I talk to entrepreneurs all the time. Frequently, I look at their business plans and advise them on changes that could make them more fundable or likely to be successful. I wanted to document some of those ideas in a blog post that I could refer entrepreneurs to read. This could save everyone a lot of time!
This post is about building financial models for business plans:
I usually build the financial model after I have done the research to write a business plan and after writing a very rough first draft of a PowerPoint describing my business, but before I actually put very much work into the business plan. It drills down to monthly revenue and expenses and has some rollups to quarterly and annual figures. Without a financial model, I won’t have a sense of the kind of sales organization, pricing, or customer volume that I will need to have to be a successful business. I went to Wharton, so I like to look at the numbers.
My financial statements tend to have a similar structure with at least these tabs:
- Balance Sheet
- Cash Flow Statement
- Profit & Loss
- Profit & Loss Quarterly
- Profit & Loss Annually
- Revenue Model (If it is too complex to easily put in the P&L, which it usually is)
- Headcount – Line by line every employee type, quantity each month and how much they will make each month – this gets rolled up into some headcount and expense numbers used in other tabs
- Assets – If there are more than a couple of depreciable kinds of things, I will model that up because it doesn’t take me that long. This is probably not necessary if you just make reasonable assumptions in the balance sheet and don’t have a business with a lot of capex.
Typically, the kinds of business I am interested in have very low capital expenditures – they are mostly about people and software – so my balance sheet and cash flow statements are pretty simple. Very little depreciation, simple AR and AP models, but the basics are there to understand how it has to grow to get profitable, financing requirements, and expenses. I suspect that if you had a business with an extremely complex capital structure, modeling the financials would be even more important.
I typically run my financial model out until I have at least a year or two of profits. Typically, I imagine that I am driving the financials towards some end-state model that represents how we would manage the business once it reached some more mature growth point. This is typically represented, in models I have built, by a revenue growth rate less than 60% year over year and margins around 20-30%. Usually the model goes out four or five years. If your margins aren’t that high yet, then you probably haven’t reached a state as a business where you can command a strong valuation based on financials rather than perceived upside. If you are still growing at greater than 60% and your margins are that high, then you are throwing off so much cash, it always feels unrealistic to me. When you don’t have to layout as much cash as growth slows, your margins probably vault to some number that seems big to me.
Study your financial model closely. I see the same mistakes time and time again:
- A large infusion of capital does not allow you to hire rapidly. You will not be able to hire people that quickly. Don’t assume you can.
- Look for big changes in expenses month over month and ask yourself, “Will I really be able to spend that much more money efficiently thirty days later?” The answer is rarely yes.
- Don’t assume you can raise capital quickly. Sometimes you can, but this is rare. Assume at least 9 months between financing rounds.
- Don’t assume salespeople will close deals for the first 90 days they are on board.
- Don’t assume you will be able to sell all of your web site impressions to advertisers. You need to keep a buffer just in case you have a slow day but you need to fill guarantees.
- Look at the quarter to quarter revenue growth: Is that realistic? Remember, your job may one day depend upon achieving that growth. Would you bet on it? It may behoove you to slow the hockey stick down a bit.
- Does it lack a hockey stick? Without an inflection point, it is not really an investable deal.
- What are your margins in the last year or two? If they are over 50%, then you are probably being too aggressive on revenue or too aggressive on expense management. Why? What good does it do to promise upfront that you will run the leanest, most capital efficient business in the world? Remember, these are commitments you are making to investors. Why not be a little more conservative on expense management (assume you spend more) and a little more conservative on revenue (assume you generate less)? You can still have a bang up business at 30% margins.
- Are you paying yourself enough? I don’t expect you to have a big salary the first year or two, but when your business gets big and has hundreds of employees, you should be able to go out to eat once or twice a year.
- Are you paying your CFO and head of sales enough? If you are building a big business, then these people have to be awesome. And if they are, they won’t be happy making peanuts as the business takes off.
It is always the same message: Your expenses are too conservative, your revenue is too aggressive and your growth and expenses are all too lumpy.