Why a seed-stage financial model matters
Most founders and investors agree that financial projections at the pre-seed and seed stages are more of a roadmap than an accurate forecast. However, angel investors and VCs will spend a fair amount of time looking and analyzing your spreadsheet, not to evaluate financial knowledge but to understand the business' unit economics and the vision of the founding team. While a wide range of resources and templates are available online, a financial model is only as good as its underlying assumptions. At BV4, we tend to prefer models that answer the following questions:
- Is your plan in line with your investment deck?
It seems like stating the obvious here. However, this is one of the most common mistakes we see when we analyze financial forecasts. While your pricing strategy or distribution channels might not be determined yet, consistency is critical for investors. If you state in your presentation a price of 10$ and the whole model is built with a price of 20$, you will raise a major red flag. Before sending out your data room to investors review all your documentation, and make sure everything is coherent.
- What is your market?
Spreadsheets are the ideal tool to showcase your market calculation. A bottom-up analysis usually works great (more about it here). It showcases a deeper understanding of the market drivers and will help you determine if you should focus on quantity or higher prices. Complement this approach with third party market research to evaluate your findings and make sure you are in the right ballpark.
- How many customers will you need to reach to achieve your targeted revenues?
A standard shortcut is to forgo the elemental quantity * price equation and use growth rates to project future revenues. While it helps make sure you are aligned with your benchmark, it does not necessarily fit the business strategy. Help outsiders understand how many customers you plan to acquire, how much market share would that represent, and use it as a sanity check. If you own 10% of the market in your first year of operations, you most probably will have to review your estimates!
- Is there a business case, and what is your cost structure?
Once you have estimated your revenues, the challenging part begins: you have to work on your costs. A good starting point is to find and look at a benchmark of publicly traded companies. Not only will you learn the standard P&L format (usually costs are split into costs of sales, sales and marketing, general and administrative, and R&D, but it can change according to industry and reporting standards), but also about the cost structure of efficient companies in a similar industry. This exercise will allow you to project your financial estimates on longer horizons.
On a shorter time frame, use your business plan and your pitching deck. How many employees do you need to hire to sustain the growth? What is the estimated marketing budget to acquire new customers? The more you ask yourself these questions, the better your model will be. It will also give you insights into your business drivers and highlight the KPIs you need to focus on in the future.
- Do you have a good understanding of how to run a business?
Nobody is expecting you to build a model to IPO on the NYSE next year. However, outsiders looking at your forecasts will challenge you on some of your assumptions. Make sure the model is pragmatic and considers the reality you live in. If you are active in the consumer space, make sure you dedicate enough resources to marketing; if you plan to hire engineers in Zurich, consider their hefty salaries.
- Why and when do you need cash?
The cash flow statement is one of your best friends as a founder. It will allow you to time your cash inflows and outflows and to know when you need to raise your next round.
As most young companies fail because of a lack of liquidity, you have to understand payment terms’ impact. When do you need to pay your employees? When do you expect to receive the money from your clients? How many days do you have to pay the bills from your suppliers? We previously wrote on this topic here.
- What happens if …?
A good model is an interactive model that allows you to understand the impact of different assumptions. Build it to make it easy to answer the question “What happens if…”. For example, what happens if your customer acquisition cost is 10$ instead of 5$? What happens if you need to hire 5 engineers instead of 2? Not only will you help investors in their due diligence and valuation process, but it will also create a tool to create contingency plans should any problem arise.
Building an excellent financial model resides mainly in asking painful questions and assembling most of the answers in a spreadsheet. It is an iterative process and should be reworked and adapted on a monthly (or quarterly) basis to remain in line with the business. Developing the product should always be a priority, but it’s never too early to start building a sound financial model. Feel free to reach out if you need any help or if you’d like to discuss it around a coffee in the Zurich area.