At their core, startups are hypotheses of economic viability. Most founders have grasped this reality and are building around a core value proposition that they can take to market. Prior to the proliferation of platform technologies, a majority of startup money would be invested in building up product development infrastructure. The financial model for such a startup would typically consist of a comprehensive three statement model that incorporates initial investments, a subsequent build up of assets, and long-term forecasting to account for product development and go-to-market initiatives. For this reason, comprehensive financial models are a necessity for early stage companies as they provide a complete picture of the business and will hopefully prevent founders from making costly mistakes like running low on cash.

Trends in lean startup practices and the increased use of low cost platform technologies have reduced the capital requirements for launching a business and bringing a product or service to market. Instead of investing heavily in costly infrastructure, capital can now be deployed to test the basic viability of a business. These tests include isolating the true customer need, understanding and solidifying unit economics, and fleshing out a basic sales strategy. This has also led to early stage capital becoming more widely available as investors can get quicker insight into whether a company may pass the test to graduate from “product viability” to “product market fit” and subsequently “market penetration.” This post by Ali Tamaseb provides an interesting perspective on how venture capital firms evaluate their investment opportunities and/or place “bets” on new companies. 

The beauty of a well-built financial model is that it can evolve and iterate as a company’s understanding of the market improves. If done right, this will involve constant brainstorming among the key management team. This has the advantage of pushing your team to ‘thinking in bets’ similar to the VC world. To reiterate, a financial model at an early stage company is a forecast of the economic plan. The goal will be to model ‘how’ the firm is going to deliver products or services and ‘how’ it is going to reach customers. In such cases, focus on customer acquisition, basic unit economics, and resource needs will build up into a P&L format, which will also serve as a proxy cashflow statement. To be clear, most early stage companies will not be profitable at a unit economic level. However, what is more instructive from a modeling perspective is how the company plans to scale existing processes as customers are added. As such, cost modeling, or the forecasting of salary, development, hosting, and general overhead costs are layered into future periods as growth occurs. 

Another key aspect of building a financial model is to set up the processes and analytic functions that can augment your understanding of the business on an ongoing basis. Without this, the financial model will never provide its optimal value to the company and its leadership. For example, the firm’s processes must be able to measure the core assumptions about product build, unit economics, and go-to-market strategy in order to test the growth hypotheses from the financial model. And finally, it goes without saying, but the specifics of a financial model and KPIs will differ from industry to industry and company to company. A generic model is no use to anyone, so take your time to be thoughtful when setting up the forecasting and reporting infrastructure the first time. 

With all that being said, benefits of having a well thought out financial model are numerous. One unanticipated benefit is the great conversations you will have with the VC community. They will greatly enjoy a conversation with founders who not only “speak their language,” but also put the requisite thought into modeling out the future of their company.