What Is Financial Modeling?

What is financial modeling all about?

How is financial modeling applicable to new startups and seasoned businesses? What should you be modeling as an entrepreneur and CEO?

This is one of the most critical parts of every business venture. Even if accounting isn’t your strong suit, you must be able to understand the basics of financial modeling in order to be successful. It can make all of the difference when it comes to beginning with a viable foundation, when it comes to raising funding for your company, and when it is time to exit.

Financial Modeling

Financial modeling is the process of creating projections of the future performance of a business or project.

It is used for financial analysis and decision-making by those inside and outside of a given organization.

This is typically in a spreadsheet-type format. Think Excel and Google Sheets. Good financial modeling software can also help streamline this process, simplify it, and produce various visual reports and representations of the data.

Depending on the purpose and uses, it may be very basic. Or it may expand to a full range of financial reports and statements. Including income and cash flow statements, balance sheets, charts and graphs, valuations, and documentation and sources for the basis of assumptions made.

Financial Modeling For Startups

All businesses need financial modeling. It can be even more of a factor for startups.

Many entrepreneurs have never had to model financials before. They’ve never used financial modeling software, run budgets, valued businesses, or made sales projections. Nor negotiated the sale of a company or been out there pitching investors for capital.

It doesn’t have to be overly complicated. There is financial modeling software that can help simplify the process. Though there are a variety of moments and stages of business when this will come into play.

Here are some of them.

Creating Your Business Plan

Running a financial model is a critical, foundational part of mapping out any new business idea. It is certainly an essential part of every business plan.

You need to know your financial needs, what you can get out of what is put in, where your break-even point is, and how your company stacks up as an investment opportunity for investors.

Without some basic financial modeling at this stage, you have little chance of getting a business loan. You won’t even know if this business has a chance of meeting your goals.

Understanding what financial modeling is is a good first step, especially when you’re trying to figure out how to present financials for a startup with no revenue. If you need more information in that area, check out this video I have created.

Pitch Decks

Another very obvious use of financial modeling for startup entrepreneurs is for their pitch decks. This applies whether you are just bouncing ideas off of peers and advisors, you are starting out raising money from family and friends, are trying to recruit a cofounder, giving guidance to your marketing team, or are pitching the most famous VC firms.

Financial modeling is a critical part of your pitch deck and any pitch. It shows how you will make money, how much there is to be made, the potential returns, and that you know what you are doing.

We’ll dig into exactly where to use financial modeling later in this article.

Ongoing Planning & Adjusting

Financial modeling isn’t just something you do once at the outset of your business, or when you need to raise more financing from investors or lenders. It should be a regular, core exercise that is used to adapt to change, identify the best moves, optimize for the best returns on your spending, and make key decisions.

Here are some prime examples of when this becomes even more important.

Recalculating In Crises

Crises are seemingly inevitable. Whether it is recessions, depressions, financial crunches, pandemic lockdowns, or natural disasters, these moments require taking a new look at your finances.

Model out the impact. Model out your various options and different scenarios for surviving and thriving through it.

There is a way through. It may be uncomfortable. Or it could present an even bigger opportunity than you were previously working on.

Major Industry Changes

In addition to the above, there can be other major shifts that disrupt your business plans. They call for similar modeling, evaluation, and mapping out.

This could be new startup competition following behind you and disrupting things. Especially if they’ve raised more capital than you. Or it could be huge incumbent corporations seeing your success and wanting to move into this space.

Perhaps it is just massive shifts in trends and behavior. Like travel, healthcare, or remote work after COVID. Or the digital revolution and eCommerce, new materials, and new markets being made possible.

Constant Iteration

Startups are constantly tweaking, iterating, testing, changing, and evolving things. The impacts and what it will take need to be modeled out in advance. Especially if you have to explain pivots to your investors.

This can include significant product changes, shifting who your target market and customers are, pricing changes, your sales model and process, and more.

Financial modeling will show you what you need to make the change, and what you can hope to come out of it. As well as balancing best and worst-case scenarios.

Expanding Your Business

Each time you reach to grow your business requires financial modeling too.

Before dreaming of opening a new branch or other location, diving into a new geographic market, or niche, or adding new products, or packages, it is vital that you run the math.

Just having fuzzy numbers in your head isn’t going to cut it. It leaves too much room for error. It is not being financially responsible to your team, investors, or others.

You need to know all the expenses, when cash will be needed, and can hope to be returned, the margins, and how they compare to other parts of your business that you could invest in.

Acquiring Other Companies

Acquiring another company, or merging them into yours, is a common way of achieving growth, improving profitability, and preparing for an even larger exit of your own. These are big and complicated financial decisions.

Here you’ll use financial modeling for valuing potential acquisitions and mergers, analyzing the math of integrating them, and the impact on your own parent company.

Here you will definitely want some input from very experienced advisors that have been involved in transactions like these before and can alert you to what you might be overlooking.

Valuing Your Own Business

This can apply to gauging what you can expect in a new funding round, and the appropriate terms at a given point in your journey. As well as for applying for debt financing, and providing your stakeholders with an idea of what you might expect in an exit or other liquidity event.

Especially when it comes to M&A transactions, structures can be complicated. Modeling can help measure and forecast different scenarios. Especially when it comes to organizing earnouts, and the terms of any deferred compensation.

There are a variety of ways to value a business. Different acquirers and investors may choose their own. Be sure you are familiar with the most common business valuation methods, and the range that will put you in for these various scenarios.

Comparing Paths For Your Business: IPO, Fundraising, Bootstrapping

Financial modeling is also not only extremely useful, but just smart to conduct whenever you are facing another decision regarding financing and capitalizing your business.

It will help you evaluate the cost of capital and varying outcomes. Use it to compare the pros and cons of continuing to bootstrap your startup, versus raising equity capital, debt financing, or taking your company public instead.

You might be quite surprised at some of the results you get. It certainly pays to know your options, and optimal moves before you commit resources and begin going down one of these paths.

Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, 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.

 

Financial Modeling & Your Pitch Deck

Financial modeling is a fundamental element of building any pitch deck.

Regardless of whether you are at the pre-seed stage, or on your Series E round, or somewhere in between, you’ll need to provide some form of financials.

While the idea, mission, and team are all a part of the decision, this is a financial transaction for both you and your investors.

Remember, that when it comes to pitch decks, this is as much a test of your ability to keep things simple and focus, as it is of the numbers themselves.

There are two most obvious slides where financial modeling is most relevant in a pitch deck.

Current & Historic Financials

If you have any meaningful existing financials and performance to report, you’ll want a slide to display this.

Investors want to know your current financial position, and how well you’ve performed with the money you’ve put into the business so far.

The later the stage of fundraising, the more financials you’ll have to report. Though you may have none at your Seed round.

Financial Forecasts

No matter what stage you are at, you will have a slide for your financial forecasts.

This slide shows investors and others what you are aiming for. It shows your goals, what you are trying to achieve, and your unit economics.

They will be using this data to evaluate your understanding of business, your industry, and fundraising, as much as the actual numbers.

Are you out of touch and have failed to do your research? Are you thinking too small, or being too outlandishly unrealistic?

Some of the specific things you will model on this slide may include the following.

Sales & Marketing

While early-stage startups do not need to break out their expenses line by line on a slide, investors will want to know how much you expect to invest in marketing, your anticipated customer acquisition cost, and the value of those customers won.

Once you hit a certain level, have found product market fit, and are ready to scale, it should just be a matter of putting X in to get Y out.

Be sure that you can explain and source your assumptions, and are knowledgeable enough about your customer acquisition costs. What is it costing per lead, versus closed sale and customer lifetime value?

User Growth

This is especially relevant for tech and pre-revenue startups. If you are still focused on acquiring users rather than actual sales or profits, how many more users do you expect this round of funding to help you add over the next 12 to 36 months?

Revenues & Profits

Although some investors have prioritized growth over profit in recent years, revenues and cash flow are still critically important. They certainly greatly de-risk a company as an investment.

What amount of revenue is expected to be achieved? How fast are you forecasting them to grow? Have you factored in retaining the same or increasing profitability in your pricing and sales structure as you grow?

Be sure you know your industry, and what realistic and competitive profit margins are. If you don’t, this will be a huge giveaway to your audience that you are just winging it, and really have no idea what you are doing.

You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.