Financial Modeling Basics for Startups
airCFO: Your Startup’s Financial Partner
Bringing a startup to life can be thrilling, challenging, exhausting, and rewarding — sometimes all at once.
If you’ve ever felt that way, we get it. And we can help.
In this article, we cover financial modeling basics for startups which entails: what financial modeling is, why it’s mission-critical to your business, and how to build your own financial model.
And if you need more, at the end of this article, we invite you to download our free guide, Financial Modeling for Startups, including links to two handy templates we share with every client. We also share what you should focus on at each stage of fundraising. Wherever you are on your startup journey, we’re here to educate, advise, and empower you with knowledge and perspective to fuel your growth and success.
What Is Financial Modeling, Anyway?
Financial forecasting is the process by which a company thinks about and prepares for its future. In other words, forecasting determines expected future results.
Financial modeling takes the financial forecasts and builds a predictive model that helps a company make sound business decisions, using known results to inform and validate a model in order to make future predictions.
This is often referred to as a “what if” analysis, where you can play with different levers for your business, such as:
- What if I raise my prices by x%?
- What if we increase headcount by x%?
- What if our COGS is reduced by x%?”
Both financial forecasting and financial modeling are powerful tools for budgeting, investment project financing, and raising capital – at every stage of your business lifecycle.
Why Financial Modeling Is Mission-Critical For Your Startup
If you’re reading this, it’s likely that you realize the value of having a financial model – so you’re already off to a great start!
Based on our experience, less than 50% of startups maintain an operational financial model – so the rest are trying to run their business with no forward-looking plan. This creates a significant risk for founders and investors alike.
Oftentimes, the reason a startup doesn’t have a financial model is that the founders, while very adept business builders, don’t yet know how to create this mission-critical tool.
That’s where airCFO comes in. We partner with startup founders like you to help you build the model from the ground up, and meet with you regularly for trusted tune-ups. When you understand the levers of costs and revenues, you can adapt as you go along.
Once you’ve defined your company’s key variables and built them into a financial model, you will have a powerful tool to help you see how your business outlook shifts as those variables are adjusted.
How To Build A Financial Model
A well-built financial model is an invaluable tool at any stage of the startup lifecycle and helps you attract critical hires, partners, and investors.
At its most basic level, a financial model is created by combining a company’s historical financials with a set of assumptions about how those historicals are likely to evolve in the future.
Historicals include past data for your company’s revenue and expenses. If your startup is already up and running, it’s important to incorporate actuals into your model so that the projections are an extension of the company’s performance to date.
Assumptions are forward-looking statements regarding income and expenses. This includes factors such as:
- How your company acquires and monetizes customers
- Your operational costs and how they change as you grow
- Where you have skill gaps on the team, and how you plan to fill them
Now, by playing with the lever of a financial model, you can answer various “what if” questions, known as outputs, and can manipulate your model’s levers to see the impact on revenue, expenses, and operations to facilitate decision-making.
Profit & Loss Projections: Start With Expenses
When building a financial model, we start with expenses as:
- Spend drives revenue – not the other way around. An integrated model should place investment in customer acquisition upstream of revenues.
- Expenses are controllable, as opposed to revenues that are subject to a large amount of variability.
- Understanding your burn rate gives you control. Getting a handle on necessary vs. nice-to-have expenses and how it impacts your burn rate – the rate at which you spend capital to finance overhead before generating positive cash flow – enables you to flex your spend up or down based on company performance.
Operating Expenses (OPEX)
Operating expenses (OPEX) are expenses that are not directly tied to the production of goods and services such as overhead, sales and marketing expenses, and payroll.
Overhead is what you pay to keep the business running. This includes things like rent, insurance, and utilities.
There are three types of overhead: fixed, variable, and semi-variable.
- Fixed overhead costs stay the same every month. Common examples are rent, web hosting, bookkeeping services, and business insurance.
- Variable overhead costs fluctuate. Common examples include utilities, building or equipment repairs, and hiring seasonal support staff.
- Semi-variable costs have both fixed and variable components. For example, your phone may have a fixed cost each month but when you go over your data limit you incur increased costs.
Sales and marketing expenses are chiefly related to expenses incurred in the pursuit of new customer acquisition. Most companies deploy a combination of sales and marketing expenses; the actual breakdown between the two will largely depend on your business model, who your customers are, and how much hand-holding your customer requires to convert. The system that generates leads and turns those leads into customers is sometimes referred to as a company’s revenue engine.
Whether your revenue engine is sales-driven or marketing-driven, you can create a simple customer acquisition model to calculate how your investment in sales & marketing results in customers.
- For a sales-driven approach, calculate the number of deals you expect each salesperson to close each month, and multiply that amount by the number of fully-ramped salespeople to generate your new customers for the month.
- For a marketing-driven approach, calculate new customers by multiplying a given month’s marketing investment by the customer acquisition cost (CAC).
Payroll expenses are salaries and wages paid to employees. For most startups, payroll expenses make up 70-80% of total spend, so it’s worth spending extra time on headcount planning during your model buildout.
Payroll expenses and also include things such as medicare and social security. As a rule of thumb, we recommend baking an additional 20-30% of salaries into your projections to account for these expenses.
Want to see this in action? Download our free guide here.
Cost of Goods Sold (COGS)
Cost of goods sold (COGS) expenses are expenses directly tied to the production of goods and services sold. These direct costs include the labor and materials (i.e. AWS Hosting) directly used to create the goods or services as well as commissions, piece-rate wages, and manufacturing supplies.
Direct Costs vs Indirect Costs
When building a financial model, we classify expenses as direct costs or indirect costs.
Direct costs are a cost that can be directly tied to the production of a good or service, or to a cost object, such as a service, product, or department. Direct costs can be fixed or variable, fluctuating based on production levels. Examples of direct costs include onboarding costs, manufacturing supplies, hosting expenses, wages for wages for customer success and/or production staff, and fuel and power consumption.
Indirect costs are activities or services that benefit more than one project and are not directly related to the production of a good or service, such as overhead. You can project indirect costs by looking at historical expenses and applying a percentage growth assumption. You can also project these expenses on a per-employee basis, such as (e.g. “we will spend $100 / month on employee education”).
Now, Project Revenue
Now that you’ve made projections for expenses, including customer acquisition projections, you need to project monetization by layering in your revenue model.
There are many revenue models available. Some common ones include:
- Subscription (SaaS): customers pay an annual or monthly subscription to access your product
- eCommerce: customers pay you an up-front fee for a physical or digital product
- Marketplace / Transaction-based: customers on either side of the marketplace transact with each other, and you take a small percentage of the transaction cost.
- Ad-supported: your product is free to use, and advertisers pay you a negotiated price per thousand impressions (CPM)
Of course, there are variations on these models as well, such as ‘freemium’, and ‘land & expand’. Sometimes these revenue models are blended, such as a subscription market place.
Cash Flow Considerations
After thoughtfully building out your company’s P&L projections, it can be tempting to assume that your projected Net Income is a reasonable substitute for your cash flows and call your model ‘complete’.
However, this is a very dangerous assumption to make, and it’s possible to manage your profitable company right into a negative bank account balance if your model doesn’t think about cash correctly.
For example, fast-growing SaaS companies can fall victim to the “SaaS cash flow trap”. Read more about this trap – and how you can avoid it – in our free guide, here.
Create Your Executive Summary
Your executive summary is an important piece of your financial model. You need to demonstrate clear thinking and due diligence so investors will feel safe and understand when and how they will make a return
Your executive summary includes:
- Short-term monthly P&L actuals & forecasts
- Longer-term quarterly/annual P&L projections
- Cash burndown visualization/runway calculation
- Key Operating Metrics
Depending on your business model, you will want to choose 2-3 key performance indicators that succinctly give your business’ key health signals in these areas.
For example, you may choose:
- Growth: MoM / YoY Growth
- Capital Efficiency: Customer Acquisition Costs, Burn Multiple
- Unit Economics: LTV / CAC, Gross Margin
- Product-Market Fit: Churn, Net Revenue Retention
In our free guide Financial Modeling for Startups, we share an example of a dashboard we may share with a founder to kickoff preparation for a Board Meeting. Get your copy here.
Revisit The Model Monthly
Operationalizing Your Model
At this point, you have a functional financial model, complete with an Executive Summary view to share with your team & investors. Congratulations! Now what?
If your model gets filed away in a Drive folder, never to be viewed again, you’ve just wasted dozens of hours and gotten very little value out of the process. The real value of an integrated financial model lies in the fact that it can be fine-tuned over time as you gain more market intelligence, updated regularly, and ultimately used to better understand the future.
At airCFO, we regularly partner with founders, our clients, on scenario planning and assumption testing on a monthly basis. Our view is that this helps management get a better sense of the business’ recent performance and where things are heading
Learn more about scenario planning and assumption testing in our free guide, here.
Want more? We’ve got you covered.
We invite you to download our free guide, Financial Modeling for Startups, including links to two handy templates we share with every client. We also share what you should focus on at each stage of fundraising.