No matter how promising your startup is, not having a sound financial plan to follow – even at an early stage – is a risky business. Not so much because you’ll need one once you’re ready to raise funds, but because financial preparedness serves the long-term interests of your startup way more than it serves any VC meeting.
For those of you who are reading and thinking, “projections at this stage are useless anyway”, “it’s not worth the effort” etc. – trust me, I have built and presented my fair share of Excel spreadsheets, so here’s a little secret: VCs are not asking for your financial plan to run a discounted cash flow analysis. As a matter of fact, early stage investing has less to do with math or whether you hit your “hockey stick” revenue target in five years. Rather, demonstrating a solid financial acumen is a testament to your ambitions, thoughtfulness and ability to defend a sustainable business model.
Here are five high level financial buckets you should consider as you build your startup’s business plan:
1) Market Size
Your total addressable market (or TAM) should include two main components: (i) The current $X market size (i.e. annual spending or the full revenue potential); (ii) The growth trajectory that would lead to $Y TAM in Z years.
Your TAM needs to be meaningful to substantiate the upside, but try to be precise about it and slice the pie so that it only includes your real TAM (including your future roadmap is fair game; but using Gartner’s global IT spending would feel like a stretch – you get the gist).
This will also serve as the top-down approach to your growth trajectory, so be prepared to address questions like: “If the market size is $X, is it realistic that your projections assume Y% market share”? Or “Your market is growing 30% annually but you project to grow only 20%. Why are you losing market share and to whom?” Or if the scenario is reversed “who are you taking market share from?”
Answers to these types of questions would serve as a sanity check to your top line expectations and an opportunity to demonstrate your competitive landscape knowledge with incumbents, new market entrants and other startups.
As simple as it may sound, the fundamental revenue driver for most business models is Price x Quantity (or PxQ): You sell Q widgets/licenses/subscriptions at a price of $P. My recommendation is to consider what ultimately drives your revenues and outline the details by segment, geography, GTM (direct/indirect), etc. Your total revenues then become the sum of each PxQ build.
Top line growth assumptions would almost certainly lead to a healthy debate around your PxQ:
On the P side the likely questions would be: How did you price your products? How does your pricing compare to other market players? Have you managed to test your pricing tiers with paying customers?
And on the Q side – Do you generate enough leads and have the marketing budget to support the funnel/conversion? Do you have the salesforce and channel capacity? Is your sales cycle realistic? Does your salesforce carry a quota that is in line with these projections?
Think about it from the standpoint of an outsider who wants to get comfortable with your assumptions, so have data to support and vet your numbers.
This exercise would also serve as the bottoms-up approach to your TAM so make sure you cross check the end results with the market size considerations I outlined in bucket #1 above and be prepared to reconcile any discrepancies.
Operating expenses are generally split into three buckets: Research & Development (R&D), Sales & Marketing (S&M) and General & Administrative (G&A). These expenses come after your Cost of Goods Sold (or COGS; the direct expenses associated with delivering your product, e.g. hosting your solution on the cloud).
For each operating expense bucket, be sure to create a simple build of number of people working per function x cost (generally fully loaded salary). For example, you may have different tiers within R&D, i.e. VP R&D (1x$A), engineers (2x$B), etc. Make sure you don’t forget other cost line items such as your office rent, accountant and external legal in G&A (there is plenty of room for future surprise costs).
Now for the “fun” part:
As your business scales, monitor your R&D, S&M and G&A margins (i.e. the % of those expenses vs. revenues) and consider how they benchmark against competitors.
Why, for example, is your sales team more effective than a competitor’s, assuming they have a higher S&M margin? Incidentally, the answer could be that you deploy efficient channels that provide leverage or that your products are self-served online and leads are getting to you via Word-of-Mouth – which is all great, just defend it with data points. In addition, there are other important cost elements that affect cash flows that I haven’t addressed here, like working capital, interest, capex, taxes and FX (will save these for another post).
4) Fundraising Amount and Use of Proceeds (UOP)
This is one of my favorite buckets. As you contemplate fundraising, you should be able to answer the following questions:
How much do you want to raise? (note: your financial model should assume this number!)
How do you plan to spend it?
How long would the money last?
What are the business milestones/KPIs you expect to achieve and are committing us all to?
When do we need to launch the next fundraising round and if we hypothetically fast forward to then, how would the company be positioned?
These seem like simple questions but truthfully, they are not. Answering them requires balancing between healthy ambitions, reality checks, limited resources and virtually permanent uncertainty.
5) Profitable Scaling
Imagine business momentum is terrific and customers sign on at an unbelievable clip. Sounds great, right? Well, it depends. What if I tell you it costs you $100 to onboard a customer but you are only “making” $50 off that customer throughout their entire lifetime? Suddenly is doesn’t sound too promising anymore (and it actually gets worse if we factor in the timing of your costs vs. future revenues).
The bottom line is that you need to add unit economics thinking to your business model. This means making sure that the customer lifetime value (CLV) surpasses the customer acquisition costs (CAC) at a unit level basis (i.e. individual customer level).
The general rule of thumb is that CLV needs to be 3x+ the CAC to ensure healthy, sustainable scaling. Also, make sure your CAC assumptions are benchmarked against your industry’s CAC.
To sum up, these buckets are not meant to be the “catch all” for financial building blocks and there are certainly important nuances in financial modeling across verticals – like different revenue models, cost structures, bespoke APIs, etc. – yet I believe that the above “financial thinking” applies to any business.
Check out my next post Less is more: How to present your startup financials in just 3 slides, in which I outline some best practices and examples for “how to present” the financials (spoiler alert: does not involve opening an Excel spreadsheet during the first VC meeting!) along with some example slides.