When you think of Financial modeling, you generally imagine a giant spreadsheet filled with numbers and obscure formulas. It's complex and hard to visualize unless you absolutely know what you are doing. But, if you imagine that this spreadsheet tells a story about your business, you can begin to see the forest for the trees.
Why am I building this thing anyway?
From a Lean Startup perspective, a financial model is the most efficient way for an entrepreneur to test and validate their assumptions about their business. Being able to understand things like how you make money and how much it costs to build what you’re selling leads to important insights that will help you be more successful down the road.
Additionally, creating a financial model allows you to communicate your assumptions with others in a logical, conventional format. Going through the motions of building the model helps give you the key insights that help you answer questions from investors during a pitch, and also provides a way for the rest of your team to understand what they need to do in order to make your startup succeed.
From Simple to Complex
With so many factors to think about, it's easy to get bogged down just by the idea of building your model. How detailed do you need to be with your user acquisition modeling? What different revenue channels should you account for? Did you remember to account for all of your expenses including your online ad campaign? How do these different assumptions change over time and how is each one related to the others?
If you over-simplify your financial model, you miss the opportunity to validate. If your model is too complex, it won’t concisely communicate your vision. Finding the right balance in the middle will cleverly demonstrate your level of sophistication to investors. Let’s be honest, investors are both greedy and risk averse. Your three main goals for your investor pitch should be to demonstrate credibility, build confidence, and show that you can make money. Your financial model needs to address all three of these things if you want to succeed.
To be credible, you'll need to consider both your internal and external constraints. To do this, it helps to model against existing successes in similar businesses to show proof that investors will accept. How much can you charge for your product? How quickly can you scale? Are your organic user acquisition plans reasonable and supportable? You'll need to be ready to address investor expectations and skepticism and be able to demonstrate that your business can be sustainable.
Top-Down vs. Bottoms-up
Often, entrepreneurs quickly throw together top-down models which often gloss over important details about the business that evolve as a startup grows. A top-down model usually starts with the market size your startup is going after and assumes that your company will capture a part of that market and will lead to the successful profit that a market of that size might bring. An example of this might be that your company makes a slot machine game for mobile devices. You can see that the top game on the app store has over 500 million downloads and given the quality of your game, you think you can do that or better. So you build a model around the assumption that your app gets 500 million downloads and you are an overnight success. This is almost always too good to be true. 500 million downloads is a great external benchmark that you should use to validate your other assumptions, but it shouldn’t be the starting point for your model.
With a bottoms-up approach for an enterprise SaaS business, revenue forecasts can be based on the target productivity of your enterprise sales team—the more sales people you hire, the more sales you should have, but the more you’ll be spending on staffing costs. For a B2C type application, you might calculate your potential revenue as a product of user growth and engagement, which itself is a product of user acquisition marketing spend combined with organic referral growth. With the mobile slot machine game example from above, you might calculate a monthly spend of $5,000 on user acquisition at an average $2 cost per acquired customer (CAC), allowing you to acquire 10,000 users per month who then each organically refer in 10 additional friends as new users. Your costs for running the game appear as staffing and business operating expenses, which should evolve as the user base and product grow over time. In this way, you can actually "see" your business take shape the way you would build it for real. This is the power of the bottoms up approach.
Retention and Churn
It's important to mention two key terms tied to how consumers interact with your business.
When new consumers come in to your product, some of them decide it's not what they are interested in and leave right away--never to spend a dime. Others see your value proposition and decide it's worth their investment to engage deeper. They stay and are hooked for a certain amount of time. The users that stay can be said to have been "retained". Retention, therefore, is an indicator of a product's "stickiness" with a consumer. This is a good thing, because it means that your product has "Target Market Fit." Target market fit simply means that the product has become something of value for a customer demographic.
However, with every customer who values your product, there are those that leave after a short while or leave right away. When users leave a product, they are considered "churned". Churn Rate is an often-oversimplified metric in user-based business models, yet it is one of THE most important metrics in subscription businesses. Therefore, effectively modeling churn will help tell investors that you truly do understand how your business works.