FP&A is a key component of every company no matter what stage they are in. Whether you are a huge, established MNC, or a small venture just setting out with less than 10 employees, a business will always need a financial plan. However, not every company has the same resources in order to go about creating one. Startups and young companies create additional challenges when trying to build their first financial model, and this can be the make it or break it point for the future of the company.
Most startups don’t start out with an FP&A team on hand. Whether it’s due to budget restraints, not enough data to analyze, or simply an unclear future, it is unrealistic to start a business with someone dedicated exclusively to FP&A from the beginning. That being said, it is a crucial business aspect and when the time comes to implement FP&A and a financial model, do not delay it!
Step 1: The need for a Financial Model
This step may seem obvious, but many startups make the mistake of creating a product or idea without immediately acting on building a financial model. This is key for 3 crucial reasons in the startup world:
For the business- Every startup needs a financial model to understand the profit margin and the resources involved. Overhead costs, time, and the market price are all aspects that need to be taken into account before the product or service can go on the market.
For the investors- Without a professionally built financial model, it will be difficult to raise funds. Even for the best of ideas, investors and money lenders need to have concrete analyzed data, expected revenue, and projections before they will take anything into consideration.
For future evaluation- A business cannot rely on intuition alone, and if there is nothing concrete to analyze in the future, then it will be significantly harder to make the necessary corrections. A financial model is the measuring stick of goal setting, and when something isn’t right, it will highlight the category that needs to be addressed.
There is no one standard for financial models, however the more in depth you go, the more you will be rewarded. For starters, when approaching investors with loads of research, data, and forecasting predictions, they are guaranteed to take the proposal more seriously. Not only will you be prepared for the questions and scenarios thrown at you, but you will also be one step ahead of the game and be able to forecast scenarios and predictions without the investors even requesting. This is guaranteed to leave a professional impression and will significantly raise your chances of receiving the investment, loan, or deal that is needed.
A financial model is not only important in order to create the persona of being organized when presenting to other people, but is even more important for the future. An in-depth financial model will propel you and your business to success and will avoid many headaches down the road. In today’s volatile economy, scenario planning is never ending.
What is the plan if there are supply chain shortages for your product?
Will the business be able to adapt if a new technology makes the service less attractive?
How will future laws, taxes, or regulations affect your business?
Will the company be able to keep up if demand is higher than originally planned?
Step 2: How to Build it
The 3 statement model is the basis for most financial models. For startups, most of the data comes from outside sources and predictions, making it harder to predict accurately. This makes it even more important to collect and analyze as much data as possible before continuing.
Manually inputting data and consolidating it all takes many hours that can be saved when using FP&A solution platforms. Many companies use automated database softwares that are built for SMBs. These platforms will consolidate data and predict future outcomes accurately, making it a good investment even for young companies with little to no data of their own.
The 3 statement model is as follows:
Income statement- In this case, the income statement may not exist if the product is not on the market yet, however it is still a crucial aspect. While these will probably only be predictions at this point, an income statement includes revenue, average order value, and cost of goods sold.
Balance sheet- This aspect is the assets, liabilities, and shareholder equity. For a startup, especially those in early stages, the balance sheet may look very skewed in comparison to established businesses. However it is important to accurately document and predict the balance sheet as these can be the first real numbers exclusively belonging to the business.
Cash flow statement- Cash flow is how much money has moved through the business, or money in vs. money out. The predictions here are difficult to make being that costs, number of employees, and actual sales will fluctuate tremendously, therefore scenario planning is key here. Cash flow predictions are crucial for investors, as this shows the ratio of how much money needs to be put out before money comes in.
Step 3: Top down or Bottom up?
There is no one right way to build a financial model, and depending on what type of business is being created, there can be many different variations. In general there are two ways to build the model:
Top Down- In a top down model you want to look at the industry as a whole and then narrow it down into smaller and smaller categories. Take for example a tangible good such as a laptop mouse that has new and improved functions. Identifying how many laptop users there are is easy, but narrowing it down gets harder. Out of all of the laptop users, how many will actually take the steps to buy it? How many sales can be expected each quarter? What are the overhead costs, and business and marketing costs?
The top down approach gets more and more difficult as you narrow it down, and involves a lot of analytics, but even more predictions. This approach garners more optimism because you are starting with the biggest possible outcome (all of the laptop users, and the biggest possible profit margin) and only then are you narrowing down the numbers. The top down approach is more attractive to both those involved in the business and investors, but it can also become a little too optimistic at times.
Bottom up- The bottom up approach focuses more on internal numbers and only then works its way up. Using the same example, the founder will calculate all of the manufacturing, marketing, and business costs for the laptop mouse, and figure out the profit margin. After that, it is possible to calculate how many sales would need to be closed each quarter in order to reach the profit that the company is looking for. Although the bottom up approach may seem more realistic, it makes the goal seem much harder to achieve and is less attractive to both the company and investors.
Many experts say that it is best to use both models, or atleast have both models on hand, especially when presenting to investors. The top down approach can be looked at as both the best case scenario, as well as the company’s long term potential. It might be unrealistic to think that 60% of laptop users will buy a certain mouse in the first year, but if the company establishes a name as the best in the field, then a 60% goal is not out of reach 4 years down the road.
The bottom up model can be looked at as the short term goals and realistic beginnings. In addition, it is good to have this as a backup plan to present to investors in case they request it. Coming prepared and being thorough is far better than being overly optimistic and unprepared.
Although startup investors are usually looking for quick and big returns, having all of the numbers on the table benefits everyone. Short term goals and crunching the numbers in preparation for all scenarios is a quality that not every startup founder has, and can put you ahead of the game in the eyes of investors and potential stakeholders.
Step 4: Adapt with the Financial Model
Once the model is built, the work doesn’t end there. As will happen so many times while executing a startup, flexibility and adapting will play a big role. Unlike other aspects where you might have to roll with the punches on the go, the financial model gives you instructions and a written scale of how to compare your progress.
This financial model forecast is essentially FP&A with less concrete data. As opposed to an established business where past analytics and a set way of doing things help predict the financial future, a startup must create goals from scratch.
Despite the difficulty of creating a financial model from nothing, it plays a critical role in seeing where to improve, what needs to be changed, and if everything is running on time as planned. This helps both the business and the investors see where more effort and money is needed, and gives a tangible rating system of the progress.
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