Building a good financial model is not easy, but it is very important to raise capital for your business. Many companies spend many hours trying to get their financial model right. The reason – – – to provide information to potential investors about the company’s projected financial performance in the hope of obtaining an investment and to show that the strategy (i.e., using dollars for things like marketing, inventory, or staffing) translates in financial gains in a reasonable period of time for that particular industry.
The model should provide the details of the big picture that the company is presenting. The key assumptions that are the drivers of the financial model are critical to thoroughly understand and communicate to potential investors. Also, if your key facts don’t make sense to investors, then your presentation won’t be considered credible. To ensure that your presentation is believable and that your financial model ultimately makes sense, be sure to test the following items when you have completed your model BEFORE you send it to anyone outside.
Test One: Make Sure the Cash Flow Makes Sense
In your cash flow model, you want to make sure you factor in when cash from sales is actually received rather than when the money is actually earned and 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-facing brick-and-mortar retail store, but not the case for an online retail store that uses a third-party sales portal to sell their products. The third party can wait 30 days or more to pay the sales money. In the meantime, while you wait for those funds, employees are due to be paid and other bills are coming in the mail. Your cash flow statement and balance sheet should take these cash inflows and outflows into account. By including this information, you show potential investors that you understand cash flow and that you’re not a complete idiot.
Second Test: You do not take income taxes into account
Most models for early-stage or start-up companies show significant losses during the first few years of business operations. For the years that 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 few years, depending on previous losses. Be sure to factor in your early years net operating loss when calculating future tax liabilities in profitable years.
Taxes can be complicated, so be sure to speak with a tax professional to understand your state and federal tax obligations, as well as the standard tax rate for your industry.
Third test: sales forecasts are based on reliable data, not on a percentage of the market
From an investor presentation standpoint, it makes sense to present your business as taking a certain percentage of the market over a specific period of time so that the investor understands the size of the opportunity. However, he must not build his business model on a percentage of the market assumption.
Sales must be calculated from a bottom-up approach. This means calculating your sales based on your sales process and cycle. If you’ve done a good job of developing the key drivers (ie assumptions) of your business model, this shouldn’t be hard to do. Examples of key drivers include:
- How long does it take to close a sale?
- What is the capacity per seller to reach potential customers?
- What is the percentage of leads that convert to sales?
- What percentage of online referrals become paying customers?
The list can go on and on, but it depends on knowing your process and sales cycle to make it credible.
At the end of the day, you are the one 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, get help. You want to be credible to potential investors.