A well-built financial model provides a detailed, numerical view of a business. An investor will use your financial model to better understand the details behind your business’ performance, filling in many of the gaps left by the detail-light (but hopefully compelling) pitch deck.
A key feature of a good model is flexibility. Someone who is unfamiliar with it should be able to access it and adjust the assumptions that underpin the forecasts. Investors will use this functionality to better understand the prospects of a business, and therefore its appeal for investment.
Building a financial model with Ithaca
Model design will be driven, in part, by the nature of the business being reflected. A SaaS business will be modelled in a different way to an ecommerce company, or a payments business. That said, the process of building a financial model with Ithaca can be broken down into six steps:
I. Meet with your expert team
At Ithaca, we match carefully match businesses to specialists within our network. The person building your financial model will both have excellent modelling skills and a thorough understanding of how your business works.
II. Compile historical data
The first step is to compile all of your historical performance (users, volumes, prices, etc) data and lay that out in your model, ideally on a monthly basis. These figures provide perspective for your forecasts and will also be used to underpin your assumptions about how the business will perform. For example, if a SaaS business has been consistently adding 1,000 new users each month for the past year, the modeller can forecast with some confidence that this trend will continue into the near future.
Not all businesses, particularly at pre-seed and seed stage, will have a bank of historical data available. Where this is the case, assumptions should be based on carefully established beliefs on the likely performance of the business. An expert review, such as those conducted by Ithaca’s teams, can provide an excellent resource to sense-check and firm up these assumptions before distributing to investors.
Once the historical base has been established, the next task is to forecast revenue generation. It is important to consider the elements that contribute to revenue, and the trends within each.
For example, a simple SaaS business offering one subscription plan will have two drivers of revenue – the number of subscribers, and the price of the plan. Within each, there are certain factors at play that need to be considered. The number of users at the end of the month is a product of the number of users at the beginning of the month, the number of new additions, and the number of users who have unsubscribed from the plan. New additions are driven by the marketing efforts, both paid and ‘organic’ channels, while the volume of unsubscribing users is driven by the perceived quality of the product by the users. The rate at which users leave the service is referred to as the ‘churn’and is a keenly tracked metric for subscription business models. For more on defining the KPIs that matter to your business, see here
Alternatively, an ecommerce business will generate revenuethrough the sale of product. This is a often a one-off, non-recurring event (butnot always) and therefore will be modelled differently to a SaaS revenue stream.While the number of sales and the price of each is important for both models, anecommerce business may focus on the number of users drawn to the website and theproportion of them that are converted into paying customers. Similarly, ongoingcustomer engagement post-sale may seek to convert one-off customers intoreturning purchasers. The effectiveness of these strategies should also becaptured in the revenue model.
A forecast expansion of the business needs to be accompanied by an understanding of the impact on the cost base, both fixed and variable. A scaling business may be expected to show increasing overheads, as the team grows larger (increasing salary expense) and needs more space (increasing rent expenses). However, increasing scale may generate purchasing efficiencies such that the per-unit input costs for the business might fall, increasing the gross margin.
There is also an important interplay between the marketing cost and the revenue growth. If a company finds most of its leads through pay per click digital marketing channels, an increase in revenue would be expected to be accompanied by a corresponding increase in marketing expense. In reality, the flow often happens in the opposite direction – the marketing budget is determined, this is then compared to the cost per click (CPC) for the campaigns and the conversion rate once the page has been accessed – to calculate the new user additions each month.
V. Cash flow (and balance sheet)
Next, the revenue and cost forecasts can be combined and presented alongside any other required capital expenditure of the business (for example in maintaining inventory, investing in development, etc).
Your cash flow statement will enable you to produce a monthly balance sheet, but in most cases this is not the primary purpose for a company seeking venture capital investment. Instead, investors will use an understanding of the cash consumption of a business (otherwise known as the ‘burn rate’) will help to forecast the length of the runway, i.e. how long the business has before it runs out of money.
Finally, the assumptions that underpin your forecasts will need to be updated and refined on an ongoing basis. As more historical performance data becomes available, this should be updated in the model and used to improve the accuracy of the assumptions.
In the context of your funding round, the financial model fills in a lot of the detail that is excluded from the ‘sales-focused’ pitch presentation. While the pitch deck might show revenue forecasts for the next five years, the financial model will show the forces that drive the sales performance (volume, pricing, etc) as well as the profitability of the operation as a whole. It is therefore important that the model is not neglected during the preparation phase.
When you engage Ithaca to support the development of your financial model, we will assemble a team that deeply understands the dynamics of your business. This will help to ensure that, as well as building a clear and flexible model, the assumptions are realistic and defensible for investor discussions.