Financial Models for Start-Ups
Most start-ups in the software space are, naturally, founded by folks whose area of expertise is technical and not financial; they are more likely to be comfortable writing or debugging computer code than to think about income statements or balance sheets. In the early stages of a start-up it is not uncommon to not have a single person on the team who can understand a full set of financial statements let alone create them.
It is, however, important that the start-up ventures undertake some level of financial analysis to determine the financial viability of the venture or determine the need for funding (when and how much). Also, the financial analysis exercise requires a systematic way of organizing one’s thinking about the costs incurred by the venture, the staffing levels, the products and revenues, etc., and the exercise can often help identify key financing elements that one may not have considered.
Most start-ups end up closing shop because they run out of funds. Having a good idea of the venture’s finances can help extend the life of the venture.
The financial analysis is an important component of investor pitches as well, and when it comes to pitching to investors, it is important that the start-up team (the team) present a coherent set of figures that can be used as a basis for valuation of the start-up. The key term here is “coherent set of figures” — by this we mean that the financials that the team presents to investors are internally consistent, i.e., the forecasted revenues are tied to products, customers, price and growth rates, and the costs are tied to actual forecasted expenses like salaries, benefits, office costs, hardware costs, etc.
To develop such figures, the typical approach is to develop an excel based financial model. Now, in most start-ups, there would be one or two members who can easily do a simple spreadsheet that will do projections of revenues and costs based on some set of assumptions. The big hurdle for most teams is to then convert these revenue/cost projections into financial statements — this is where some knowledge of finance and accounting is important. And as discussed earlier, most teams don’t have a financial guru on their team. So many teams revert to the time and tested method of downloading a spreadsheet from the web and using that spreadsheet to generate the financials.
Obviously, this approach, while commonplace, has its flaws. First, there is no guarantee that the downloaded spreadsheet has no errors. Second, the spreadsheet often will need to be customized for the specific need of the team (say the spreadsheet wants the data in quarterly intervals while the team needs to present the data in annual intervals) and this will require some financial know-how to do correctly.
To help start-ups and other non-finance professionals develop financial models, we have developed a website, MyFinModel, that generates a full set of financial statements using pre-defined templates for a variety of scenarios. The advantage of this type of web based model is that the analyst can spend time thinking about the inputs and outputs and not worry about building a model from scratch. One disadvantage of this tool is that the tool may not work for all situations.
We describe one of these, SaaS Finance, appropriate for Software as a Service (SaaS) type start-ups in this article.
II. Financial Models for SaaS
The typical financial model is based on discounted cash flow (DCF) analysis, the pillar of modern financial modeling. It relies on projecting the cost and revenue streams in the future, and then discounting the future values back to the today’s value. Details of discounted cash flow modeling can be found any standard finance textbook or articles on the web.
We have provided two levels of financial for SaaS on the MyFinModel website. One is the basic SaaS model and the other is an advanced SaaS model. The advanced models allow for more input parameters while the basic model is more appropriate for simpler situations. In this article, we will use the basic model as the tool for exposition.
2.1 Key Inputs
For any financial model there are several inputs. We have categorized them into four groups for sake of clarity. Note that we use an example to illustrate the discussion — the screenshots from SaaS model show this example.
a. Model Parameters
For any model, the analyst needs to consider the following overall parameters (these can be specified using the drop-down menus as shown in Figure 1):
- Type of Period: This defines if the model is run on a monthly, quarterly, semester or annual basis.
- Number of Periods: defines the model horizon.
- Starting period (year/month): defines when the model should start.
- Revenue Categories: Specifies how many revenue categories are included in the model.
- One-off Costs and Recurring Costs: Specifies how many one-off and recurring costs will the project incur.
- Other Costs Categories: Specifies how many other cost categories are included in the model that are not included in the direct costs as well as recurring costs.
- Capex Items — defines the number of capital items that you will need to depreciate.
- Currency: defines the currency of the analysis.
- Output units: thousands, millions or billions.
b. Revenue Information
The next category of inputs relates to revenues (see Figure 2). In a typical SaaS business, revenue is generated by one or more of the following categories (but not limited to):
- Subscription services: relevant data needed are the number of visitors to the site at the start, growth rate of organic visitors, rate of change of growth, viral rate, subscription fees, upselling services and fees, reporting services and fees, customization services and fees, advertising revenues, API sales, and other sales. The analyst can plug in the relevant data and if necessary leave zeros for categories that are not relevant to the business.
- Product sales: some start-ups may have product sales as well. These can be added in the model — both volume and price for the product are plugged in.
The implied revenue model basically is that the venture has some initial set of visitors, of these visitors some become subscribers who pay for the service offered by the venture. Some of these subscribers buy additional services (“upselling”), some require customization and some require additional reports. Finally, there are some advertising and API revenue opportunities and some product sales opportunities.
For the purposes of our example, we use some values for a web-based data business.
c. Cost Information
Every business incurs some costs and it is important to estimate these. The SaaS model categorizes the costs in a few groups (see Figure 3):
- Start-up and ongoing costs: These are recurring costs that are incurred every month. These typically include office rents, utilities, supplies, advertising, legal, tax and other services, social charges on salaries, etc.
- The largest cost in a typical start-up is the salaries of employees. We provide the usual employee categories and the number of employees and their salaries are needed.
- Other costs: These can be costs not considered in the prior categories.
- Capitalized costs: In some ventures, there are large equipment purchases that are capitalized over the useful life of the equipment. These need to be accounted for differently than the other costs.
d. Financing Information
In the final category of input data, we need the financing information. Here we are looking for information that describes how the venture will be financed when the revenues do not cover costs (which is the case for most start-ups during their initial growth phase). Additional information as shown in Figure 4 is needed for valuation purposes.
2.2 Key Outputs
Once the key inputs are provided, the analyst can click “Run Model” icon and viola, in a few seconds the model generates summary charts (as shown in Figure 5), a full set of financial statements (see Figure 6) and various other supporting tables that show some of the calculation details.
The financial statements created by the model include the income statement, the cash flow statement and the balance sheet. In addition, we provide estimates of the free cash flows, and estimates for the value of the business based on the assumptions provided in the input section.
2.3 Other Models
We have described SaaS model in the prior section. MyFinModel provides several other models that can be more appropriate for your venture. These include DCF models, project finance models, proposal pricing models, etc.
III. Caveats and Closure
We have provided an overview of the different inputs and outputs of a typical financial model for SaaS start-ups, and how MyFinModel can help build these models quickly.
Note that we recommend that you use the tools from MyFinModel to determine financial feasibility of your business model and to test out different scenarios. If you are in the process of raising finance for your venture, we would recommend that you work with a finance professional who can tailor a model for your specific venture, and take into account the local accounting rules.