How to Make a Killer Financial Model for your Early Stage African Startup
Let’s face it, Financial Models take a long time to build and (for some reason that I don’t fully understand) for the majority of people spending hours tinkering with Excel is not a fun process. Besides, everyone knows that projections are always wrong and you’ve heard from other founders that they have raised funds from VCs with little more than a well-crafted story.
It is no wonder that many founders decide to either take a chance and not build a model or, in most cases, just prepare one half heartedly to tick a box in their fundraising exercise.
Other founders will decide to outsource it to a consultant (which in my opinion is very sensible) but then not bother trying to understand its workings and the result. This might render the exercise useless if a VC wants to scrutinise it with you and you can’t explain the thinking behind it.
For number oriented people — and many institutional investors tend to have someone in the team that is — the financial model is where we see if the plot of the story is coherent.
Most founders now understand the importance of storytelling and of having a great deck, but many fail to see that financial models are just another way to tell your story.
I have spent over two years helping early stage African startups raise funds and during this time I have seen a lot of Financial Models. Not surprisingly the startups with the best models tend to get funds with more ease. Not only that, but I’ve seen numerous cases where an amazing storyteller with a promising startup gets investors excited only to then start seeing many of them drop off once they take a look at their financial model (and data room). As Specth.p from Creandum puts it:
“If the deck is for getting your foot into the door, then the business plan (as well as any other materials you will share in the data room later on) will actually help you make it through the door frame to the other side.”
What should you include in it?
The exact structure of the model might vary based on your sector, business model and stage, but most models will include the following sections:
Summary/ Overview / Dashboard
This is a great opportunity to provide a snapshot of the best aspects of your startup’s projections and go beyond the typical metrics (revenue, expenditures, etc.) I recommend that you include your Key Performance Indicators (KPIs).
Some people use only charts, but the best practice is to use a combination of yearly tables and charts. I would recommend including at least the following yearly tables:
- A Profit and Loss table including: Sales or GMV (if applicable), revenue, cost of goods sold, operating expenses, EBITDA and cash available.
- If revenue comes from more than one source and/or geography, I’d include a separate yearly revenue table breaking it down by the top categories.
- An operational table including key parameters such as the number of subscribers and/or users, team headcount by main categories (e.g. developers, sales, customer service), number of countries in operations, LTV/CAC, churn, etc.
- An operational table with your KPIs.
I would then make charts showing the content of table 1 and 2 and some of the key parameters in tables 3 and 4.
Assumptions
This is the heart of the model as all your projections should be tied to assumptions. It is good practice to have a separate tab with the assumptions alongside an explanation. This makes your model easier to understand and to tinker around. It will also help you minimize and correct errors.
The type and number of assumptions will vary, but for early stage startups I would recommend keeping it simple. Just focus on the essential KPIs and drivers of the business.
Remember that while investors know the assumptions are likely to be wrong, it is an opportunity to showcase how you think and plan.
Calculations: Drivers of Revenue, Expenses, etc.
It is good practice to have a separate tab to calculate different aspects of the model such as the drivers of revenue, customer growth, expenses, etc.
The difference between assumptions and calculations is not always clear. Assumptions are based on data, ideally past performance or industry benchmarks (although we all know that often they are just best guesses). Calculations go a bit deeper and try to illustrate what you know (or think) drives the assumptions and how different aspects of your business are connected.
A key calculation are revenue drivers. Finmark has a great post going into more detail, but let’s assume for instance that you can see that revenue grew on average 20% m-o-m for the last 6 months. Your assumption then could be that your revenue will grow 20% m-o-m for the remainder of the year. But what drives that growth? Is it virality (i.e. luck), marketing, the sales team? You would ideally find the driver to then justify changes in the assumption.
Let’s say that you find (or suspect) that every additional $1,000 dollars you spend on marketing leads to 1,000 new customers which result in an extra 5% in revenue. In that case, you could infer that if you spent an extra $8,000 in marketing, you’d get 8,000 new customers and that will lead to an extra 40% in revenue. This is a bit rough and you could try to be more sophisticated by assuming decreasing returns of marketing but for an early stage startup it should suffice.
The same process goes with expense drivers. Many people just extrapolate an assumption from the past or assume costs increase a fix percentage per year but that is a bit poor. Ideally you would understand what drives the movement in expenses and model accordingly. For instance, customer services can only serve a limited number of customers so as you grow the number of customers, the customer service team will have to grow accordingly.
The calculations tab should clearly show those steps and how each aspect is linked to each other.
This section is useful to investors but in my opinion more so to entrepreneurs because thinking through what drives each aspect of your business will help you make informed decisions about your startup’s operations and strategy.
Team and Salaries
This section should give a detailed idea of the different roles in the company and what you think you will need. This helps investors get an idea of how deeply you’ve got in your thoughts and how realistic you are in terms of headcount and salaries to attract top talent.
Financial Statements
There are three types of financial statements:
- Balance sheet. A snapshot in time of what you own and owe.
- Profit and loss statement (P&L). The accounting revenue and expenses across time.
- Cash flow statement. How the money actually enters and exits your bank account each month and how much money you have left at any given time.
This might be contentious, but for asset light early stage startups I would suggest just focusing on the cash flow statement as that shows how well the business manages its cash position.
This is essential information for an investor because running short of cash is one of the most common causes of failure for a business.
If you want to be thorough however, I would also include a high level overview of the other two financial statements. Monthly figures are usually better, but I’ve seen quite a few good models just showing annual figures.
Some people use only one tab for the three statements. Depending on length, it might be better to have a separate tab for each.
A note on design
As mentioned, the financial model is just another way to tell your story and as with the deck, you should try to make it easy to read. That also entails making it aesthetically pleasing. I am not saying you should hire a designer — please don’t. Just try to remove clutter and have it tidy. this can be done with simple obvious things like removing tabs with old unused calculations, separating long sections in different tabs, potentially using colours to divide sections within a tab and being consistent with the font types and sizes.
I would also recommend using real labels for dates. Many people use “month 1” or “year 1”. I would use the real months or years e.g. “Jan 23” or “2023”. Otherwise it feels you made a generic model that you are recycling and it’s difficult to gauge if it has even been updated recently. In this regard, I would also suggest you make clear what periods are actuals and what are forecasts by adding an “A” or an “F” at the end of each month or year. Alternatively, you could colour code actuals and forecasts.
Conclusion
Financial models can be a bit frustrating because they are time consuming and can be complex, especially for people not familiar with them. Besides, we all know that it’s impossible to forecast the future, especially with startups tackling fast moving new markets. Let alone startups tackling new markets in Africa where the difficulties just compound.
It is then easy to just create a quick model to tick a box in the fundraising to do list. However, this would be a mistake because spending some time and resources building a financial model can be very valuable.
Internally, creating a financial model can be a good exercise to help you think through the key drivers of your startup’s financial performance. You could then use that to make informed decisions about your startup’s operations and strategy.
Perhaps more importantly, a well thought through financial model will help you complement your story and will signal to investors that you are a credible founder. This will substantially increase the chances of succeeding in your fundraise.
In another post I will cover how many investors read your financial model to help you build one with the investor in mind.
