Why Startup Companies Need Financial Models

In a world that is essentially run by money and numbers, we have seen an increase in the number of new businesses in the past few years. As we see how developing countries emerge and come to play in the global business arena, we also see local startup companies mushrooming from everywhere. There seems to be a boost in the entrepreneurial spirit in these countries. But more than just being part of the startup craze, the most important thing is to survive the competition. Ideally, new companies have to realize the importance of having a financial model. 

What is a financial model?

According to Businessdictionary.com, a financial model is a: “Mathematical representation of key financial and operational relationships. Comprising of one or several sets of equations, it is used in analyzing how a business will react to different economic situations or events, and in estimating the outcome of financial decisions before committing any funds.”

To keep it short, a financial model is basically a projection of your cost and revenue for a given period of time. For startups, a financial model can be primarily used to determine if the venture is reasonably ‘worth it’. It is an indispensable way of showing the real potential of your business through numbers. 

So why do startups need to come up with a financial model?

Other than determining if the venture is worth it or not, here are five more reasons why you should create a financial model:

1.   Attract potential investors

Building a startup company is yet another form of trade that comes with several risks. And having a financial model is a good way of assessing these risks along with the attractiveness of the investment. It is one of the most important factors that potential investors will look into when considering an investment. Investors, lenders and even your business partners would want to see a detailed financial plan with logical and realistic assumptions.

2.   Provides an overview of cash calculation

Coming up with a financial model is basically geared towards creating a general picture of where the money is coming from and where it will go. Your financial model should tell a story. It should provide you with ideas on how you are going to manage financial operations and how you are going to raise that capital you need.

3.  Helps improve your business model

Part of creating a business model involves the goals that you have already laid at the start of the venture. The financial model, on the other hand, pushes you to consider all the factors to achieve those set of goals that will ultimately affect the profitability of your business. A financial model should provide a good insight on improving your business model in order to make it more realistic and attainable.

4.  A baseline to track your progress

You may have set realistic and attainable goals, planned the steps in detail, but without tracking your progress, you might lose important things that need to be done consistently in order to make it successful. A financial model should provide you a reference point to help you determine your milestones and to keep you right on track.

A few tips on building your startup’s financial model

As pointed out above, your model plays a crucial role in defining the potential of your business and in attracting investors. It should represent a specific outline of how your business really works. To help you do that, here are a few tips you have to remember when building your startup financial model:

1.   Make it systematic

The key to creating a startup financial model is to make it systematic. You have to provide a coherent documentation of your model. The same as any good research, you have to make sure your model is of good quality. It is, one way or another, a representation of your company, so make sure it is well-organized and it should provide a good impression to your company.

2.   Make it logical and realistic

The fact that your financial model is made up of predictions and assumptions, it will definitely not result to what is originally planned. There are a lot of uncontrollable factors that could affect the end result. The fact that there is a big difference between the actual numbers found in your model and in reality, the most important factor to consider is the logic behind the numbers.

Investors are more interested in knowing the reasons behind those numbers. You may not be able to exactly predict the future, but you have to make sure you are providing them a logical and realistic course towards the end result.

3.   Gather factual data for your assumptions

Without good inputs to your financial model, others may find it useless. 

Finding good data to provide solid assumptions and drivers for your business is undeniably challenging. To help you gather good data as grounds for your assumptions, do your research and create possible scenarios.

When you do your research, ask potential customers, ask the opinion of experts, and ask the experience of other entrepreneurs. Find comparable companies and study their structure.

Creating possible scenarios will also help you understand the possible outcomes of your key inputs. Come up with a range of possible scenarios that will show several outcomes – it could be the best, the worst or the most realistic.

4.  Build the model yourself

There are many entrepreneurs struggling to create a financial model themselves, so they resort to finding templates from the web. However, financial model templates are often hard to find on the web and resources are quite limited. More so, a financial model template may be suitable for one type of business, but not for another even if they are more or less in the same line of business. For instance, a financial model template may be fit for a startup e-commerce company but cannot be used for another type of online business such as an online comparison portal. It could be possible for you to crunch the data all over again but may take a lot of your time and effort.

Others resort to asking investment bankers or MBAs to help them build their financial models. However, despite the fact that investment bankers or MBAs have extensive experience in creating financial models, what they usually create may not match the financial projections for startups, or may even be in conflict with the core business concepts. The type of financial models they build are usually too complicated and tells little about the actual business model for a startup.

So what is the best way? Create your own. Look for examples and seek for other entrepreneurs’ help.

These are just a few of the many tips you can consider when building your startup financial model. You have to remember that it requires patience and hard work. But it helps to think that it is basically a forecast of how you are going to burn your initial cash in a specific period of time. It does not have to be overly complicated.