Not every small business owner or entrepreneur is a finance expert, but it’s important to become as well-versed in business finance early on if you’re committed to your startup business. The finances behind any business, particularly those early in their existence, are crucial to the success and future of companies.
Without a solid financial model, it’s much more likely that a startup will fail. That’s why it’s important to understand how to build a financial model for a startup.
- When it comes to why startups shut down, “running out of cash” was responsible for 29% of business failure, with “pricing and cost issues” coming in at 18%, and a “product without a business model” at 17%. Having a well-constructed business plan – beyond just a good idea and some business connections – seems essential to success.
- 82% of businesses fail because of cash flow problems
- 40% of small businesses are profitable, 30% break even and 30% regularly lose money
How can startup owners build a financial foundation and help secure a future for themselves? According to Founder Institute, “creating a financial model forces an entrepreneur to plan very specifically how their business will work, how users and customers find and use their products, and how those processes create revenues and costs. In addition, having a solid financial model is also a pre-requisite for raising your first round of startup funding.”
What to know about building a financial model for a startup
Do you know how to build a financial model for a startup? It can be challenging and intimidating for aspiring business owners to know where to begin with their financial planning. Here are some common models to consider when developing your financial model for a startup and use to guide your financial projections.
1. Bottom-up startup financial model
A bottoms-up financial model starts with several assumptions – usually 5 to 15 – that are useful for a startup trying to decide on a particular product direction, distribution method or strategy, business partnership or other factors that could have a significant impact on business. Assumptions can include revenue growth, employee headcount, and salaries, cost of goods, cost of workspace, advertising expenses, and more. Founder Institute notes that many startups should start with this model as it “looks at the overall market and uses this information to identify your company demographics and target mark.” The top-down market projection starts with a potential market size, identifying the relevant segment, and analyzing data to calculate the total potential revenue.
2. Top-down startup financial model
Businesses who benefit most from this model are those that know the amount of money they need to raise in a certain amount of time and are researching revenue, margins, and growth necessary to be successful. With these numbers in mind startups and small business owners can work backward to understand how much they need to grow you need to grow and think about which distribution channels can provide the best path from where a business is to where they need to be.
3. Standard financial model
Some entrepreneurs find success with the standard financial model, used by over 15,000 startup operations and developed by the professional modeler, Taylor Davidson, founder of Foresight. His mission is to help “entrepreneurs…spend less time on finance and more time on their products.” This five-year financial model helps aspiring business owners and small businesses looking for funding to analyze and understand factors such as revenue, cost, financial statements, valuation, and other metrics. Using a template like this allows you to build on the past success, knowledge, and expertise of financial experts and business owners.
Building a smart financial plan for your startup
Ultimately, whatever financial model you use for your startup will depend on your business and financial needs and experience, but the importance of a financial model for a startup applies to everyone. No one can know the future for certain, but financial models give startups a better sense of what could happen and answer important business questions that help owners, financiers, stockholders, and more.
Ernst & Young notes, “you need [a financial model] to build an economically viable business. Why? Because by quantifying (and then validating) your business plan and business model, assumptions and vision you are able of finding out whether you can turn your ideas into a sustainably operating business. Moreover, if you build different versions (“scenarios”) you are better prepared for the future, especially if things do not go the way you planned. What if you launch half a year later? Answering such a question in your “worst case scenario” helps you anticipate how your cash flow, profitability, and funding need are impacted.”
A solid working financial model for a startup creates a business roadmap and offers insight to help entrepreneurs and small business owners understand the path and potential pitfalls towards success. When you’re working out how to build a financial model for a startup starting with a pre-existing financial model or template as your jumping off point, you are much more able to progress your business plan, secure funding, and consider and plan for potential risks.