What is Financial Modeling for Startups?
Financial modeling for startups is the process of projecting and forecasting revenue, customers, employees, costs etc., for the future to understand and assess the profitability and viability of the business. Given that the startup is still going into shape, this modeling will help prepare the budget and business plan for them and will help present that to the potential investors.
Two Approaches to Startup Financial Modeling
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Source: Financial Modelling for Startups (wallstreetmojo.com)
#1 – Top-Down Approach
In the top-down approach, the entrepreneur starts with macro factors and then work through the micro factors. Starting points are the industry standards, and then it narrows down to targets that the companies can fit in. This approach helps in defining the forecast based on the market shareMarket ShareMarket share determines the company's contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company's market position when compared to that of its competitors.read more that you want to acquire.
TAM (Total Available Market), SAM (Serviceable Available Market) and SOM (Serviceable Obtainable Market) model help in this kind of approach. In this model at first, TAM for the product is estimated. Then we have to decide the part of the market which we want to acquire, which is known as SAM. From that SAM, actual service base of the company is known as SOM based on the existing competition. So in this model, we start with industry size to the market share that we can capture.
#2 – Bottom Down Approach
The main problem in a top-down approach is that it can be too optimistic. Usually, we take SOM as a percentage of the total market, which is very hard to achieve. In the bottom down approach, the entrepreneur takes the tiny portion of the market for his sales and then assess the sales from his company’s inside point of view to estimate the forecasts and modeling procedures.
Steps to Create a Startup Financial Model
Here we use the top-down approach to create the financial model in excelCreate The Financial Model In ExcelFinancial modeling in Excel refers to a tool used for preparing the expected financial statements predicting the company's financial performance in a future period using the assumptions and historical performance information.read more
- Revenue: The first thing is to determine and forecast the revenue for the product that you are launching. It can be a bit tricky because you are a new entrant into the market. For determining the sales, you can use the Total Available Market (TAM), Serviceable Available Market (SAM) and Serviceable Available Market (SOM) model. For that, first, the total available market is to be determined and from that company’s estimated revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more needs to be found out.
- Costs: This can be an easier part since the firm has control into its resource and overhead costs. Costs will include direct costsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more, overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more etc.
- Income – To achieve and calculate Operating Income and Net IncomeNet IncomeNet Income formula is calculated by deducting direct and indirect expenses from the total revenue of a business.. It is the most important number for the Company, analysts, investors, and shareholders of the Company as it measures the profit earned by the Company over a period of time.read more, we use the above two parameters. You can calculate Operating income by subtracting operating costs from revenue.
- Growth Rate – The future growth rateGrowth RateThe Growth rate formula is used to calculate the annual growth of the company for a particular period. It is computed by subtracting the prior value from the current value and dividing the result by the prior value.read more for revenue and costs also needs to be determined, which can be quite tricky, given the uncertainties over the future. For projecting future revenue, industry outlook and the company’s available cash and future investment needs to be seen. Cost projection can be a function of revenue.
Below is the excel format for the Startup financial model:
Assumptions Used in the Model
- Base Revenue or market share is one of the main assumptions for the startups. Usually, entrepreneurs try to drive it through the industry standard and their positioning.
- Growth rate: This is one of the main assumptions which drives the whole financial model. While taking the growth rate of the revenue and cost, the entrepreneur needs to understand the macroeconomic factors also such as industry or country health and then look through their startups’ cash position.
- Future investment: For the growth, startups need continuous investment from the external sources, and they will have to make that assumption also while creating the financial model.
Why should an Entrepreneur Focus on Financial Model?
While creating the financial model, the entrepreneur can understand some aspects of their business which he otherwise won’t be able to understand. Though there are many templates for financial modeling are present online, but entrepreneurs should always create the model, keeping in mind the nature and assumptions of their business.
Also by working through each row and column of the financial model, the entrepreneur can understand what the missing aspects of the business are; or what elements are not necessary and remove those from the financial model. It also boosts their confidence while presenting to the investors.
Why Build Financial Model for Startups?
- It helps in understanding the revenue and cash flow forecastCash Flow ForecastCash flow forecasting is forecasting or anticipating the cash inflow and outflow for the future period by the management of the business to make sure that the business will have sufficient funds to carry out the activities on a regular basis, and if there is any shortfall, they has to plan for alternate sources of funding for the business. read more for the business.
- It helps in understanding the assumptions that the company has taken while creating the business.
- Investors carefully look through the financial model before investing in the business.
- It helps in understanding the viability and profitability of the businessProfitability Of The BusinessProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more.
- Helps in presenting the real picture of the business to the external investor and debating the investment terms.
- It helps in quantifying the assumptions for the startups.
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