A good startup financial model can help you identify and address problems, keep your teams aligned and raise funding more efficiently. But a bad financial model can be worse than not having a model at all.
In this article you’ll learn how to build a financial model that accelerates your business. We’ll also cover some financial modeling best practices and mistakes to avoid.
Build a Financial Model That Is Realistic
No founder thinks they’re going to be among the nine out of 10 that fail, but the odds are stacked against us. That tells me that entrepreneurs are naturally optimistic people, which means our forecasts tend to be optimistic.
That’s why I encourage founders to create not one startup financial model, but three:
- Base model: What do you think is going to happen?
- Upside model: What would happen if every flip of the coin realistically went your way? This is the best-case scenario model.
- Downside model: What if things go really south — if we don’t sell as much as we thought, and that big partnership doesn’t come through, and these expenses were more than we expected? This is the worst-case scenario model.
Your base model will probably be a lot closer to your upside model the first time you create it. Make it closer to the middle point between the upside and downside models. This gives you optionality. Now you have a wide range of scenarios planned for. If you do better than expected, now you know what to do, and you’re prepared if things go worse than expected.
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Avoid Misunderstandings
Your financial model is the story of your startup told through numbers. If you get your numbers wrong, or if your numbers don’t align with your story, it can cause serious problems.
Here are three tips to avoid misunderstandings in your startup financial model:
Use Standard Metrics and Definitions
Don’t get cute when you calculate your customer acquisition cost (CAC). I don’t know a single investor who trusts an entrepreneur’s calculation of CAC payback. Part of the problem is there isn’t a universally accepted way to do it. But the more you do it in a standard way — by dividing your sales and marketing costs by the number of customers you’ve acquired — the less likely they are to find a discrepancy.
Make Sure Everything Adds Up
Something as simple as an addition error in Microsoft Excel can have disastrous consequences. Always double-check your math. It’s hard to do in complex models with interdependent formulas, but accuracy is important.
Don’t Give Investors Your Model Right Away
As I said earlier, financial modeling tells your story through numbers. But the numbers themselves need to be interpreted. And if you don’t provide that narrative, it’s easy for investors to misinterpret the numbers.
If an investor insists on getting your startup financial model before they talk to you, either send them your key performance indicators or your three-statement model. But don’t send them the whole thing. Schedule an hour to walk them through it first.
Financial Modeling Mistakes to Avoid
The biggest mistake you can make with your startup financial model is not updating it.
So much changes in a startup that the value of a stagnant model gets cut in half every month. Three months out, your model is practically useless if you don’t keep it up to date.
Here are two more mistakes to avoid when you build a financial model:
Trying to Create the Perfect Model
The more interconnected assumptions that you make, the more one incorrect assumption can throw your whole model off. Sometimes too much detail is actually not helpful, and spending so much time on it can take away from other areas of the business.
Not Sharing the Model with Your Team
A lot of people should have access to your model. Your investors — those who are part of your board, or observers, or who engage with you regularly — should definitely have access, as should your executive team and accounting firm.
The more people who have access, the more you can ensure that everyone is aligned — and that’s one of the main benefits of building a startup financial model in the first place.
