Financial Models Are (Still) Always Wrong: Create One Anyway

After a lot of interest from entrepreneurs for a simplified version of that model, today I’m releasing a streamlined version that will make it easier for entrepreneurs to start understanding the equation underlying their businesses.
BY Taylor Davidson | November 12th, 2009

In January I released a financial model for startups to help entrepreneurs model and understand the story behind their business. After a lot of interest from entrepreneurs for a simplified version of that model, today I’m releasing a streamlined version that will make it easier for entrepreneurs to start understanding the equation underlying their businesses.

Want to learn more? Learn how to build financial models or download a financial model template for startups.

This streamlined financial model is intended to help entrepreneurs:

  • Create marketing plans and estimate the costs and success in acquiring customers
  • Estimate pricing plans, price points and estimate revenues
  • Understand the key components of cost of goods sold (COGS) and selling, general and administrative (SG&A) costs behind the business
  • Understand the basic net income behind these estimates

The model uses a mix of assumptions to estimate all revenue and cost line-items monthly over a four year period, and then sums the monthly results into years for an easy view into the various time periods.

Please note a couple limitations:

  • The model is not built for all types of businesses or for all different types of revenue or cost models.
  • The model is not robust enough for raising investment capital. It does not estimate complete balance sheets, statements of cash flows, sources and uses of funds, financing requirements, calculate capitalization tables and other information necessary for potential investors.

But this model is enough for an entrepreneur to get started understanding their business idea.

But wait: why is creating a financial model important?

To quote past thoughts:

Creating a financial model forces an entrepreneur to outline very specifically how a business “works”: how a company creates their products, how users and customers find and use their products and how those processes create revenues and costs. The result, a set of operational metrics, financial statements and the “equation of the business”, is one view of a potential reality of the business. While any one view is inevitably wrong, by digging deeper and analyzing the key drivers and testing a range of assumptions an entrepreneur can create multiple views to help make crucial product design, marketing, organizational and strategy decisions.

Instead of focusing on the bottom line profit and net income, focus on the assumptions and key drivers of the business. Developing a financial model creates the type of thought and data that helps entrepreneurs figure out what they are betting on and how likely their bets will pay off.

What is needed to start creating a financial model?

The best way to start building a financial model is to start thinking about how the business works:

  • What is the product / service and what customer need does it serve?
  • How do you identify your addressable market and target customers?
  • How do you market your product/service and acquire customers?
  • What are the revenue streams? (prices, sales of products or services, advertising, usage fees, etc.)
  • What costs will the business create? (i.e. employees, web hosting, SG&A, various fixed costs, variable costs)
  • What timeline of development and product launch and market / customer adoption are you expecting?
  • What do you know about the market? (# of potential customers, $ spent currently, market trends, growth, competitors, etc.)
  • What lessons, revenue / cost models and performance / operational metrics exist from studying existing competitors and complementary and substitute products?
  • What big bets are you placing (implicitly or explicitly)? What are the key drivers in the equation behind your business?

And building a financial model is a great way to understand one’s business, the key decisions you face and the bets you’re placing. As Mark Suster has explained:

Financial models are the Lingua Franca of investors. But they should also be the map and the Lingua Franca of your management discussions.

Want to learn more? Learn how to build financial models or download a financial model template for startups.