The 5 Key Steps for Preparing Your Startup’s Financial Model for Fundraising
Part 1 of 5 in the “Financial Modelling for Startups” Series
Raising financing from venture capitalists and institutional investors can be a significant hurdle for any startup. Whether a venture seeks funding for product development, testing of market hypotheses, or scaling up of operations, at some point, every founder has to prepare for the often time-consuming and stressful process of fundraising.
And although some challenges are unavoidable, there are distinct steps a founder can take to build a business case that is both reasonable and convincing for investors. In this series, I want to share a few suggestions for those steps.
Successful fundraising involves storytelling. Because startups usually only have limited historical data to back up their business case, investors evaluate a potential deal as a bet on a few connected hypotheses about the relevant market segment, the founding team’s capabilities, and the fit between the opportunity itself and the plan to achieve it.
In this way, the founder’s primary job when fundraising is to communicate the hypotheses clearly and convincingly to support a compelling story and long-term vision.
Thus, apart from storytelling, critical reasoning skills also play a crucial role in successfully securing financing. While a pitch deck is the most standard tool to illustrate the overall vision, investors usually request a financial model outlining the business plan to analyze its underlying economics.
A financial model serves as a virtual re-creation of the business and thus shows the founder’s assessment of the business case’s primary relationships and dynamics. Being prepared to discuss and defend the dynamics modelled into such a plan is often a determining factor for closing the deal.
Consequently, building a financial model for potential investors involves a lot more than choosing the right template or formatting. It is an opportunity to present a framework for the hypotheses that together form your business case, making it easier for investors to place their bets.
The following series aims to outline key steps founders can take in preparing their financial model for a fundraising process and themselves for discussions surrounding it. However, it will not include excel formulas, formatting guides, or one-size-fits-all templates. These types of resources are widely available online.
Instead, the focus here will be on the thinking process that should go into each step of the modelling process to maximize the probability of success when trying to convince investors to finance your company.
Although following these steps will significantly improve your preparation for discussions with potential investors, the investor’s exact requirements for the model and the depth of conversations might differ depending on the particular investor, your startup’s lifecycle stage, and your competitive field.
Purpose and Structure: Organization is Everything
Before thinking in detail about the dynamics in your model, it is essential to reflect on the ultimate purpose of building it in the first place.
Investors analyze a startup’s financial model to understand the founder’s assessment of the business case’s primary relationships. Many founders have the false assumption that investors want to see highly sophisticated quantitative techniques and detailed multi-year forecasts.
However, investors are aware that ventures operate in highly uncertain environments that require constant experimentation and evolution, especially in the early stages of a company’s life cycle. Investors understand implicitly that making precise predictions about a startup’s mid- to long-term business projections is impossible.
A further common misconception is that projections for a startup investment case have to hit specific figures in terms of customers, revenues, or other metrics within a pre-defined time to be considered an exciting opportunity. Though this notion certainly has some truth since investors will have expectations about growth rates and milestones the business should target given the underlying business model and industry, it also must be believable.
It is important to differentiate between showing a reasonable game plan for achieving the next scale phase (e.g., from 1.000 to 100.000 to 1.000.000 customers) and artificially blowing up your projections by adjusting assumptions until you have reached a number that gets attention in your pitch deck.
Founders should always have in mind that successful fundraising means selling a bet based on a set of established hypotheses.
It does not matter how high your projected revenue figure next year is and how promising your investment case looks like if reasonable and defendable assumptions do not back the projections.
A well-designed model makes it easy and intuitive for the investor to follow the line of reasoning that makes a bet represented by your business case an attractive one. In this sense, determining the right structure for your model is an essential but often underrated factor.
When approaching the planning process, it is useful to think in terms of logical blocks that represent the business case.
Each block has its own set of assumptions that flow from a designated input sheet into the calculations that lead to desired outputs. In terms of results, startup investors are usually most interested in your P&L calculations, starting with the generation of revenue and continued down to EBITDA and net income, as well as your cash flow projections. A fully functional balance sheet forecast will seldom be necessary for early-stage startups.
Therefore, it makes sense to organize your model into blocks representing the generation of sales (i.e., the engine for revenue generation), the costs necessary to achieve your growth projections (i.e., COGS and Opex), and other cash-flow relevant items (e.g., investments in capital assets).
When further breaking down those blocks, founders should follow the general principles of financial modelling, such as separating inputs and outputs, clearly outlining assumptions (e.g., highlighting with different font colours), and using consistent formatting.
Also, try to avoid intertwined and unnecessarily complicated formulas. The model is not a tool to showcase your spreadsheet skills but acts as an informational foundation for further discussions with the investor about the main assumptions driving the results.
Lastly, it is essential to let the purpose of the model drive its functionality and how you approach building it. Investors will see the model as a reflection of your thinking process. A model that is free of errors and easy to understand and audit reflects a structured and rational approach to planning your company’s future, which ultimately supports your image as a founder that investors can trust with their money.
Introduction, Purpose, and Structure: Key Takeaways
A founder’s main task in fundraising is compellingly presenting and selling a bet to investors.
The financial model prepared for fundraising is an opportunity to present hypotheses about the future potential and attractiveness of the venture investment case.
Investors do not place bets without trust in the offering party and a with a clear perspective on the bet’s conditions.
When building a model, it is essential to have its purpose in mind and always maintain a consistent structure to represent a rational and clear thinking process.
- Communicate your assessment of the basic assumptions, drivers, and relationships within the business case
- Illustrate your way of thinking and planning
- Build a foundation for further discussion
- Organize your model into logical blocks (e.g., sales assumptions, cost assumptions, assumptions concerning other cash-flow relevant items)
- Highlight your assumptions (e.g., through formatting) and separate input variables and outputs on different sheets (e.g., assumptions sheet, calculation sheet, output sheet)
- Make the model easy to understand and audit by using only standard formulas and consistent formatting.
As we will see, the parts of a well-prepared financial model reflect the most important components of every startup’s business case.
When trying to persuade someone to place a bet on your venture, the logical way to start is to understand the opportunity to develop a plan to capture and ultimately monetize it.
Therefore, Part 2 of the series will discuss some suggestions on outlining and analyzing the opportunity through market sizing, which is not mandatory in a typical model, but, through implementing, can yield valuable insights for the steps that follow.
If you are a founder looking for an investment, I hope you find this article series helpful for your preparation.
Find the additional parts here:
- Part 1: Purpose and Organization
- Part 2: Market Sizing
- Part 3: Unit Economics and KPIs
- Part 4: Scenario Planning
- Part 5: Storytelling
Especially if you are working in the fields of FinTech, Blockchain or AI, I would love to hear about your company so feel free to connect with me on LinkedIn.
Similarly, if you are a VC Investor and have some feedback or additional notes on this topic, I would love to learn more about your views.
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