6 questions that will help you build an ‘investor ready’ financial model.
As a founder embarking on your first fundraise from an institution or angel group, you will be expected to have prepared a financial model. For many founders, the idea of having to produce a financial model that is deemed ‘investor ready’ may be a daunting task.
You may be asking yourself ‘What are investors looking for in a financial model?’, ‘Are there areas that I should pay more attention to?’, ‘Am I unknowingly creating red flags in the financial model?’.
If this sounds like you or your business, this article will guide you through the key elements of your financial model and how to build it ‘investor ready’ to support a successful fundraise.
How will an investor use the financial model?
The main purpose of the financial model is to allow the investor to assess the financial performance of your company. This will include historic financial performance that supports the story of the business to date. The financial model will show an investor how the company is expected to perform and will help them calculate their potential returns based on factors such as revenue or EBITDA growth.
What financial information should the financial model contain?
The three core pillars for the model will be Profit and Loss (P&L), the balance sheet and cash flow statement. If your business has product or stock, a working capital statement will also be beneficial.
You will be expected to show each of these core statements on a monthly basis.
The core statements enable the investor to build a clear picture of your business. You’d be surprised how much a model can reveal about a business!
What timeframe should the financial model cover?
Most early-stage institutional investors will hold their investments for three to five years so I would typically recommend 4 years from the point of investment for most businesses. Your financial model should also align with your business plan. If your growth plan spans four years, then your financial model should reflect this.
Our business changes too quickly, how can we forecast four years in advance?!
Investors in growth companies understand that businesses don’t stand still at this stage of their lifecycle. Deviations from the original plan are not uncommon or unexpected. The key is to have the first 12 months post-investment nailed down within your financial model.
You must be able to stand firm behind the assumptions you have made in order to drive the projected performance. Specific data points will be essential at this stage, the reasons for which we will explore further later in this article. A few examples include;
- revenue generation based on existing sales, prospect conversion rates, pipeline or average order value
- Cost of Sales based on existing prices
- Overheads driven by bottom-up assumptions using metrics such as Customer Acquisition Cost (CAC) for marketing
How should the financial model be built?
There are different ways to build financial models. The best financial models for the purposes of early institutional fundraises are those built using bottom-up methodology. This means starting with the underlying assumptions, data points and/or metrics available to you, ideally from internal sources, to drive your forecasts.
The example below shows how the data assumptions ultimately drive the output seen on the core statements: the P&L in this particular instance.
This, clearly, only scratches the surface. There will be many more variables to consider when building your model. Depending on your business, other variables might include customer churn rates, sales cycles, various sensitivities, recruitment ramp up and a step up in fixed overheads.
There should be a clear, justifiable case for every assumption used in the financial model build, as each will be scrutinised by any potential investor. Any assumptions that are out of kilter with your historic performance, such as a historic churn of 15% vs assumed 5%, will be a red flag for any potential investor. This is because they look to historic performance as a guide for future projections.
Potential investors will not appreciate any arbitrary, ‘hard typed’ figures going straight into the P&L, Balance sheet or Cash flow statement because it makes the model very difficult to analyse and stress test. The exception to this is when inputting historic data, where it is not uncommon to see ‘hard typed’ figures in the core statements.
There is no defined rule, but your financial model workbook will ideally include the following tabs; data assumptions tab, calculation tabs (Revenue, COS, Opex etc.) and an output tab (P&L, Balance sheet, Cash flow and/or KPI’s). This will ensure that your financial model is dynamic, easy to follow and allow for underlying assumptions to be changed, therefore enabling the model to be updated with ease.
What will an investor look at within the financial model?
The short answer is that investors will look at the whole model. No stone will be left unturned! Nonetheless, I would advise you to prepare answers for the following questions that any investor will almost certainly ask;
- Is the rate of growth achievable? What underpins this growth?
- Are there any fluctuations? Why or why not? Seasonality?
- If multiple streams exist, how does the mix change over time and why?
- What is the story behind historic revenue?
- Are imminent revenue claims backed up by confirmed pipeline or current conversion rates?
- Is the gross margin consistent or lumpy? Why?
- How does the gross margin compare to comparable companies in the same sector?
- Are margin improvements expected over time? If so, why?
- If multiple revenue streams exist, do certain streams demand better margin than others? Does this impact the sales mix weighting?
- Does the Opex scale to support the business growth?
- How is headcount scaled? Are there enough staff in the business and in the respective departments to support the growth? Can hires be recruited and inducted at the pace outlined?
- Is R&D sufficient over the course of the plan? Will the business continue to invest and remain innovative by the end of the plan?
- What is the breakdown of marketing costs? Are these costs sufficient to execute the plan? Does the business continue to invest in marketing throughout the duration of the plan?
Too often, we see financial models that show insufficient operational costs to support rapid sales growth. Marketing and R&D spend also often decline rapidly as a percentage of revenue in the latter years of the plan. An investor will probably be planning their exit in the later stages of the business plan and they will need the business to continue investing in marketing and R&D to sustain growth.
Financial Model; a key to success
The building of an ‘investor ready’ financial model is no small undertaking. It is important to get the financial model right given it is a crucial part of any fundraise. A robust financial model provides comprehensive information that will speed up the fundraising process, identify potential bottlenecks and help you assign KPI’s to your plan.
You should now have at least a feel for the content, structure and make up of your first ‘investor ready’ financial model. This will help you understand whether it can be completed in-house or whether you need external help. There are lots of options when it comes to getting external help, including our own financial model build team.
If you would like to talk about your financial model or any of the challenges around financial model building for a fundraise, please get in touch.
Previous articles in this series include ‘five things you need to know about angel investors’ and ‘crucial ‘need-to-knows’ when considering your first funding round from angel investors’.