Financial modeling helps you pack your suitcase for your startup’s growth journey. But there are many different types of financial models, and they can each help you in different ways.
You can only build a sound financial model once you understand the financial objectives you set in your strategic plan. If you have the benefit of time, it’s important to consider which key metrics you will track, as well as the historical financial performance of your startup. Alternatively, you can look at competitors or industry standards and then fine-tune based on your company’s differentiators.
Let’s explore the definition of financial modeling and discuss a few types of financial models that are particularly useful for startups.
Table of Contents
- What Is Financial Modeling?
- Types of Financial Models
- Benefits of Financial Modeling
- Get Started with Financial Modeling
What is Financial Modeling?
Financial modeling is a representation of financial outcomes experienced, or expected to be experienced, based on a set of business decisions, operational inputs and predicted metrics.
In other words, a financial model answers the question, what is the financial outcome of my startup’s business plans? Financial models present similar information to financial reports but often divide that information in different ways with different presentations.
Thorough financial modeling drives strategic growth and allows founders to predict when they should adjust their plans or stay the course.
Types of Financial Models
The major types of financial models are:
- Booking and Revenue Model
- Quota and Compensation Planning Model
- Operational Expenses Planning Model
- Scenario Planning
These models are all important for startups. They help you plan for growth and provide a blueprint for how to adjust when unexpected events happen.
Let’s take a look at each type:
1. Booking and Revenue Model
Rather than counting cash as it comes in, use this model to help predict and forecast revenue from future sales.
Building a booking and revenue model helps you make sure you have the resources to achieve your desired level of business growth. Financial modeling will start with some level of expectation of how much revenue you’ll generate, which will then help you arrive at the appropriate amount of capital to spend on the expenses and the business functions to support that revenue.
In addition to factoring in your predicted revenue, the booking and revenue model zeroes in on the customer-focused aspects of your business, such as pricing and packaging, customer retention, pipeline development and sales conversion.
There are two major ways to approach a booking and revenue model. The top-down approach starts with a goal, such as growing your revenue 10% year over year. From there, you break down how many customers you’ll need, the average contract or sales prices and the expenses you need to support that number.
With a bottoms-up approach, you’ll do the reverse. You’ll start by looking at the size of your sales team’s quotas and — assuming they all reach their goals — determine a realistic revenue number.
A bookings and revenue model is one input to a financial forecast, because it models the inputs and events that ultimately lead to revenue (think: qualified leads, demos and conversion metrics). It utilizes these specific aspects of bookings and revenue (that may be non-financial in nature) to ultimately predict top-line revenue.
2. Quota and Compensation Planning Model
The quota and compensation planning model is tied closely to bookings and revenue.
This form of model typically focuses on employees and their compensation, with extra emphasis on the sales team. Included in this model is information on commission plans, accelerator and bonus programs, quota attainment projections, hiring roadmaps, profit-sharing plans and more.
You’re effectively trying to model the size of your sales team and its compensation structure to match the bookings and revenue model you’ve already established. For example, if your bookings and revenue model says you need to generate $1 million worth of bookings, you need your sales team’s quotas to total more than $1 million. It’s possible you’ll need to hire more salespeople, adjust their goals or tinker with their base salaries vs. variable earnings structure to make this a reality.
Quota model and compensation planning is especially important for high-growth SaaS companies because so much of their resources are applied towards sales and marketing efforts to grow annual recurring revenue.
3. Operational Expenses Planning Model
As every startup leader knows, salespeople are only part of the revenue-generating equation. Every company needs additional staff to support the money-making efforts of the sales team.
You need to hire a marketing team that helps generate leads with content and advertising campaigns. You’ll require customer success professionals to support new and existing accounts.
Crucial business functions such as IT and human resources need to scale as you add more employees. Of course, growing all these departments includes expenses that must be accounted for.
That’s where the operational expenses planning model comes into play.
4. Scenario Planning
Startup founders and operators need the tools to make data-driven decisions. Scenario planning helps you prepare for major events in your business roadmap, such as mergers and acquisitions, facility expansions, new product introductions and unexpected external events.
Operational expenses can be dialed up or dialed down based on the amount of revenue that’s being generated. Most companies will build out three types of scenarios based on their sales plan: aggressive, moderate and conservative.
Your funding position and bookings trends should correlate to your capital expenditure, also known as your burn rate. If you’re having a slow year, you should understand where you can limit expenses. Alternatively, if your product or service is flying off the shelves — or you’re deploying capital from a recent fundraising round — you should already have a plan for allocating spending to accelerate growth.
Scenario planning is useful when you’re preparing for one of those major events listed above. For example, you should be able to quickly adjust if a pending merger or facility expansion falls through at the last minute.
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Get started with our Financial Modeling and Forecasting Playbook.
Benefits of Financial Modeling
The benefits of financial modeling include:
- Setting proper expectations
- Providing data-driven metrics to show revenue
- Aligning departments on a shared vision of success
Remember: Success is relative to expectations. Consider two common scenarios:
Scenario A: Business is slow this quarter. You didn’t see it coming. Suddenly, you have to consider laying off new hires and delaying the new office expansion.
Scenario B: Business is slow this quarter, but your financial model accounted for a slow quarter. You limited expenses to adjust accordingly ahead of time. You stay the course.
Both scenarios included a slow quarter. However, the only thing worse than a slow quarter is a slow quarter you didn’t predict. As long as you’re prepared for whatever’s coming next, you’ll be able to plan, modify and set proper expectations.
Comprehensive financial modeling helps provide data-driven metrics to show that your revenue expectations are accurate — and whether or not you’re reaching those expectations. This helps every department align on a shared vision of success, which keeps everyone motivated towards the same goals.
Get Started with Financial Modeling
These four common types of financial models can help you throughout the startup journey.
When you’re just getting started, it’s critical to nail the basics. A simple financial model can be very effective, starting with a basic income statement and information on your capital runway. Defining what financial success looks like for your company in the next 12 months will enable alignment among your leadership team and investors.
For many startups, profitability could be months or years away. A solid financial forecast can help you measure success even when profit is off the table. Put your model to work by reviewing actual performance against predictions to make informed decisions and timely pivots. Finally, trust the work you’ve put into building it and actually utilize the insights your forecast provides.