How to Create an Investor Ready Financial Model
Don’t trip yourself up at the starting line
Your numbers tell the story that investors need to understand. If they don’t tell a simple and clear story that marries with your vision, your market and your ability to execute, then raising is going to be hard. Investors carefully look through the financial model before investing in the business so it's vital you get this element right.
So before you start putting anything into a spreadsheet, it's critical to understand that knowing how to present them and the story they tell can be the difference between success and failure and that you need to put more care and attention into your numbers and understanding them than the time and money you spend perfecting the look and design of your pitch deck.
More than just numbers
The varying quality of financial models that investors see is stark and sometimes disconcerting, considering the sums of money on the table. FundingHero works with Founders to ensure their financial models tell their business’ story in numbers, in an easy to understand format, and give an investor immediate confidence when they see them for the first time.
It’s vital that any materials an investor sees need to be the best representation of you; that your business’ credentials stand up to scrutiny and that you don’t roll out the excuse: “I’m not great with spreadsheets or numbers”. You wouldn’t present a poorly formatted pitch deck, so why do that with an overly simplified financial model, with ill-conceived assumptions, formula errors, poor formatting and missing key information. Any of these common issues can stop investors dead in their tracks.
The next few pages provide you with a guide to some of the most common issues we see in most financial models and the key things you need to know in advance to create an investor ready financial model that will impress and build credibility to raise you those precious funds, there are;
1. Purpose of the numbers
4. Round size
1. Purpose of the numbers
99/100 startups underperform their financial forecast
A large number also significantly underperform. They feel a need to create knock out numbers that will wow investors with the level of growth, profits & returns they will generate within 1-2 years and make everyone multi millionaires within 3-5 years. But the level to which these are over hyped & over optimistic only leads to issues. Ambition is a prerequisite, but the extent to which is the balancing act.
Backable or delusional is the key question
There isn’t a need to overshoot and set overly optimistic expectations from the outset, you aren’t giving yourself the best chance to show investors you can set targets that are realistic and achievable. Setting pragmatic, credible assumptions shows you are more likely to be able to manage your cash runway and scale your business diligently and investors will be more confident in you for that than huge fanciful figures. How do you want that first post investment meeting to go… “we’ve missed our targets by a mile….”, or “we’ve had a great first quarter and are on plan”.
Who is the target investor?
This is key and must be taken into context when understanding who your target investor is. You need to understand who you are pitching to; what they need to see to get excited and fit their investment thesis.
A VC for example will not entertain your model unless they can see a significant multiple on exit opportunity. The VC model has a very high failure rate, which may mean 8 or 9 out of 10 investments in their portfolio typically fail to make the returns they expect. Therefore they can only afford to look at businesses with significant market scale opportunity to make their fund deliver the return it needs. They will assess how many future rounds are needed and an approximate level of dilution, coupled with a reasonable timeframe before they finally see a return.
So flex your numbers accordingly if your ambition and ability to execute matches theirs and then paint the story with your numbers appropriately to the investor.
Dampening down the numbers doesn’t mean dampening down ambitions
If you don't plan on building the next Unicorn or Decacorn then ensure you create numbers you feel are optimistic enough still to excite people but are achievable. You can explain the upsides to any plan or the potential scale of your opportunity and this is always better than apologising for missing targets. Most businesses can see a whole range of upside revenue opportunities, but if you throw them all in from day 1 the credibility of actually delivering it will raise a smirk from the investor and take your ambition at its face value, but start to sensitise your plan by stripping out whole revenue streams. When this starts it's just creating doubt after doubt for them and this means risk.
Instead, it's a refreshing position when you paint a story of viability but with exciting potential, not creating a load of red flag risks from day 1. Remember, not all businesses need to hit £50m+ in turnover. Only a small % of startups ever will, the majority that manage to scale may sit happily well below this and they make up a vast % of every economy in the world.
So when you can create a financial model that makes sense in terms of the market share you can genuinely reach and win and create a profitable business at a healthy level it will give investors a warm sense of your ability to actually deliver your plan. You're not shooting for the moon and risking blowing up spectacularly, instead you can show achievable milestones to explain what you will execute at each stage to make the this business successful and profitable.
Assumptions are key to credibility
Whatever core assumptions you use, you need to justify them during any investment conversation, so be prepared to back them up, with evidence and research and be aware how sensitive they are in your model. Use our Financial Model canvas to help capture them for ease of reference and to cover off your key areas in case you're not sure what to include.
Growth is rarely a straight line
Firstly growth isn't a simple 100% year on year. Early stage businesses will often find those first few years hard to get decent traction whilst they are trying to build a product that is functional enough to really compete but most importantly get it in front of enough people. It takes time for people to build brand trust before committing with money, so the early years are slow whilst aware and trust builds, but then can see some strong upticks over time.
Secondly, avoid using an annual growth number and dividing it by 12. Growth happens incrementally. It's a compound effect and as said is triggered by slow burning marketing and sales efforts and normally a % building monthly that improves over time once the foundations are in place. If you just take a desired growth of say 1200 new customers in a year, then add 100 new per month, the issue is your first 6 months will be significantly short as they ramp up gradually and therefore your cash and profit will be dramatically impacted and your cash runway massively in doubt.
Consider your pipeline period
Your pipeline cycle from prospect to revenue is one of your biggest modelling assumptions. Invest in Sales & Marketing, then see results in 6-12 months time. It most definitely is not: hire sales person month 1, sales increase in month 2. This is fiction not reality and creates a massive hole in your runway.
Huge hockey-stick growth raises questions
Scalability is an important aspect to portray in any business model, but avoid overly aggressive hockey-stick curved growth at least until your business has proven sales traction and the market demand is there. Building traction on scale takes time and quick growth is definitely achievable, but rare for real exponential rapid growth that has revenue projections bordering on vertical lines jumping out in the later years.
Don’t materially underestimate costs
Generally most Founders do. What costs to include, the timing they commence and then how they appropriately scale is so important. Most models create a perfect storm of overinflated revenue & underestimated costs - resulting in a cashflow disaster. Even if you can't think of what costs to add in, just add some decent general contingency as a blanket % of revenue to ensure your profit doesn't look ridiculous.
Model & understand your working capital
The biggest risk to businesses is running out of cash through over trading, so planning a commercial strategy that creates a favourable cash upfront model is the dream and de-risks your model significantly. If you can’t then there are working capital solutions you can apply for to ease the pressure between funding rounds. Equity isn't the only answer.
Ensure to include all taxes
7 out of 10 models we see are missing the common taxes like national Insurance and corporation tax or get in a real pickle with VAT. It looks amateurish and impacts investor confidence when the basics are omitted.
Make the numbers frictionless for the reader. Keep it simple
Over-complicated spreadsheets are a burden, with the risk of formula errors, lengths of time spent building and updating them and then lengthy sessions having to explain them to people.
Have an overview page in your model
A summary P&L, Cash Flow and key metrics and KPIs - all for the next 3-5 years, along with visualizations of performance and trends.
Don’t make the reader work
Whether it's graphs or other visuals - make sure your financial information can be easily understood at a glance and doesn’t require a spreadsheet audit. A story paints a 1,000 words.
4. Round Size
With any round size, you need to be clear on the why, what and where:
- Why are you raising? Be clear on the reason you have decided to seek other people's money to help you.
- What are you going to spend it on? Break the total down into smaller amounts to clearly show the key components you plan to invest in to deliver your business goals and provide a return on investment.
- Where that’s going to get you. Will the funds last 18 months and help hit your milestones and KPIs before you next need to raise?
Include milestones and targets such as users, revenue and cash burn
Adding these gives a richer context for the amount being sought and investors can more easily make an assessment in your plan’s viability.
How much is enough?
The simple answer is how much your financial model tells you, not an arbitrary £150k, or £250k. Things to consider;
1) Consider your round size as a function of your valuation. Each round typically sells 10-20% of your equity. Raise too much too soon and you may overly dilute.
2) Raise enough to ensure you won’t run out of funds before you’ve reached your traction goals. Traction often comes much but much slower than expected.
3) If you raise too little and run out of funds before you’ve registered strong enough growth, you may be under pressure to raise at a lower valuation next round; a dreaded ‘down round’.
At FundingHero we aid Founders with their financial models. No investor expects Founders to be financial modelling wizards, but they will expect a level of care and attention to show you understand your numbers and your business is actually viable, with the relevant risks understood.
Our services cover:
- Headline model reviews
- Detailed reviews to help validate your financial plan
- Model building to raise initial & scale up funding or debt.
We work with you to ensure one of the most important documents your business has to present can be done so with confidence. Contact us at hello@FundingHero.co.uk to see how we can help.