Founder Tips for Building a Financial Model
Intimidated by the idea of financial modeling? You’re not alone! Here are some quick and dirty tips to get you in motion around building a financial model. And you don’t have to have a background in finance to make a solid model. In fact, we highly recommend that every founder makes a financial model to deepen their understanding of what drives their business. We hope these tips help.
DO NOT use templates for your financial model, while they may feel like they save you time, you still need to understand how every line is calculated and how each cell is linked. They tend to be either too complex for most early-stage startups or not specific enough to your business model.
The goal of building a financial model is to learn about your business and understand what drives it, so do not outsource it to a finance expert. Anyone can learn how to build a financial model, do not let the idea intimidate you. As the founder, you need to know your business and its numbers, and own the model.
Startup financial modeling focuses on two parts: the revenue build - how you make your money, and the income statement - your revenues and expenses a.k.a. P&L (profit and loss) or statement of operations. You don't need to worry about other financial statements like cash flow statement and balance sheet at this moment.
Your financial model is to project your future growth and also expenses. If you are pre-funding, pre-seed, or seed stage, you should start building your model for the next twelve to eighteen months, month-over-month. Anything longer like projecting out your next three to five years will feel like writing a fantasy novel.
Start your model by focusing on just a single month, work through the relationships and how to calculate each item before projecting out into the future.
Before we get to the revenue in our income statement, we need to first understand how we make this money - i.e. the revenue build. How much do you charge? How many times do you sell your product or service? Think about what allows you to sell more? Start with how are people discovering you? What is causing them to pay? And what keeps them paying? If you have multiple revenue streams, do a revenue build for each.
When modeling your expenses, we first look at COGS (Cost of Goods Sold), these are the direct costs of producing each additional unit of product or service you're selling. It includes the cost of materials and labor it takes to produce the good. For software companies, it's the cost of servers. For physical goods, it can including packaging and delivery costs. Revenue - COGS = Gross Profit
Your operating expenses fall into three major categories: 1. Research & Development (R&D) - typically this is the salaries of your engineer and designer. 2. Selling & Marketing (S&M) - the cost of any ads you buy and the salaries of your salespeople and marketing staff, 3. General & Administrative (G&A) - other operating costs of your business such as your salary, legal fees, office space. Gross Profit - Operating Expenses = Operating Income
Your sales and marketing costs should be linked to your revenue build in some way as your investments in sales and marketing should yield higher revenues. Make sure to consider your salary in your expenses - do not forego this expense! Your time is valuable.
EBITDA is a term you may get asked about, it stands for Earnings Before Interest, Tax, Depreciation, and Amortization; another one is EBIT - Earnings Before Interest and tax. You can use them interchangeably with operating income (unless you have some valuable equipment or property): your revenue minus your expenses (both COGS and operating expenses).
Margins are financial metrics that tell us how efficient our business is expressed in percentages, and we like to say it means, "divide by the revenue." So your gross margin = gross profit / revenue, and your operating margin = operating income / revenue.
Best practice: color-code your cells, any cells in which you input numbers are called hardcoded data and should be blue - these can be assumptions you're making or historical data you have or a guess you want to make as a starting point. Any cell that is a formula and is linked to another cell should be black. As a general rule, you want your financial model to be mostly formulas or black.
To level up, you can duplicate your financial model for different market outcomes, an optimistic one called, "bull case," and a pessimistic one, called "bear case."