Most entrepreneurs tend to avoid this area of the business and, as a result, are badly surprised by cost realities and investor expectations. They seem to think that financial projections are simply invented numbers for investors and not useful. In reality, it’s like jumping in your car for a long hard drive with no destination in mind. Chances are, you won’t enjoy success from the trip.
What is a business financial model, really? In most cases, it is merely a Microsoft Excel spreadsheet loaded with your cost and revenue projections for your startup, starting now and extending five years into the future. For more value, a few variables can be added like product volume growth rate and number of salesmen, for “what if” analyses.
Why? So you can make decisions and manage the business, because we are all mere mortals and can’t possibly keep all these numbers and calculations in our head. You can use it to decide whether and when the business is going to be profitable, given rational projections of costs and income (these assumptions are referred to as your business model). Secondarily, it will be required by potential investors to validate how much money you need to get started and how much return they can expect on their investment.
When? The financial model should be running even before you incorporate the business and build prototype products. Would you start driving your car on a long trip before you knew where you were going? If you can’t make that objective, then at least wait to approach potential investors until your model is working–investors have little tolerance for startups with no financial plan.
How? Start with a sample business model, available in generic form or customized for specific industries, from many sources on the Internet. Another alternative is to download a free sample model from my website that I built for a specific startup, with elements suggested by angel investors and venture capitalists, ready to be customized to your business.
If you are not computer literate in Microsoft Excel, your first task is to find someone who has the time and expertise to convert your base set of costs and revenues into projection formulas, cash flow summaries and a profit and loss statement.
Do your own, if you can, because you know the numbers. In fact, this is the easy part. More challenging is “defining” the business model (assembling all the real variables of your projected business, pricing assumptions, staffing requirements, marketing costs, sales costs and revenue flows).
This business model can then be used for many purposes, such as risk and profit assessment, projecting the values of assumptions that are made based on existing market conditions, calculating the margins that are needed to avoid adverse situations and various forms of sensitivity analysis. These are necessary to estimate capital investment requirements, plan capital allocation and measure financial performance.
Creating financial projections allows you to see areas of strength and weakness in your proposed business model, enabling you to make critical changes that will allow your business to run more successfully.
While people start businesses for many reasons, making money is usually important. Even a non-profit can’t afford to lose money. You won’t know if you can meet these expectations until you build a financial model with reasonable financial projections.
It’s a great learning experience and you can do it yourself, but don’t hesitate to ask for help from a professional if you need it. You will be amazed at how clear the relationship becomes between pricing, cost and volume. When you lose money on every item, it’s hard to make it up in volume.
Image credit: CC by Estuado Lara