When pressed, founders often say that there’s just too much uncertainty at the beginning. We don’t even have a business model so why would we try to build a 24-month projection!
Here are 4 good reasons why.
1. You may not have revenue but you still have costs.
Startups that cite uncertainty as an excuse are typically referring to revenue. They are conveniently forgetting about costs. Start by listing the monthly costs the founders are incurring by running the business. Next divide the current cash position by this monthly cost total to estimate your runway. Let’s say the monthly costs are $5,000 per month and there’s $25,000 in the bank.
This means in the next 5 months, the startup will either have to reach monthly revenues of $5,000 or raise money from investors. Simple calculations like these help founders focus on what’s important and help keep the business alive in early months.
2. Validate your business model.
Financial models can also be used to validate your business model. In fact, if you haven’t validated your business model with some basic calculations, it’s likely to fall apart under some pretty basic questioning.
Let’s say we want to sell a cloud storage product on a freemium basis to consumers. We’ll charge paying customers $20 per month for the product and it will cost $4 per month to support paying customers and $1 per month to support freemium users.
If we perform a simple break-even analysis, this means our price can support one paying customer and 16 freemium customers, or a 5.9% conversion rate. Dropbox and Evernote have conversion rates in the 4-6% range so this seems defendable. But hang on. We haven’t yet included any customer acquisition costs, or any gross margin.
To be sustainable, our startup will have to increase prices, reduce the cost of servicing users or move away from the freemium model altogether.
To avoid launching an unsustainable product, build a financial model that includes reasonable estimates for conversion rate, customer acquisition costs and gross margin. This will help you decide quickly the price and business model for your product and whether they represent compelling value for a customer.
3. Monthly targets help to focus and align the team
In a startup, there are always fifty tasks you could be doing, twenty tasks you should be doing and on a couple of tasks you must be doing. Financial models help align the team around the critical couple of tasks.
Let’s say in the first month of operation, our financial model assumed acquiring 300 new paying users, from a conversion rate of 6%. Our conversion rate turned out to be 9% but we only acquired 240 new paying users. What does this mean? We need more visitors to the website! For the next month, the team can align on a primary goal of increasing traffic to the site.
Without a financial model and projected path to success, it’s easy for the team to disagree on where time and money should be spent. With a financial model, alignment and focus is a lot more achievable.
4. Investors will demand a financial model.
Investors will almost always demand a financial model. So if you’re startup needs to raise money, you’re going to have to build one. The early you start, the more time you have to refine the model and the more accurate and robust it will be in investor pitches.
To start building your financial model today, this link provides a list of great Excel model templates and practices for startups. Be sure to check it out.
Aidan Corbett is the Founder & CEO of Kubicle - the fastest and easiest way to develop advanced Excel and PowerPoint skills for business.