretty much infinite, hence founders always have to make the decision of which scenarios to include.
• When raising funding, serving investors a worst case scenario on the silverplate may also negatively impact your possibility to raise funding, or at least lead to a number of questions about your financials. Additionally, investors want to understand your vision and core assumptions about your business (and the underlying validation for those), hence, showing them five different scenarios with different CAPEX and risk appetite might not make

In general, a scenario analysis can be an interesting technique to identify the risks, but also opportunities, of your startups financials. However, keep in mind that investors, provided with multiple scenarios, will usually look at your worst case scenario and adjust it to the additional risks they see.

Sensitivity Analysis

The sensitivity analysis is a process that allows you to see how changes in certain key variables would impact your financial model. For example, you could see how your financial model would be impacted if the cost of goods sold (COGS) increases by 10%. This allows you to identify which variables have the biggest impact on your financial model, and make more informed decisions about how to manage those variables.

Pros:

• Helps you identify which variables have the biggest impact on your financial model, allowing you to make more informed decisions about how to manage those variables. For example, if you identify that COGS have a tremendous impact on your future financial performance, be sure to reduce the risk of input price volatility through close collaborations with your key suppliers, as well as having the right contracts in place with those partners.
• The sensitivity analysis can help you identify potential risks and opportunities in your business model. Being proactive about those with your investors, as well as already having a strategy on how you plan to mitigate those risks, will be a tremendous bonus for your credibility during the fundraising process.

Cons:

• It is a very difficult task to accurately predict how changes in variables will impact your financial model. Nevertheless, playing around with a few variations of different variables will quickly give you a good idea of which factors impact your financial performance to which extent. However, the results largely depend on the quality of the assumptions made, so be sure to back them by relevant types of validation.
• The sensitivity analysis may not be able to account for the interaction and correlation between different variables, which can impact the overall result. So be sure to also check the impact of individual variables separately.

Monte Carlo Simulation

Monte Carlo simulation is a statistical method that uses random sampling to model the probability of different outcomes in a financial model. It is a powerful tool that allows startups to understand the potential performance of their business under different scenarios and make more informed decisions about how to grow and scale.

Speaking of scenarios! One of the main differences between the Monte Carlo simulation and scenario analysis is the way in which they model different outcomes. Monte Carlo simulation uses random sampling to model the probability of different outcomes, whereas scenario analysis involves creating specific scenarios and analyzing the potential financial performance of your business under each scenario.

Pros:

• Monte Carlo simulation can provide a more accurate and explicit picture of the potential outcomes for your business, by showing you how your business would perform under different conditions, enabling you to make better-informed decisions about how to grow.
• Just like other advanced financial modeling techniques, it can help you identify potential risks and opportunities in your business model, allowing you to make more informed decisions about the strategic path you are going to take.

Cons:

• It is difficult to take into account all the external factors that may impact the business with the Monte Carlo Simulation, including the market volatility, changes in regulations, or unforeseeable events (hint: pandemics).
• The Monte Carlo simulation requires a good understanding of statistical and mathematical concepts in order to set up and run the simulations correctly. It can also be complex to interpret and understand the results, which may require the help of an expert.

In conclusion, advanced financial modeling techniques such as Sensitivity Analysis, Scenario Analysis, and Monte Carlo Simulation can be powerful tools for early-stage startups to understand the potential performance of their business under different conditions and make more informed decisions about how to grow and scale.

Each technique has its own set of pros and cons and it may be of help to consult external fundraising experts/financial analysts to determine which techniques are most appropriate for your business. It’s worth noting that no one technique is the best fit for every startup, as the choice of technique will depend on the stage, industry, and business model of the startup. It’s essential to take into consideration the specific needs, resources and data available for each startup when choosing the most suitable technique.

Ideally, startups play around with a combination of these techniques to get a more comprehensive understanding of the financial performance of their business, and a feel of the technique that works best for them. With the right approach and the right tools, early-stage startups can make better-informed decisions and increase their chances of success in the long run.