Building a good financial model isn’t easy but is so important to raising capital for your business. Many companies spend many hours trying to get their financial model just right. The reason – – – to provide potential investors information on the company’s projected financial performance in the hopes of garnering an investment and to show that the strategy (i.e. use of dollars for such things as marketing, inventory or staffing) translate into financial gain in a reasonable period of time for that particular industry.
The model should provide the details of the big picture that the company is pitching. The key assumptions that are the drivers of the financial model are critical to understand thoroughly as well as communicate to potential investors. In addition, if you key drivers don’t make sense to investors then your pitch will not be deemed credible. In order to ensure that your pitch is credible and in essence your financial model makes sense, make sure to test the following items when your model has been completed BEFORE sending to anyone externally.
First Test: Make sure cash flow makes sense
In your cash flow model, you must make sure to account for when cash from sales is actually received rather than when earned and when money is actually paid out for expenses. Many models assume that when a sale occurs the business receives the money at the same time. However, this may be the scenario for a consumer-oriented brick and mortar retail store but not the case for an online retail store using a 3rd party sales portal to hock its products. The 3rd party may wait for 30-days or more to pay out monies for sales. In the meantime while you are waiting for those funds, employees need to get paid and other bills are arriving in the mail. Your cash flow statement and balance sheet must take these in and out flows of cash into account. By including this information, you show potential investors that you understand cash flow and are not a complete idiot.
Second Test: You don’t account for income taxes
Most models for early stage or start-up companies show significant losses during the first years of business operations. For the years there were losses, there is no tax liability. However, when you start making a profit, there may or may not be a tax liability for the first several years depending on the earlier losses. Make sure to take into account your net operating losses from the early years when calculating future tax liabilities in the profitable years.
Taxes can be complicated so make sure to talk to a tax professional to get an understanding of your state and federal tax liabilities as well as the standard tax rate for your industry.
Third Test: Sales forecasts are based on reliable data not a percent of the market
From an investor presentation standpoint, it makes sense to present your business as garnering a certain percent of the market over a specified time period in order for the investor to understand the size of the opportunity. However, you should not build your business model on a percentage of the market assumption.
Sales should be calculated from a bottoms-up approach. This means calculating your sales based on your sales process and cycle. If you did a good job building out your key drivers (i.e. assumptions) of your business model, this should not be difficult to do. Examples of key drivers include:
- How long does it take to close a sale?
- What is the capacity per sales person to reach leads?
- What is the percentage of leads that turn to sales?
- What percentage of online referrals convert to paying customers?
The list can go on and on but is dependent on knowing your sales process and cycle to make it credible.
At the end of the day, it is you who is selling yourself and the company to investors. You need to understand the key drivers of your business model and explain them both strategically and financially. If you need help with the financial part, then get help. You want to be credible to potential investors.