The support we provide at Villgro Africa to our incubation portfolio covers every aspect of a business, supporting its growth in order to de-risk it for future investment. One tool that we use to prepare startups for investment is financial modelling. But what exactly is a financial model? When should a startup build one? And what is a financial model used for?
A financial model is a key document in a business, especially when looking for funding. It answers the question: If we invest in you now, what assurances do we have that we will get a return on our investment? It is, essentially, a mathematical representation of a business, not just showing where it stands at the current time, but also providing a projection of what the future of the business might look like. If you’re able to translate your vision for your business into a mathematical form that actually shows how it might perform in the future, it becomes easier to convince an investor that your business is going to be profitable and to specify the amount of investment needed in order to make that success possible.
There are several factors to consider, or variables to input, when building a financial model. This includes both projected costs and projected revenue. On the cost side: How much does it cost to create your product or provide your service? What do you expect to pay on salaries and when will you plan on hiring for certain roles? What are necessary operational costs, such as laptops for staff? And once your product or service is created, how much will it cost to get it to your customers? On the revenue side: How much will you sell your product or service for? What is your target market and how big is that market? How many potential customers are out there?
The companies that need financial modelling the most are those that are ready to get dilutive capital, giving shares of their business in return for funding (either now or in the future). A full financial model is not necessary for every company at every stage. For very early stage companies, by the time they actually need the financial model, the economic conditions and many of the assumptions may have changed. For example, a company that is fully grant funded and is not having any traction or revenue should wait for when they are ready to scale or at least have reasonable revenue to validate that there is a market for their product. They should at least have a roadmap or a plan of how they want to scale their product or service.
But it’s never too early to start thinking about a financial model. Even when a company first joins our incubation program, we start thinking about how we can start building something out that we can iterate, so that by the time investors are coming on board, we have a story to tell that makes sense up to their stage of the business.
There are several ways to value a company and financial modelling is one way to do this. It’s basically a projection of the future, so then it can be discounted to the present using the discounted cash flow method to get the current value. You are using future cash flows to determine what the present value of your company is.
Financial modelling is an especially useful tool for valuing startups. When you’re innovating or doing something unconventional, it can be challenging to value your company based on its comparison to other similar businesses, so although there are several ways to value a company, financial modelling is often ideal for a startup.
The most important thing to focus on when starting to build a financial model is the assumptions. You need to get your assumptions right because if they are off, everything else will be off as well. If your assumptions are too optimistic, it means that you don't understand your market very well. You don’t understand the amount of work that needs to be invested to get customers to buy your product. It can also look like you haven't done enough research to warrant an investor to come on board. It's best to be very realistic with your assumptions and build a model that you can easily defend, and not just with the numbers but with research that can be backed by data as well as your past performance.
So, for instance, if I'm looking at a model for a company that has been there for four or five years, it’s important to demonstrate growth based on past performance. Say last year you had $60,000 in revenue, and then next year you show that it will be four times that. But your employees have remained the same, you have not increased your marketing costs, and your assumptions don't look like it's actually possible with your current resources. This brings a lot of doubt. Get your assumptions right, be very realistic, make them defendable, and back them up with data.
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