Prepare to raise a funding round is one of the most important tasks any founder goes through. Putting together a deck, teaser and summary requires a thorough knowledge of the story of a startup and the market in which it operates. But for many founders, the most challenging required item is often the most crucial: building a financial model.
A sound financial model not only helps founders understand their own business and how much capital to raise, but is usually required by an investor, who will comb through the model during due diligence.
Your model is your financial roadmap. As a founder, it’s your responsibility to never lose sight of your “runway” – how long it will take you to run out of money – which is calculated by dividing your available cash by your monthly burn rate. Your model should reflect a runway long enough to get you to your next round of funding or break-even cash flow under a more conservative set of revenue assumptions. What do the next twelve to eighteen months look like from a cash flow perspective? For example, does the company have enough runway, even if you only make half of your projected revenue – or no revenue at all?
This is the end goal of your model: to show a coherent way to a potential investor how your business will grow from both a revenue and cost perspective and to indicate how much money you should be raising. While it may feel unfamiliar, as a founder there are a few key things to keep in mind to ensure your financial model is both a powerful tool for you and ready for investors.
As a founder, it’s your responsibility to never lose sight of your “runway” – how long it will take you to run out of money – which is calculated by dividing your available cash by your monthly burn rate.
Build a model for the next five years
No one can predict the future, but you need to tell an interesting story that demonstrates your company’s growth potential. It usually takes five years to show how a company scales, and if you are not realistic in presenting how your company will do that, the model may be discounted by an investor. Most investors will want to see a three-year projection at a minimum, but five years provides a more reasonable increase in sales and profitability.
A financial model often contains a few different statements: income statement (profit and loss statement), cash flow statement, and a balance sheet. For early-stage companies, with limited assets and liabilities, a balance sheet will often not be as relevant as it is for a later stage company. The focus is therefore on the income statement and a version of a cash flow statement. Your income statement can be broken down into sales, cost of goods sold, gross profit, fixed costs, and EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA can serve as a proxy for cash flow, or you can create a more formal cash flow statement.
There are two ways to build a financial model: upside down And bottom above. In a upside down approach, you estimate the size of the market and calculate your percentage of that total market turnover each year. a bottom above model is more powerful, detailed and comprehensive. In this model, you start with detailed assumptions that drive revenue and build on each other.