Financial modeling for startups can help you identify and address issues before they become serious problems.
At my previous company, we had a bad financial model that almost killed us. We were able to recover and successfully sell the business, but that was a really painful misstep.
That’s why I now try to help other entrepreneurs solve the problem of not understanding their finances.
What is Financial Modeling?
Financial modeling is the process of combining your past financial data and your current key performance indicators (KPIs) to tell the story of your startup’s future through numbers.
When a lot of people think about financial modeling, they think about a profit and loss statement or a three-statement model. That’s actually financial reporting, which is often a view of the past.
An income statement gives you the expenses and revenue that are coming into your business. The balance sheet gives you your total balances after accounting for your expenses and revenue. And your cash flow statement marries the income statement and balance sheet together to show you how money is moving.
You might also think about your KPIs, but those are most useful for telling you what’s happening now.
When you take your historical reports and current KPIs and assign some assumptions to them, that is a financial model, which looks towards the future.
The Importance of Financial Modeling for Startups
I could’ve built a better business the first time around if I had better financial acumen. Here are five reasons why financial modeling for startups is so important:
Financial modeling helps you put your ideas on paper. It lets you take things out for a test drive before implementing them — for example, seeing how a different pricing strategy might affect your growth.
You wouldn’t build a car without a blueprint, and you shouldn’t build a business without a financial model.
Once you’ve put your ideas down on paper, it gives you something to keep yourself accountable. Every month you can look back and say, “I thought we were going to do this. How did we actually do?”
You can’t improve what you don’t measure. If you don’t put a stake in the ground and then check to see how you’re doing relative to how you thought you’d do, you’re not going to make any improvements and you’re going to miss a lot of really important trends.
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Financial modeling will give you foresight into issues before it’s too late. Time and time again I see entrepreneurs realize that they’re going to run out of money in two to three months, and then it’s a last-minute scramble to fundraise and cut costs.
Building a financial model isn’t going to prevent you from running out of money. But it will tell you six to nine months ahead of time. And the difference between two to three months and six to nine months is tremendous.
Financial modeling can help your startup raise money more efficiently and make sure you don’t over-dilute yourself.
When you’re fundraising, the biggest challenge is getting people to say yes. But raising too much venture capital is just as much of a problem. What if you get to your next milestone and you still have 50 percent of the funding you raised in your last round? You could have raised that money in a more cost-effective manner.
Building out a model will help you figure out how much you need to raise to get to your next milestone.
A financial model makes sure that your entire team is aligned. Once a month I actually go through our financials with all of our employees. It helps create awareness about what’s going on.
For example, I can walk through it with engineers: “Here’s where we run out of money. To not run out of money, here’s when we need to fundraise. To fundraise, we need this many customers and this many bigger customers. And to get those bigger customers, we need these features.”
Now there’s a timetable. Now the engineers understand why I’m freaking out about getting these new features even though we’re still far away from the day when we’d run out of money.
Early-stage companies have a million things going on and are just trying to stay alive. Despite all these competing priorities, it’s crucial to keep track of your finances. I’ll be the first to say I didn’t do that at first, but as I grew as a CEO, I learned how important financial modeling for startups is.