The Art of Startup Financial Modelling: fiction meets finance
Q: A potential seed investor has asked us for a financial forecast for the next three years. I don’t currently have a financial forecast and I’m not sure how much detail to go into, since we’re only just getting started. Do you have any guidance?
When it comes to forecasting revenue for your startup, consider it a work of speculative fiction — akin to a Hollywood script which is “based on a true story.” Your projections might be grounded in your startup’s past performance, but the reality is, the future is a wild and unpredictable beast.
In fact, if your financial future closely mirrors your past, you might be running a traditional business, not a startup. That’s perfectly fine, but it’s not what venture capitalists (VCs) are looking for.
The Illusion of Predictability
Some investors will want to see a 3–5 year financial forecast or business plan from you, but not really because they’d ever believe your projections.
Some might ask for it because it makes them feel like they’re de-risking their investment decision for themselves or for the investors they represent (they’re not actually, but beliefs are important too).
Mostly, investors just want to see how you think, and how you’d go about building those models.
The Importance of the Thought Process
Your financial model is more than a set of numbers; it’s a reflection of your vision, your understanding of the market, and your strategic planning abilities. Here’s what investors are really looking for:
1. Assumptions and Rationality: They want to see if your assumptions are realistic and well-founded. Are you basing your revenue growth on sound market research? Do your cost projections account for potential pitfalls?
2. Flexibility and Adaptability: Can your model adapt to changes? The startup landscape is ever-changing, and the ability to pivot is crucial. Your financial model should reflect potential scenarios and demonstrate your readiness to adapt.
3. Understanding Key Drivers: Do you know what drives your business? Identifying and focusing on key metrics shows that you have a deep understanding of what makes your startup tick.
The X axis is as important as the Y axis
The longer your prior revenue history, the more accurate you’re likely to be about your financial modelling, but the reverse is also true — the less time you’ve been in business, the less of the future you’re likely to be able to predict.
So don’t be the three-month-old startup with a financial model that shows you breaking-even in a year’s time and leading into a five year prediction that you’ll become a revenue unicorn.
In general, most startups project too far into their financial future; a good rule of thumb I often recommend is to show an investor roughly a future twice as long as your past trading history. If you’ve only just started charging customers to use your MVP, the next year is probably a credible forecast, and another year after that is useful only in that it shows how you’ve built your model and how you think strategically.
Collaboration is Key
Let’s be real: not all founders are financial wizards. If numbers aren’t your thing, collaborate with someone who is skilled in financial modelling. This collaboration can bring out the best in your projections and ensure they are at least a bit credible.
Visualising Success
Your financial model should tell a story — a story of growth, potential, and success. Use visuals to your advantage. Graphs, charts, and other visual aids can make complex data more digestible and highlight key points effectively. Remember, a picture is worth a thousand words, and in the world of startups, it can be worth millions of dollars in investment.
Personally, I find that while I might struggle with the intricacies of financial models, I’m good at visual pattern-matching. One thing that never changes in startup pitch decks is that revenue line — always forecasting that exponential revenue growth, up and to the right!
There will be future variations that you can predict (like a dip or a flattening in revenue each time you execute the “landing” part of your “land-and-expand” strategy in overseas markets) and then there will be some unexpected terrain ahead that you can’t predict (like a competitor being acquired by a tech giant and suddenly 10x-ing their marketing spend).
There’s obviously no need to forecast the unforecastable but it can be a welcome change to meet a startup capable of forecasting the forecastable, such as a ‘land-and-expand dip’ plateauing revenue and increasing opex for a few quarters while the company adjusts to the new terrain.
Final Thoughts
Financial modelling for startups is fairly dismal as forms of art go, but it’s as much storytelling as it is a science. It’s about crafting a narrative that investors can believe in a little bit, even if they know it’s a bit of a fantasy. The numbers you present are less about exact predictions and more about showcasing your strategic thinking, your understanding of the market, and your vision for the future. So, embrace the speculative fiction of financial forecasting, collaborate with experts, and paint a compelling picture of your startup’s potential. After all, in the world of venture capital, belief is the most valuable currency you can bank.
