Financial Modelling for Startups – A Few Notes

Financial Modelling for Startups – A Few Notes

Over the past year, I volunteered at various events organized to help startups created by young founders. I actively participated in these events as I wanted to build by business acumen and put my recently acquired finance and valuation skills into practice and meet some curious minds in the process. During this time, I have heard some great ideas and seen people attempt to solve interesting problems, but I have also seen many entrepreneurs struggle with the financial aspect of their business and grapple with financial models, with some even not bothering to create one. So, I tried my best to assist them in the process of valuation and give some advice based on what I recently learned from my studies in the university. I want to use this blog as an opportunity to record some of my thoughts on building a financial model for startups from my brief experience working with entrepreneurs.

1) Build a Discounted Cash Flow (DCF) Valuation Model as a Thought Exercise

There are numerous ways to value a startup including the earnings multiple method, comparison valuation model and the DCF valuation model. For some extremely young companies, the intrinsic value derived from a DCF valuation may not be useful but the process of building a DCF model by itself is a valuable exercise.  

One of the key components of the DCF model is the Free Cash Flow (FCF). By building an operating model to arrive at the FCF, the founders of the startup run through the steps of what it takes to scale a business. For example, you can monitor how the fixed and variable costs change as the business scales up and begins to take advantage of its size.

Therefore, the process of building a DCF valuation model is a useful thought experiment for every founder as it helps them think about the business in a long-term fashion and it helps them identify issues that they initially had not thought of. This in turn makes the founders better prepared to answer questions from experienced investment professionals.

2) Forecast on a Monthly Basis for 12 Months

More often than not, founders provide a high-level forecast done on a yearly basis. While this is useful to understand the bigger picture, discerning investors will focus on the first year of the business which is crucial not just for the success but for survival of the firm. This is the period of time where the assumptions are most realistic and assessable. Beyond this period, the variance between the assumptions and actuals increase dramatically with some startups completely pivoting from their original idea. Things change quickly at the early stages of a business and in order to understand the business in detail it is wise to forecast on a monthly basis for first 12 months of operations. This level of granularity helps to track the progress of the business and keep an eye on important metrics such as cash burn.

Do focus beyond the first year but keep in mind that the forecast is extremely uncertain and do not expect investors to take it too seriously. Once the monthly forecasts are completed, they can be summed up into a yearly summary sheet for convenience.

3) Estimate the Realistic Market Size

While this may seem obvious, many startups fail to provide a realistic size of their potential market. Due to the over excitement about the product along with the access provided by the internet, many startups believe that they can take over the whole world and so they fail to set any rational parameters. While I admire the ambition, when it comes to valuation it is important to be realistic. Potential investors would like to see the product become successful in the immediate local market first before looking beyond at the larger market.

Firstly, founders need to do their own homework and not rely on third-party research. I have seen numerous pitch decks that just quote a number from a research report but if you ask them the inputs and assumptions used to arrive at the figure, they are stumped. I would suggest a bottom-up approach to derive the market size. This can be done by first estimating the individual spend level of a customer or a group of customers and then determining how many of these customers are there. The market size is calculated by multiplying these two figures. While this may seem like a simple calculation, there is a lot of work needed to arrive at the relevant inputs as there can be multiple groups of customers with various levels of spending. By going through this arduous process, entrepreneurs may come across customer groups that they initially failed to even consider. 

4) Structure the Model into Stages

If you have ambitious expansion plans, consider breaking them down into phases and reflecting that in the financial models and look for financing at each stage instead of all at once. For example, stage one of the financial model can be focused on the local market. Estimate the revenue, costs and cash flows and the time associated with capturing this market. Value the business accordingly based on this stage and focus on getting the capital required to achieve this. Potential investors may be more confident in investing once they see that you have broken down your vision into a realistic timeline and you are working towards it. At the end of the stage 1, if the initial investors are happy with the progress it is easier to convince them to reinvest in the business due to the proven track record.

Many entrepreneurs like to cram and hasten their expansion plan in the hope of showing how valuable the idea is.  Unfortunately, the realities of expansion are much harder, and it is wiser to be realistic and conservative and build in stages.

5) Justify Your Assumptions and Defend Them

I have seen many entrepreneurs arrive at growth rates and multiples based on a gut feeling and when I ask them their reasoning, they shrug their shoulders. One of the most important things in the financial model is the assumptions. Analysts spend weeks researching and justifying every assumption they put in a model to arrive at the valuation and founders not only need to do the same but go beyond this. Valuing a public limited company is relatively easy due to the abundant, publicly available information, valuing a startup is much harder and requires deeper and creative research.

Don’t just pluck an EBITDA multiple based on another startup’s precedent transaction. Take the time to understand the nuances of the businesses and see if your business is a true comparable company. If it is not, make the necessary adjustment to the multiples. Perhaps your business has a larger market size, more active users at present than the other company did at the time they were sold. In such a scenario, it is justifiable to have a slightly higher multiple.

This logic and reasoning is important as potential investors will undoubtedly question the assumptions and the founder must be ready to defend them. By walking them through your reasoning, they understand that the figure is carefully calibrated instead of an arbitrary number.

I suggest running a sensitivity analysis on the key assumptions in your model to identify the factors that have the largest impact on valuation. Spend your time justifying these assumptions as they are once likely to be challenged. Conduct and document your research so you can clearly explain your reasoning.

6) Align the Pitch Deck and Financial Model

 The pitch deck and the financial model should both reflect the same story and be consistent. While many founders take the time to perfect the pitch deck and practice their pitching, they fail to provide the same care and attention to their financial models. This leads to some discrepancies that can hurt thier credibility in meetings. For example, if you mention Product X is the most profitable in your product portfolio, ensure that the margins of the product align with your statement.

Also, take the time to evaluate what is the best way to present the financial data. Entrepreneurs need to take the time and effort to identify the key financial data to display which do not ruin the flow of the presentation and the story they are trying to build. It is best to refrain from blindly pasting graphs on the slide deck without seeing how it contributes to your narrative. It is possible to talk about the financials later in detail and they all do not need to be dumped onto the deck.

 These are just a few thoughts from my limited experience. Please feel free to let me know your thoughts on Reddit and if you have any counter opinions, I am always happy to hear as I am looking to learn. Cheers!