What Financial Models Do

What financial models do? What is the purpose of them for entrepreneurs and startup founders?

You are either the type of entrepreneur who loves and thrives on financial modeling, or who just can’t bear to stomach more than a few seconds of it. Regardless of this, you need financial models as an entrepreneur and founder. You at least need to know how to read basic financial models, know what they are for and how to leverage their findings. 

These are just some of the reasons you’ll use financial models on your entrepreneurial journey.

Raising Capital

One of the most basic and common reasons for financial models for entrepreneurs is for raising startup capital. 

These financial models can be used to demonstrate to investors an expected return at different stages, as well as how much is needed. 

They can also be used by founders and current shareholders to better understand the future impact of taking in loans and equity holders.

Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Making Acquisitions

If your business does well and is effective at raising capital, you’ll eventually probably be in a position to make acquisitions of other companies.

When it comes down to what financial models do, they can help you assess the benefit, opportunities, and risks of mergers and acquisitions, as well as what it will mean for your own financial models when others are evaluating your company. 

This also applies to evaluate these factors when it comes to acquiring new technology or assets, and how those outcomes can be improved. 

Evaluating New Projects

Dynamic financial models are great for evaluating the strengths and weaknesses of new projects and initiatives. They help determine if they are a good fit and worthy of your focus. 

For example, Google isn’t going to devote any resources to a project unless it has the potential to become a $5B venture. It just isn’t worth their time. Depending on the stage you are at, this may be $10M or $100M.

Part of what financial models do is to enable you to ask “what if?” What if you invest in more stores or branches? What financial impact will it have? What could the impact on cash flow and profits be from expanding into new markets, verticals, or countries?

These models are good to run on a regular basis, and especially when it looks like big changes are in the works. What if a crisis impacts ‘abc’ or results in ‘xyz’? What if it lasts 36 months instead of three to six months? What will that mean for revenues and sustainability?

Budgeting & Forecasting

At the outset of a business venture financial models definitely help identify cash needs and what can hope to be gained from going into this business. It helps clarify where money should be spent to achieve the desired goals and the anticipated return on that. 

These are also tools to revisit on a recurring basis. You should be constantly forecasting based on changes and new data, as well as how the journey is unfolding. 

Being able to see three to five years out helps executives and key team members to be strategic in the moves they make today, the relationships they go out to build, and the branding and product features that will create a ladder to where they want to go. This is a critical aspect of what financial models do.

Business Cost Cutting 

In fast-growth startup money often comes and leaves quickly. Often the board is happily operating at losses in exchange for growth. Then things can change, and you may have to quickly restructure and map a fast route to true profitability and sustainability. 

Use financial modeling to see where costs can be cut, and the outcomes. What difference will massive layoffs make? How about shutting down stores or ending certain product lines? How will divesting assets or spinning businesses out of the parent company improve the bottom line and balance the budget?

Allocating Capital

An important component of what financial models do is that they can provide great clarity on where to allocate capital. This is important internally as a brand new startup, as a large company, and in between when you are pitching investors and are laying out your planned use of funds. 

If you forecast you can reach a certain milestone, you need to be focused on where to use the money to get there for sure. 

This will be part of your business plan and the roadmap that you design for the next 18 to 24 months of the execution. On the video below I cover in detail how to write a business plan.

Business Valuation

You can use financial models to get a better idea of the value of your own business. You may do this for calculating potential financing, as well as when plotting your way to an exit through acquisition. Just be sure you understand how those you plan to present to view opportunities like this, and the factors they base value on. 

Recruiting

Key team members, cofounders, and advisors are savvier than ever. They want to see the potential of this company.

This is especially true if you are offering options and equity. What will that stake really be worth? Is it big enough to warrant their time and investment?

A peek at your basic financial forecast will tell them a lot about your ability to pull off this idea too. It shows whether you’ve done your homework, are being realistic, and really understand this space. 

Cash Flow Forecasting

Sometimes it’s all about cash flow. Young startups are especially susceptible to the risk of cash flow shortages. Even Elon Musk with all of his billions in the paper has sometimes admitted he’s on the verge of bankruptcy and virtually has no cash. COVID-19 was a huge reminder of how even the biggest and longest-running companies can be at risk of failure from interruptions to cash flow.

Just a few weeks into the virus and Neiman Marcus announced bankruptcy. Many others have shuttered stores and will never open again. Use financial modeling to foresee these threats, prepare to weather them, and thrive and expand when others drop the ball. 

Hopefully, this post provided some clarity on what financial models do.