Every startup has to build a Financial Model (or sometimes people call it a business plan).
I will walk you through my framework for building a financial plan.
I have used this framework for over 100 startups in the past 6 years.
Let us begin,
Step 1: Define your objective and audience.
Your objective can be internal planning or fundraising. The audience can be your team or external investors. You have to build it from the audience's perspective considering what they want to see in the plan. Eventually, all financial plans will have 3 Financial Statements and Business KPIs as the output. However, how you achieve it, what architecture you follow, and how you lay out your information would make a difference to the audience. A poorly designed financial plan reduces its usability and leaves the audience confused and frustrated.
Step 2: Define your "Plan Period" and "Planning Frequency".
The Plan Period can be anything between 1 year (or 12 Months) to 5 years (or 60 Months). Generally, for the internal plans, it is good to plan a set plan period for the next 12 to 24 months. However, for the external plans, you have to set the plan period as at least 36 Months. The internal plan audience (i.e. your team) has short-term objectives such as "quarterly targets"; however, the external investors have a longer time horizon as the startup investment period is 3-5 years.
Planning Frequency can be quarterly, monthly, weekly, or daily. The Planning Frequency is based on your sales cycle. Planning Frequency for an e-commerce company executing 100 orders daily and making an internal plan should plan weekly. However, a B2B SaaS company having an AOV of $50,000 and a sales cycle of six months can work with monthly or quarterly plan frequency. However, of all external plans, one must choose planning frequency as monthly or quarterly. Weekly is too short a time period for an external audience.
Step 3: Define your business constraints.
It is an important step that sets the boundary condition for the model.
The constraints can be:
Financial: Defined by the money you have and money you can raise.
Human Resource: How quickly you can expand your team and make them productive. Hiring the right talent is one of the tedious tasks in building a company. It is people who derive growth.
Technology or Product: Are your current offering good enough for your expected growth? Is your product stable enough? What growth rate the current set of product features can sustain?
Step 4: Define your high-level business goals.
It is important to define your goals for the plan period based on your business constraints. The goals should include customer metrics, revenue metrics, profitability metrics, or team size.
Step 5: Build your Revenue Model.
This step has multiple sub-steps:
Step 5.1: Collect & Refine your data
Start with listing all customer acquisition channels: organic & paid and B2B & B2C.
Define your customer acquisition funnel for each customer acquisition channel.
Collect actual internal data and external industry average data for conversion rates, ROAS, and ROI across each of these funnels.
Also, collect actual internal data and external industry average data regarding customer retention, renewals, upsell and cross-sell as per your offerings and customer segmentation.
Adjust data for scale. It is known that conversion rates and returns drop with the increase in efforts called diminishing marginal returns.
Step 5.2: Start building your Revenue Model
Allocate resources (funds and people) across each of the acquisition channels as per the planning frequency (let's say monthly). Apply the assumed growth rate across planning frequency (monthly growth rate). Business growth assumptions can be based on previous growth, industry growth, business constraints, and goals.
Model the customer acquisition funnel considering resources and conversion rates to arrive at customers or orders for the entire period.
Multiply customer or order numbers with your ARPU (Average Revenue per Customer) or AOV (Average Order Value) to determine the monthly revenue numbers.
Apply customer or revenue churn numbers to determine revenue loss.
Model cross-sell and up-sell revenue numbers as per your product offerings and cross-sell and up-sell numbers.
Repeat the process for each product offering and customer segment.
Step 5.3: Iterate your assumptions to arrive at suitable revenue numbers which are in line with your business constraints and goals.
Step 6: Build your cost structure.
Cost structure varies as per the product/services offered. In this post, I will talk about the cost structure of a technology company.
Step 6.1: List all your business cost heads:
Technology Costs: Serves, hosting, software, and APIs
Payment Processing Costs: Cost towards payment gateway.
Employee Costs: Salaries, bonuses, benefits, and payroll taxes,
Sales & Marketing Costs: List all sales & marketing costs. Also covered in Step 5.
Customer Support/Success: Costs associated with after-sales engagements.
Hiring Expense
Rent, Utilities, Office Supplies & Software
Travel & Meals Expense
Professional Services: Tax, Audit, Legal & Consultants
Business Insurance
Licensing & Regulatory Costs
Contingencies
Other Costs
Step 6.2: Determine & List the drivers of each of the cost heads.
Drivers of costs can be sales, number of employees, no. of new employees, number of sales employees, etc.
Step 6.3: Determine the relationship between Cost Heads and Cost Drivers.
The relationship between the Cost Heads and the Cost Drivers is determined based on past company data and external benchmark data. The relationship between the Cost Heads and the Cost drivers can be linear, linear with diminishing marginal output, or parabolic.
Step 6.4: Draw all your costs for all the plan frequencies (Refer to PART 1 ) and build your cost schedule.
Step 7: Build Your P&L Statement.
P&L components are already modelled in revenue and cost section just collate them all and present them in neat format.
Step 8: Build your balance sheet.
The balance sheet is relatively simple for an asset-light software business. Fixed assets are generally computers, laptops, mobiles, and office furniture. These assets depreciate as per the applicable depreciation rate. Better to use depreciation rates as per applicable tax laws.
Thus, the fixed asset scales as per the increase in company head count. Also, consider the capex related to the up gradation of these assets in the future.
Model receivables, payables, and advances are other assets & liabilities as per business practices. Most technology companies operate on advance billing and limited vendor credit period.
At last, build the funding schedule per the cash required to run the business. For certain model, determining the funding requirements is the primary objective of the financial model.
Step 9: Build Your Cashflow Statement
From your P&L and B/S build your cashflow statements.
Step 10: Build your KPI Dashboard
Each business has its own KPIs. Nevertheless, most technology companies track one or more of these KPIs:
Customers, Bookings, Revenues, MRR, ARR, CAC, LTV, Churn, etc.
Here is a link to my previous blog regarding business KPIs.
Model business KPIs using the revenue and cost model built in previous steps.
Step 11: Build your sensitivities
Run sensitivities around to model the variability of business Revenues (ARR), Margins, and Cash Balance with respect to changes in AOV/ARPU, CAC, Churn Rate, etc.
Step 12: Build your summary dashboard
At last, build the summary dashboard with Business KPIs, Summary P&L, B/S, and cash flows. Add beautiful charts and graphs to complete the dashboard.
Please have a look at a sample financial model for fundraising in Our Work section of our website www.venturecanvas.in.
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Pro Tip: Using a user-centric architecture for your plan is crucial. If the model is built for users who are not the author of the model, it would be better when all assumptions are shown in one section and all the results are shown in the other section of the model. Scattering the assumptions and the results all over the model will lead to low usability for any new user.
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Important Note: Plans are not set in stone. Planning documents are live documents. They should be updated based on new information available. However, these are also signal documents, particularly to the external audience, that the team has thought through various aspects of the business and put together a plan based on all the available information and their judgment at the time of planning.
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