Five Practical Tips for Startup Financial Modeling
I often get the question during annual planning season and fundraising discussions of how to build an effective financial model.
I actually really enjoy the exercise of financial modeling because it forces everyone to think about their goals, hopes, and dreams for the business in a more structured manner. It opens up a ton of discussion on inputs, outputs, the role of luck, and the risk-reward tradeoff we all make on a daily basis. There’s also something to interacting with your business on paper in a 2+ dimensional responsive format, rather than just linearly as if in conversation.
I personally approach financial modeling with the goal of making it a useful exercise with the key deliverable being a financial model in Google Sheets or Excel that has ongoing operational value. Not something you do once a year, drop in a pitch deck, and never look at again.
To that end, a financial model should be five things: (1) ambitious, (2) achievable, (3) personally motivating, (4) easily understood, and (5) built by YOU.
(1) Ambitious
That a startup financial model should be ambitious is self-explanatory. It should aim high and not be overly afraid of failure. Everyone should feel like their capabilities will be stretched to achieve it, and everyone should expect to grow from achieving it. This is why we got into startups, right?
(2) Achievable
An ambitious model doesn’t carry any practical weight if it’s not realistically achievable. Financial modeling shouldn’t be a throwaway hour one spends in Excel or Google Sheets doing a rudimentary exponential growth function on current revenue, and then dropping an output chart in a deck to show investors. That’s not only a waste of time, it can also strain credibility.
The reason I care about financial models is because I assume a company will roughly staff and spend to the plan they show me. If there’s no rational basis to believe the inputs in the plan (i.e. spend) correlate to the outputs in the plan (i.e. growth), or if there isn’t a plan at all, then staffing and spending into the void are a recipe for disaster. It’s worth spending real time on a financial plan even if its just projecting the next 6–12 months.
The ultimate test of whether a plan is achievable is if the leadership team and investors would sign up to it to guarantee the outcome at a 75–90% level of confidence.
Earlier in my career I worked closely with a company that repeatedly missed their plans to the point that it was demoralizing for the company no matter what it achieved, and the investors could no longer trust their ability to execute or even understand their own business. A mentor at the time asked the company for their “pinky plan” meaning the financial plan they would chop off their own pinky for if they didn’t achieve it. We finally got a dramatically shaved down plan. The company achieved it, built trust with their investors and confidence in themselves, and got to keep their pinkies.
(3) Personally Motivating
Another tip I picked up along the way is a financial plan can be both ambitious and achievable, but if it isn’t personally motivating for the founders, leadership team, or broader team, then it isn’t ready to be the go-forward operating plan. This can happen when a business has multiple shareholders with different interests. See my post on VC economics and why fund size matters to companies for an explanation on why shareholders can become misaligned.
If you’re being pushed or pulled toward certain goal outcomes or metrics that you aren’t excited about, then it’s not a plan worth signing up for.
And speak up if this is the case because when you take on institutional investors at the Series A or later, the financial plan typically needs to be board approved and will be the stick for which you are measured against and held accountable. It’s also how you will hold your team accountable, determine bonuses, etc.
If you’re not excited by it, you’re not likely to succeed in putting it into action.
(4) Easily Understood
I strongly caution against building complex models with dozens of tabs, especially at the early startup stage. The more complication and tabs you add, the harder it is for anyone including yourself to understand it. When this happens your financial model loses its value as an operating model.
While there are myriad of variables that impact your business, you should really build a model around at most 1–3 key variables. Every business can be distilled down to the key 1–3 things that will largely determine the success of the business. You’ll know what they are.
Furthermore, the bigger the company gets the more people who will need to be able to wrap their head around the model quickly. Resist the urge toward “tab creep.” You will thank yourself later.
It’s like Mark Twain’s famous quote “If I had more time, I would have written a shorter letter.”
(5) Built by YOU
With all due respect to outsourced CFOs and bookkeeping firms, you really should build and “own” the financial model internally.
It’s way more important that you build and control the main levers of your financial model than it is to have something precise- and professional-looking with 50 inscrutable tabs built by a recovering investment banking analyst whose incentive is not to simplify themselves out of a job.
Much of the output from these outsourced financial models are actually really interesting summary analytics on historical performance. Take these for what they are: analytics and intelligence, but not the internal operating model.
In addition, the financial model doesn’t have to be connected into your accounting and bookkeeping systems at all. It should be informed by it and regularly evaluated against actual results, but it does not need to be precise on every expense category. Better to build from scratch and think holistically about your fixed and variable costs than to build off something designed for a different purpose (bookkeeping).
Most importantly, you can’t let someone outside your company bottleneck your day-to-day, hour-to-hour discussions that require financial modeling. I’ve worked with companies where I’ve built the model and therefore become the “owner” of the model, which meant I was relied upon to run the math on what outputs could be expected from what inputs, or what inputs would be needed to achieve certain outputs. Sometimes I would be able to successfully hand over the model and then extract myself, but other times the transition never happened and my day job as a VC with a dozen other company responsibilities added a day or week to what needed to be a much more nimble process.
Own your model.
In summary, financial modeling doesn’t have to be a crazy stressful process that takes hours of your precious time away from customers to spend buried deep in Excel. Some of the smoothest functioning organizations I’ve worked with have had dead simple two-tab financial models.
If you follow these five tips to make your financial models (1) ambitious, (2) achievable, (3) personally motivating, (4) easily understood, and (5) built by YOU, you too can have a nimble finance and strategic planning function that serves to accelerate your business.
