5 Top Issues with Startup Financial Models

By Trevor Lew

“All models are wrong, but some are useful”

Founders of startups looking to raise capital are essentially required to present a financial model that captures the quantitative picture of the company along with forward projections. These models aren’t necessarily intended to be set in stone predictions for the next 5 years but rather to be tools to communicate the founder’s thought processes and key assumptions. Below are some issues for founders to avoid in building financial models:

Issue 1: Lack of interest in the financial model

Occasionally, entrepreneurs will avoid bringing up their financial model or try to gloss over the details. This issue is often magnified when a third party was hired to build it for them. While there is some value in working with someone experienced in Excel and model structures, this can become an issue.

Usually the issue arises when entrepreneurs try to abdicate ownership of the numbers and business assumptions to a third party. At the end of the day, investors are evaluating the entrepreneur’s grasp and confidence in the numbers as well as what they say.

Issue 2: Not including the historical data

Another big issue that we come across is that the financial models tend to be ONLY forward-looking. This is to say that they don’t include historical data or data from prior periods. The justification that we often hear is something along the lines of, “it’s the future of the company that matters and not what happened 3 years ago.”

While we don’t completely disagree, historical context is invaluable when considering the reasonableness of future estimates. For a lot of early stage companies, their numbers are going to look very different in the next 3 years as opposed to the last 3 years, but we are looking to see how that story is told.

Another key point in this exercise is that we are looking to see more examples of the entrepreneur in action. During a capital raise, everything is framed as of a point in time. However, there is a lot of company history before the raise, and we are trying to get sense of the entrepreneur’s decision-making during that time and marrying it to the story being verbalized.

Issue 3: KPIs and assumptions are not identified and separated

Key performance indicators (“KPIs”) are what they sound like: key to the business. These are the major drivers that both parties will focus on. Having these identified and laid out are crucial for evaluating a business. These include operating metrics like users, customers, downloads, churn, LTV, CAC, transactions facilitated, etc.

Similarly, the assumptions in a financial model will relate to the metrics, and we are often seeking to manipulate these assumptions to produce a range of outcomes. Therefore, it’s easiest for clarity and practicality for the assumptions to be broken out separately in the model.

Often entrepreneurs will produce standard financial models that aren’t tied to KPIs or have future assumptions mixed in with the model’s outputs. While these entrepreneurs often have a good sense of the business in their head, they need to be in the practice of gathering and presenting the information in a way that other parties can digest. It will be very difficult for a company to be funded without being able to communicate why.

Issue 4: Not having known key costs represented properly

Some parts of the model are going to be more uncertain than others. However, key costs are likely known quantities and should be represented as such. More detail should signal to us that these future numbers have been well researched and understood. Showing too little detail can give us the impression that these are more ideas than concrete plans or that the entrepreneur isn’t detailed oriented enough around the financial model.

The largest expense for a lot of startups is headcount. The use of funds for a lot of capital raises involves hiring more personnel. A necessity for a strong financial model is an employee section that details headcount and compensation information by department with historical and projected periods.

Issue 5: No post investment utility

One of our biggest pet peeves is that the financial model is often created only for the capital raise and has no relation to the reports or processes used to manage the business. This issue often dovetails with companies not being as disciplined with consolidating all their key data points in a simple to view and an easy to understand format.

It’s certainly understandable that startup executives want to spend time on improving their firm’s KPIs but tracking and reporting data are very important too. The business will only grow more complicated with new service offerings, locations, and internal teams, so it’s best to keep scalability in mind. The numbers discussed and shown during diligence are going to be the basis an investor evaluates a founder’s performance. It’s best to get any issues out as early as possible instead of springing them at the next board meeting.

Conclusion

Startups have a lot going on and don’t have the luxury of a financial planning and analysis team working on reporting full-time. However, many of the benefits of a well built and managed financial model extend past the capital raising stage and into good company management. Hopefully these tips were helpful!