The Challenge of Financial Modeling for Startups
Even if you know how to build a financial model, it is vital to recognize the unique obstacles facing startups. This includes their unpredictability. New businesses do not have the historical patterns normally used for predicting everything from future revenues and seasonal fluctuations to operational expenses. Forecasting for startups is more difficult than existing companies without past performance data. To succeed, founders must engage in thorough market analysis and adapt to real-time information as new trends emerge.
Often, startups operate in emerging industries, presenting a further challenge. In these situations, you must rely heavily on assumptions, which can significantly skew the projection if they do not materialize. You can incorporate conservative assumptions and scenario analysis to mitigate potential issues caused by developing markets.
Assumptions and Considerations for Startup Modeling
The output of a financial model for startup businesses is only as good as its inputs. Accurate assumptions are critical to a model’s success.
Revenue Projections for Startups
One of the tricky aspects of startup financial modeling is answering the question, “How do you forecast revenue growth for a new product or service?” Models often rely on historical growth patterns to project future revenues. This approach is impossible for startups, though. As there is no track record, realistic revenue projections for new businesses stem from a combination of methods, including top-down and bottom-up forecasting.
Using Top-Down & Bottom-Up
Top-down methods project a business’ revenue by estimating the company’s share of the total market. Bottom-up forecasting considers the company’s specific operations building up to total revenue based on micro factors. Top-down methods work better for long-term forecasting, while bottom-up approaches are often helpful for the shorter term.
Incorporating the Network Effect
It is also essential to consider that revenue growth may not follow a linear process. Instead, the business could experience scaling revenue for exponential, non-linear growth. One startup growth lever to be aware of is the network effect, where each new user incrementally increases the value of the service, expediting the business’ market penetration.
The network effect can lead to hypergrowth and exponentially scale revenue. This is common for social media businesses like Facebook or TikTok, as the platform will become increasingly valuable with more users. By integrating the network effect and other growth levers into your startup projections, you can mirror the startup’s potential for expansion and revenue generation.
Forecasting Startup Expenses
Projecting expenses tends to be slightly easier than forecasting revenue because the subject company has historical cost outlines and some control over costs. With a startup, there is no pattern of expenses. In this case, the business may underestimate its costs. To counter this error, consider all contingencies and compare the company to similar ones in the industry. You can use the metrics from comparable businesses as your benchmark.
Within expense forecasting, you should also consider the cost of employment. Labor can account for a significant portion of a startup’s cash expenditures. While mature businesses tend to have more consistent employment costs, when modeling with startups, you must make assumptions about hiring as the company grows. Be conservative in your estimates and consider labor costs for comparable companies.
How to Build a Financial Model with Multiple Funding Rounds
Financing is a fundamental assumption for startup financial modeling. You may wonder, how many funding rounds should I plan for? Unfortunately, there is no simple answer to this question. Each business is different. Some may require pre-seed or seed funding only, and others may eventually go public through an Initial Public Offering (IPO). Regardless of how many financing rounds the startup has, it is essential to reflect the changes in the model.
The founder and existing shareholders will see their ownership diluted during equity fundraising as the total number of shares increases, in turn decreasing the ownership percentage.
For example, if you own five of the ten outstanding shares of a business, you have a 50% ownership stake in the business. What would happen if you obtain additional financing for the company in exchange for five new shares? The total outstanding shares would now be fifteen (ten original plus five new shares). Your ownership stake would fall to 33% as you own five of the fifteen outstanding shares.
As you can see, funding can dilute shareholders, and you need to reflect current ownership details in the model. Any events impacting the number of shares will also affect per-share metrics, including earnings per share (EPS).
Equity-Based Compensation
Equity-based compensation is another factor causing dilution that can potentially impact your model. New businesses often use this form of incentive to align employee interests with the company’s. Equity-based pay can be share allocations, stock options, or employee share purchase plans. These offers can incentivize enhanced employee productivity and loyalty in a way cash wages cannot. They can also help balance incentives with a startup’s need for capital conservation. When generating financial forecasts for startups, incorporate how these compensation programs dilute ownership and any impact they may have on the business.
Key Performance Indicators (KPIs) for Startups
As part of the startup financial modeling process, you will identify key performance indicators (KPIs) to offer insights into the company. These ensure alignment with long-term goals and investor expectations. KPIs provide a quantifiable measure of the company’s strengths compared to other businesses in the same industry. For a startup, they can determine its health and growth prospects.
A few of the typical startup KPIs include the following:
- Monthly recurring revenue (MRR), demonstrating continuous revenue expectations. This metric is often helpful for valuing e-commerce startups. You can calculate MMR by summing up all monthly income sources from an automatic renewal program.
- Churn rate, indicating the percentage of lost customers over a set period. The calculation for a company’s churn rate is the number of lost clients divided by its total number of customers.
- Lifetime value (LTV), tells how much the business can earn from an average customer. To calculate the LTV, divide the per-customer contribution margin after marketing (CMAM) by the churn rate.
- Customer acquisition cost (CAC), representing the price of gaining a new customer. Calculate this metric by dividing the company’s marketing costs by the number of new customers.
- LTV/CAC ratio, allowing comparison throughout time and against competitors. To calculate the indicator, you can use the following equation: (contribution margin after marketing/churn rate) divided by (marketing expense/amount of new customers). A higher LTV/CAC ratio is better from the startup’s perspective.
For startup businesses specifically, you will want to consider its cash burn rate and runaway rate. These KPIs will help investors determine how long the company can function without attaining an inflow of cash from additional financing.
- The gross burn rate offers information about a company’s efficiency. To calculate a business’s gross burn rate, divide its cash balance by its monthly operating expenses.
- The net burn rate reveals how quickly a company loses money at its current level of operation. You can calculate this metric by dividing total cash by the business’ monthly operating loss.
- The runaway rate gives insight into how long the business can survive in its current condition. To find a startup’s runaway rate, divide its cash balance by the monthly burn rate.
Integrating these and other KPIs into your startup’s financial model is essential for informed decision-making, helping founders and financiers pivot strategies when necessary.
Fundraising for Startups
Financial modeling for startups can help the business make strategic decisions regarding its day-to-day function. How else can it help? Modeling can be a valuable fundraising tool.
Potential investors and venture capital firms request a startup’s financial forecasts to help them evaluate its growth potential. You can establish credibility with potential investors by building and keeping up-to-date financial projections. To be prepared for any financing needs, it is critical to adapt your model after each funding stage to reflect equity dilution and any fluctuations in valuation.
Conclusion
Knowing how to build a financial model for startup businesses involves a unique set of considerations compared to financial modeling for more mature businesses. It necessitates a comprehensive understanding of growth levers, cost structures, and KPI metrics specific to evolving companies. Although it has challenges, creating a sound model for your startup can help drive decision-making, ensuring startup sustainability despite uncertain conditions.
