10 thoughts for small businesses and startups on financial modeling

When Ross and I were working on the crowdSPRING business model late in 2006 we needed to prove something to ourselves before we asked others to risk an investment in our business: could our idea become a profitable and viable business? For both of us there was significant opportunity cost in pursuing this venture/dream and we needed to be able to answer for ourselves (and our families) one question  in the affirmative: “is this worth it?” In order to answer this question we needed to first analyze the historical data that our research was uncovering on the market (such as incumbent’s historical growth, revenue, and traffic) and use this analysis to build our own projections for crowdSPRING. We also needed to ascertain a value for the company, which we could justify to potential investors, banks, and other interested parties. Our approach to this was to build a model which could not just answer those questions in a meaningful way, but which would act as a tool for our financial management of the company going forward. What we ended up with was (probably) overkill, and the typical response we got was “Why did you bother with so much detail?” Well, our answer to that was “Better too much, than too little.” Here are 10 tips gleaned from our own learnings on building a great financial model:

1. Learn from your ancestors. Just as I advised last week in writing business plans, you should get your hands on a template. Many others have cracked this nut before you and you can benefit greatly from their work. Find a template or ask for help from someone with experience in building complex spreadsheets. Also, read everything you can get your hands on; the business press has hundreds of great titles on this topic and the information contained in those is priceless to the entrepreneurial community. (photo credit: er1danus)

2. Gather your wits (and your data). Be sure that you are storing and organizing your data well. Your market research, historical data on comparable companies, traffic data for other websites, and any relevant information you have uncovered in your readings. When you start to construct your spreadsheet, you will need to access these raw numbers for inclusion and you will want to be able to find them quickly.

3. Stay organized. It is critical that your spreadsheet be well organized. Use multiple worksheet tabs within the spreadsheet; keep your charts and tables clearly defined and labeled; use data tables but try not to let them get too large and unwieldy. Keep in mind that if you get hit by a bus, someone else may need to access your information and make sense of it.

4. Always assume. Build a Table of Assumptions and take advantage of Excel’s ability to reference other cells and worksheets. This is a very important part of the process and one you will want to be able to refer to often as you justify your projections and valuation. I can also not stress enough the value of linking your formulas to this table. Why make yourself go through and adjust values in 27 cells across 8 separate worksheets, when changing one will change the others automatically?

5. Project, project, project. There are a number of viable strategies that others have used to develop projections and arrive at a valuation: 1) find a comparable company from your own industry and use historical data from that company to determine sales history and growth in its early years. From this you can extrapolate your own company’s growth. 2) If you have sales commitments already in hand, use these amounts to project your worst-case scenario and add to that for additional projected sales. 3) Conduct detailed market research to determine overall demand. Rationalize the percentage of this market which your new company might control and use this along with your own set of assumptions to arrive at your projections.  And finally as a note on setting up your spreadsheet: be sure to determine exactly what data you need to project into the future, and design your formulas so that you can change this quickly. Make sure that your projection formulas are linked to your table of assumptions, so that they will update automatically whenever you change those.

6. BWML. This is not an acronym for an obscure government agency, but rather a pragmatic approach to modeling projections and budgets. It stands for Best-Worst-Most Likely case scenarios, and you should always prepare all three. This is a real-world approach that recognizes that no one can predict the future and allows you to define a range of possible outcomes. For instance your worst case scenario could assume no growth in the first two years, your best case might assume 10% growth for those years, and your most-likely case might assume 5%. Set up your spreadsheet so that you can very quickly analyze various “what-if” scenarios and see the impact of each in a broad way. (NB: thanks to Steve Rogers for helping me to understand the value of this particular strategy)

7. Bring Value to your workA critical challenge for any start-up in the earliest stages is determining the value of your (as-of-yet-non-existent) company. This is an essential exercise, as you will need to be able to justify the equity you will give up in exchange for the capital you hope to raise, before presenting the company to potential investors. There are various methods used to value a pre-revenue venture, but whatever method you choose, be sure you have strong rationale to back up your approach. Our strategy was to use two methods and present an average of the results as our proposed valuation. Here are the two we used: (photo credit: Mykl Roventine)

A) MULTIPLE OF CASHFLOW METHOD. Different industries use different multiples of EBITDA to value businesses. Do some homework, find the current multiplier for your industry, and determine if it is the correct one to apply to your projections. For instance, when we were doing the initial valuations for our own financial modeling, we looked at 2005 multipliers for several relevant industries. Different industries have different multiple benchmarks and at that time Internet businesses had an EBITDA multiplier of 39.83 and the advertising industry was 10.83. We took a conservative approach and used a multiplier of 3x for our valuation using this model model.

B) CASHFLOW  CAPITALIZATION METHOD. This is a bit trickier, but this more sophisticated method returns a typically reliable valuation. To determine value using this method, you must first determine the Present Value of your “free” cash flows for the first 5 years of your business (the “Planning Period”) and the second 5 years (the “Residual Period”). This model takes into account your assumed Cost of Capital (or “Discount Rate”), your projected revenue (and your projected rate of revenue growth), depreciation of your assets, your working capital, and your capital expenditures to arrive at your projected Free Cash Flow.

Finally, you may want to present your potential investors with the projected CAGR (compound annual growth rate) for their investment such that they can have an idea of the future value of their investment. This number, presented as a percentage value, is arrived at by using this formula (where ending value is the present value of your Planning Period (see #2, above), the beginning value is the total of your capital raise, and the number of years is the number of years in your Planning Period):

8. Make a (Financial) statement. Don’t forget to include – front and center – your financial statements. These are what investors will want to look at and yours should be clean, simple, and honest and should project out at least 5 years. Your financial statements will include a Balance Sheet, an Income Statement, and a Statement of Cash Flows. In addition, it is a good idea to include a “Table of Key Ratios” which include projected ratios: Gross Margin, Return on Equity, Current, Debt/Equity, and a couple of operating ratios, including Days Payable and Days Receivable. Smart investors will want to perform an analysis of these ratios to gain a better understanding of your venture’s vulnerabilities and strengths.

9. Let me make a plug. Don’t. Some entrepreneurs will build out their financial model by backing into the numbers they believe investors will want to see. This is easy enough to do using excel and other tools, but it is equally easy to spot this trick. The best investors for your business are knowledgeable and sophisticated and they will spot a plug a mile away. Always use honest numbers, solid data, and defendable assumptions to arrive at a fair value and reasonable projections.

10. Make it pretty. Please. And last, but not least – try to make your model presentable and visually pleasing. Remember that you are presenting a LOT of very complex information and it should be your goal to make that information as digestible as possible. Use charts to display growth and make sure you are visually consistent with these (pick a color scheme!). Use nice, clean, well laid out tables to present historical data. Color code for readability and clarity. Have friends look it over and give you their feedback on your visual presentation. These efforts will pay off every time you share your model with an audience and are able to quickly explain the various components. (photo credit: chotda)

We have also built a little Excel budget template which may come in handy for you. Download it here and enjoy, but please send us your questions and your feedback.

Here are some links to some other posts on related topics:

Start-up Tip: What’s Your Revenue Model?

Start-up Tip: Ten Suggestions For Raising Start-up Capital From Angels