Impacts of financial decisions
Seven Financial Modeling Mistakes Start-Ups Should Avoid
Financial models have personalities. That may sound strange, but it’s true. And not only do they have personalities, but they tend to mirror the organizations they represent.
Large public company financial models tend to be rigid, mechanical, and biased towards prior period data. Like the overall culture at many large companies, making changes to this model is typically met with consternation (the model itself may automatically schedule meetings to stop you). Conversely, start-up financial models are usually dynamic, balancing both art and science, and they are able to adjust to a changing environment — or they should be.
Due to the oversupply of models and methods out there, too many start-ups are using financial models that are unable to meet their needs. The result is a lack of information and insight for both the leadership team and investors. Fortunately, the differences between a good and bad financial model are not impossible to fix. Below are the top seven problems in start-up financial models today.
1. Failing to thoroughly understand the business
The first problem may reside with the actual finance person or team performing the modeling work. Whether it’s an internal person, a fractional CFO, or a consultant, truly understanding the commercial and monetization model and strategy of the business is the first step in creating a useful financial model.
For instance, if the company is a manufacturing business, does it manufacture all of its products internally, or does it use a third-party manufacturer? That’s an important distinction when considering how revenue growth will impact its fixed overhead costs.
2. Unclear goals
Not all financial models have the same goal. A financial model used for a quarterly forecast is different than a model for an annual budget, which is different than a five to seven year model needed for a round of fundraising.
Even for fundraising rounds, a long-term model for internal use by the board or founders will have different nuances and assumptions than one meant for a venture capital firm. Failing to understand that goal (and the audience) could produce results that provide too much information in one setting and too little in another.
3. False precision
One risk in both modeling and in finance overall is false precision. In financial modeling, false precision occurs when assumptions or data is included in a model beyond what is possible to know. For example, some start-ups (and even large companies) focus more on sales assumptions in year four or insignificant expense amounts in year two as much as they focus on the current year’s revenue budget.
In this case, it is important to remember that investors are much more worried about your grasp of the commercial assumptions and your vision for the business plan than they are about whether your general and administrative budget in five years is accurate to the nearest thousand.
4. Focusing on point estimates
Financial models can be too focused on point estimates rather than the range of possibilities. While point estimates are needed to produce complete pro-forma financial statements and consider annual goals, ranges and sensitivities are more helpful to the start-up leadership team. After all, one of the reasons you develop a financial model is to provide leadership with enough information and insight to make better decisions and to understand the impact of those decisions.
Understanding the possibilities of different assumptions and business decisions ultimately improve the quality of strategic decisions. Using models that more fully express the range of possibilities also impacts investor conversations as well, since they want to focus their understanding on the overall business model and strategy rather than focusing on exact estimates.
5. Neglecting key metrics
Financial statements are important, but business decisions and investor inquiries are driven by performance metrics and insights. When an investor asks you about your monthly recurring revenue, customer acquisition cost, deal win rate, manufacturing speed, or staff utilization, sending a spreadsheet of an income statement is not a helpful response.
Including key performance metrics in your financial model will help you tell the story of your business in a variety of relevant ways. Key metrics will also help you focus on problem areas if the financial forecast is not measuring up to the original forecast.
6. Unrealistic expense growth and scale assumptions
Start-ups should achieve some degree of scale over time. However, even the most challenging investor will expect reasonable expense growth in the short-term. Unfortunately, many financial models demonstrate the opposite.
Doubling sales in one year? That could be possible given a groundbreaking product, but is typically impossible at only a 5 percent increase in sales and marketing spend. Increasing manufacturing production due to increased sales? Great progress, but it is unreasonable to assume manufacturing output is increasing by 50 percent over two years with no increases in fixed overhead costs.
Investors will lose confidence in these types of financial models quickly. Not only will projections like these prove to be inaccurate, but you can also lose your credibility as a leader who has a firm grasp of what it takes to grow the business. Remember, as the financial model takes on the personality of its business, that personality cannot afford to be naïve and simply hopeful.
7. Pouring the model in concrete
A financial model, especially for a start-up, is a living document. Too many models are frozen in time. An organization needs to be able to easily update a model as the economy, industry, or the business itself changes. One of the marks of a good financial model is the ability for non-finance professionals to update it in real time.
How we can help
Start-up companies move fast, and the leadership team is too busy building the company to be led astray by a poor financial model that makes fundraising or decision making difficult. Start-ups are successful when there is a combination of a solid team, a winning idea, and a decent road map.
An experienced, operational CFO can design and lead the company to a strong financial model that can be the map for your journey. CLA can connect you with an outsourced CFO and a process that is structured to serve entrepreneurial companies at this stage and help create opportunities for long-term growth.