Context for reading the following is that this view is aligned towards a “bottom-up” financial model vs. a “top-down” financial model.
Read: 5 Reason Why A Bottom-Up Financial Model is Better
If you believe that a top-down financial model for a startup is better then this page may not resonate.
Financial Model for Startups
As an entrepreneur or operator, the goal is to be disciplined with capital from Day 1 and to manage cashflow efficiently.
This ‘model’ is completely hypothetical and designed to illustrate the logic through various steps relative to the underlying risks in the business. Whether SaaS or eCommerce, the general principles are the same, but the inputs/outputs would obviously be different.
Considerations for New Business ‘Models’
Financial modelling is very difficult, but for the purposes of creating a new business (ie. startup finance) you don’t need Investment Banking models.
Read finance + investing blogs and investors are looking for key factors related to growth (multiples) and profitability (EBITDA). These are either publicly-traded companies or late venture-stage companies with established business models and clear product-market fit.
Investors at this stage think about returns relative to indexes, portfolios, and strategies. They are judging their returns against interest rates (risk-free rate of return) and may be willing to lose money, but not see an investment go to zero.
Financial modelling for a new business is completely different. It is a race against the clock and, in many cases, the business will go to zero.
The only reason it won’t go to zero is because it becomes ‘cashflow positive’ before the moment the bank account(s) are empty and grows into a thriving business. Cashflow can emerge from two possible sources:
- revenue generation
- financing
*technically, donations are possible through mechanisms like crowdfunding
The distinction between cash positive and profitability is important. Naturally, the goal is to build a profitable business model at some point. But the question is when?
As long as there is cash in the bank, founders and their teams can ‘fight another day.’ Inflection points are very difficult to predict. When we look at markets, the history of successful companies, and other data points, we see repeatedly:
- many entrepreneurs who were on the brink of failure before succeeding
- the ‘turning point’ coming precisely because their backs were against the wall
Money in the bank (ie. cash) means the trajectory continues. The great unknown of history is how many more successful companies would there have been if they could have fought another day/week/month?
That doesn’t mean that clearly failing businesses should continue to burn money until they go to zero. It means they have a choice about whether to continue or not. No money in the bank leaves no choice.
A meticulous understanding of inflows and outflows is essential for early-stage financial models. Below are the components for creating a financial model that can be used to better communicate the risks and rewards of a business to others.
Understanding Cashflow
What is Cashflow?
If we think about a business like breathing, then cashflow is like oxygen. When we inhale, we take in oxygen in the same way as we take in cash/capital:
- a customer pays us
- an investor or lender adds capital
When we exhale , the carbon dioxide flows out in the same way we outflow capital for:
- costs to produce a good or service
- paying suppliers, distributors, etc
- acquiring new customers, maintaining existing ones
- paying staff salary, other operating expenses
- fixed costs such as a lease or leasehold improvements
- any taxes or administrative costs to keep the business alive
Everybody knows that if we don’t get enough oxygen we will die. In the same way, if a business does not get enough cash inflows at the right time, it too will die.
So where do we start?
Cash Burn & Burn Rate
Since outflows are most likely to exceed inflows in the early stage of a business, we need to know:
- what the main cost drivers are
- when the cash flows out
- monthly burn rates
When revenues are uncertain, you want to minimize the burn rate(s). Burn rate is the net negative cash outflows for a given month.
The above represents Operating Expenses (we will look at Variable and Fixed Costs further down).
Spending money doesn’t correlate to making money unless there is a clear, validated path.
Typically in a startup financial model, cost projections are too low and revenue projections are too high. Getting one or two customers is amazing, but taking the next step from there can take time if it involves:
- spending money on sales/marketing
- hiring specific talent
- building prototypes or delivering orders
Hypothetical Startup Example – Raise $150K
Costs Tab
- two founders raise $150,000
- they want to pay themselves and one developer
- they plan to develop a new software product in Q1
- they plan to start marketing in Q2 and allocating a small budget to that
- they are hoping to start seeing customers in Q2, growing into Q3
As we can see from the above model, they will run out of money in Q3 unless:
- they earn more than $10,000 in revenue by month 9
- they raise more money to start
- they raise more money again in Q3
Neither option would necessarily be easy. If the opportunity presented itself to raise more than $150K, then in theory that would be great right?
- well the more you raise, and the earlier, the more equity you give away
- if you add more money via debt financing, you take on greater risk
SAFE’s (Simple Agreement for Future Equity) exist to at least partially solve these problems, but they have a valuation cap on them, so even though they help to prevent dilution, anyone raising more money earlier on gives up more equity.
That’s why we need to look at revenue generation and the revenue model next.
Revenue Model
B2B (Business-to-Business) vs. B2C (Business-to-Consumer)
B2B models are typically characterized by recurring contracts (subscriptions, retainers, etc) and juicy margins. Not always of course, but nowadays a lot of individuals strive to create recurring revenue streams with other businesses.
B2C models are more typically one-off payments for a good or service. Again, not always, as there are many subscription models or hybrid member/non-member models.
B2C models can be alluring to chase in most cases, but the lack of certainty from ongoing ‘one-off’ payments makes it difficult to:
- Project revenues
- Estimate required marketing budgets to acquire X # of customers
B2B models are often easier in this regard, but are subject to a number of key factors related to:
- The Sales Cycle (time from first contact to closing the deal)
- The Approval Process – medium to larger businesses have a chain of command to approve any purchase
- Payment Terms – often times businesses have Pay in 30 or Pay in 60 contracts as to when they pay, which impacts cashflow
While a consumer will stick in their credit card and pay, a business often has a finance department and will require an entirely different payment process.
These are, of course, generalizations. Some B2B models target small operators who can buy quickly, and some B2C models are high-ticket items that require financing.
Assumptions Tab
The revenue model will start with some set of assumptions. To illustrate this, we will look at the same Startup that has raised $150K.
Let’s say, hypothetically, that they plan to build a B2B software stack:
- the founders will work together with the developer to build the product in the first 3 months
- they will start marketing it to customers in month 4 via cold call, cold email, and paid marketing channels
We can see how many cold emails and cold calls they plan to send each month, along with the corresponding conversion rates of their efforts. They will also run Paid Ads to acquire customers.
For their efforts, they plan to get 55 New Customers each month in months 4 – 6 and 103 New Customers in months 7 – 9. These types of ‘assumptions’ help build the framework for the Revenue model, and are also helpful when sharing the model with others.
If we assume founders will be working 25 days per month:
- 1,000 cold emails is 40 per day
- 500 cold calls is 20 per day
- 40 Customers Acquired on Paid Channels is ~1.6 per day
Are these reasonable assumptions?
Furthermore, are the assumptions about conversion reasonable?
Until there is a product ready, they are just assumptions. But the logic behind them needs to be sound and they need to be ‘stress tested.’
As an addendum, it is usually best to focus on one or two channels. Maybe the strategy is purely Paid Ads or purely cold outreach. That’s ok. Different top-middle-bottom of the funnel strategies work differently depending on the segment.
But many assume ‘money spent’ equals customers and that is almost never the case. Customers don’t just show up at the door. Extensive research bears this out.
Revenue Tab
When we extrapolate these numbers to a revenue model, we see how they look. For the purposes of this model, we assume they chose the following pricing model:
- $0 Free
- $30 monthly for Standard
- $75 monthly for Premium
Churn starts at 10% for months 4 – 6 and goes down to 8% months 7 -9 as the product gets better.
We can see the results above:
- roughly $1,000 in revenue in month 4, trending upwards to ~$10,000 in revenue by month 9
As each and every variable is changed – in either the Assumptions tab or the Revenues tab – the outputs, ie. Revenues, will change. Let’s say we can change two sets of assumptions:
- CAC is actually $75 instead of $50
- Pricing model goes to Free – $50 – $100
What is the result?
- we can see that revenue ticks up nicely
- total revenue increases from $31,306 to $34,876 between months 4 – 9
This is why we need a dynamic model where assumptions can be updated and tested in real-time. Each small change can make a big difference.
The question now, is how does the overall model look?
Going Cash Positive
If we look at the updated revenue assumptions above, we can see what has happened to the original $150,000 the company raised. For simplicity’s sake, we added a 10% Variable Cost to the delivery of the SaaS product to the customer (payments, onboarding, etc.).
What we can see is that with the addition of the revenues, we have a cash balance of $21,389 at the end of month 9. Is that good or bad?
It depends how you look at it. Revenues have gone from $0 to nearly $12,000 ($10,700 gross) in that time period; however, Expenses total roughly $18,000. The business is still burning approximately $7,300.
The burn rate is shrinking, so if we extrapolated this out, the business would get very close to cash positive at almost exactly the same time as it was about to run out of money.
Becoming ‘cash positive’ happens when the inflows (gross) exceed the outflows. If the company is burning $18,000 per month, they would need to sell $20,000 in revenue (with a 10% variable cost) to reach cash positive.
These are exactly the type of ‘gut check’ scenarios that become very difficult to envision, but are very common:
- if you were looking at this model on Day 1, as an investor, would you invest in it?
- if you were looking at this model on Day 1, as a founder, would you try to raise more?
- if you were looking at this model on Day 1, as an employee, would you join this company?
The model is actually pretty good for a potential investor – subject to valuation concerns – because if you believed in the story and the team, you would be happy to see the model going cash positive right at the end of the first year. You would probably recommend they raise more in order to give them a buffer, maybe to around $250,000.
As a founder, you would probably take that $250,000 as a cushion even though you would be giving away more equity. That doesn’t mean you would go out and spend more, it means that you could afford to miss your projections and still continue on with business into year 2.
As an early-stage employee, if the company only raised $150,000 you may ask for equity in exchange for participation given the risks. If they raised $250,000, you would feel a lot more secure with the job prospects.
Since raising money takes time – from creating the pitch, talking to investors, due diligence, and closing – it is best to have a reasonable ‘runway’ of arguably 12- 18 months. This model is only looking at 9 months to illustrate the thought process, as it is not uncommon for companies to ‘underfund’ themselves.
Paradoxically, the ideal amount is not always offered and tradeoffs have to be made. What if in this situation, only $150,000 was offered and the founders couldn’t take a salary? The model would indicate a decent shot of going cash positive later in the year, but could the founders survive that long without any salary? What about a half salary?
The types of scenarios are not uncommon, as the ‘ideal’ scenario does not always present itself, especially when market conditions tighten as they are now.
Taxes, Write-Offs, Other Considerations
As this is a model to evaluate the cashflow of a startup or new business, taxes are not mentioned or modeled. There are:
- goods and services taxes
- payroll taxes
- unemployment and pension-related taxes
All of these should be ’rounded’ into the model instead of creating too many variables to play with. Taxes can naturally affect pricing a lot when you take into consideration that in a jurisdiction like the UK, companies must charge VAT as part of the price, while in North America, good and services taxes are added onto the pricing.
As far as Income Taxes go, these typically only become an issue farther into the future (years 3 – 5) since the company is realizing a loss. Furthermore, losses from the early years can be accrued against future gains, which is why good accounting is important.
Some business models that revolve around real-estate and other fixed costs can be used to create write-offs and tax incentives that further reduce a business’s future tax bill. Amortization can be applied to equipment, and employees can write-off certain expenses to lower their personal expenditures.
None of that changes the fact that the average startup or new business is in a race against the clock.
If you can get to the point where a business is optimizing for taxation, that is great, but the vast majority never get there.
Valuation and Future Rounds
This leads us to the final set of points around valuation.
Ideally, less is more. Less capital raised means more equity for founders and founding teams.
In practice, it is much more difficult. Unforeseen circumstances, such as 2020, can change a business’s outlook overnight.
When a company has to raise on the ‘backfoot’ (ie. in desperate times), the sharks usually come out. That’s why we see big rounds in jurisdictions like Silicon Valley when it sometimes seems completely non-sensical to raise such an amount. The term ‘war chest’ applies here because if conditions turn down, valuations get crushed and desperation sets in.
There are too many examples to name of companies that were worth astronomical amounts on paper several years ago and went bankrupt in the blink of an eye.
Most professional investors do due diligence and are looking not only for great businesses, but also:
- clean Cap Tables (# and quality of other investors)
- favorable terms (preferred shares, voting rights, board seats, etc.)
- a liquidity event (which is why many VCs take ‘liquidation preference’)
In the dream phase, many think their shares are worth $millions, but startup and small business shares are illiquid unless:
- someone buys out the company
- someone invests in the company
- the company IPOs
One ‘promise’ some investors like to hear is a share buyback agreement, but this requires a company to not only become profitable, but also build a significant positive cash bank balance.
Cash is king even beyond startup phase. There are 100 other things a company can do with positive cashflow beyond buying out investors. Sometimes, it is necessary and other times it is not. If there are any bad investors on the Cap Table then, yes, share buyback is usually the best option.
But usually what investors want is a vision where they invest today, and the company is worth much more in a reasonable future time frame (3 -5 years, 7 – 10 years). The company can go and raise more money, or control their own destiny towards some kind of liquidity event.
But there needs to be something that is ‘envisioned’ in the future to generate a significant return for investors. VCs want 10X cash on cash, some investors may be happy with 2X. There isn’t one rule, but the potential growth plane of a startup is typically meant to be exponential, not linear.
Generating linear 10% per year returns is not typical of a startup or new business, growth is almost always unpredictable and non-linear. If we are talking about a service business or something where time is traded for money, the parameters would be completely different and the model would be much simpler; but the upside is capped.
Anyone who invests in an early-stage company, however, takes on significant risk and should be rewarded in the event of success. In all probability, a startup investment goes to zero.
Financial models are at least a step towards articulating the risks, managing expectations, setting assumptions, and ideally derisking the model to buy as much time as possible to achieve product-market fit, growth, and profitability.
As an entrepreneur or operator, the goal is to be disciplined with capital from Day 1 and to manage cashflow efficiently.
More Resources
Customer Validation and Cashflow Modelling
Founder’s Factory – A Startup’s Guide to Financial Modelling