This is a guest post by Ivan Hoo, Co-Founder of Inverse
One of the most common questions I hear from first-time entrepreneurs is why they should bother developing a financial model if the forecast numbers are just forecasts?
To answer that question, let’s look at the following scenarios.
- The company wants to raise £300k. Investors want to know how the investment will be spent and how will those spendings grow the business.
- The company sells its products with 90 days credit terms, but it has 30 days payment terms with its suppliers. What’s the working capital requirement as it grows?
- The company is not expecting to turn profitable while it focuses on developing the product. How long will the investment keep the lights on before it needs to start worrying about the next fundraising? When and how much does the company need to raise next?
I can continue, but hopefully, this illustrates my point. These are very valid and practical questions that may get asked. Most entrepreneurs probably have some ideas about how they should tackle the questions above and instinctively know the answer. But unless the calculations are all written down, presented in a standardised financial statement, it is hard for investors to get into the entrepreneur’s mind and decide if the investment is suitable for them. Now that we understand the financial model’s role in fundraising, next,
I’ll explain the four crucial elements in a financial model.
- Integrated three statements – income statement, Balance sheet and cash flow statement
- Use of funds analysis
- Scenario analysis
- Valuation & cap table
Integrated three statements
I assume that the readers here have a reasonable understanding of the income statement, balance sheet, and cash flow statement. If you want a refresher, I highly recommend this excellent short and practical book ‘Short introduction to accounting‘ by Prof Richard Barker (Cambridge)
A three statement model is simply a forecasting model that has all three statements integrated. The income statement will connect with the balance sheet, and the cash flow statement will calculate the end-of-month cash, which can then plug into the balance sheet to make it balance. Three statement model is fundamental to the more advanced financial model, such as LBO (Leveraged buyout), merger model and various other types of models.
It is vital to present all three statements together because it only tells part of the story when separated.
Below is an example of the process of piecing together a three statement model.
Image 1: The cash flow statement takes information from the income statement and balance sheet to calculate the cash balance at the end of the forecast period. This cash is then plugged into the balance sheet in the forecast period, and the balance sheet will be balanced.
That said, I have frequently come across financial models that are just an income statement or a cash flow statement. While they are not wrong and can be adequate for some investors, it has many limitations.
Suppose the company produces only an income statement forecast. In that case, it will not capture other valuable information such as the cash in the bank or the cash flow it receives from customers paying for an annual subscription. Both are recorded in the cash flow statement/balance sheet.
If a company only runs cash flow projection, in this instance, it does not capture the correct profit margins of the business, which makes it hard for investors to benchmark against the competitions. Also, cash received is not equal to revenue.
It is important to note that the Income statement follows the principle of accrual accounting. Here, revenue is only earned when the service is delivered. Customers paying upfront £120 in Jan for an annual subscription does not generate £120 in revenue that month, but £10. It will, however, contribute £120 cash, and a liability of £110 will be recorded in the balance sheet (Deferred revenue)
Image 2: Revenue is earned as the service is delivered. Prepayment from customers is a liability until they are earned.
Use of funds analysis
Use of funds analysis takes the information from the three statements to show where the money is spent. Very often, you’ll see a campaign with the following use of funds statement:
30% in wages;
20% in working capital;
20% in marketing & advertising;
30% in other expenditures.
A manufacturer may need to invest in machinery, labours; a software company may need to hire developers to complete the product development; a consumer product company may need to purchase stocks, which is the working capital. These expenditures will need to be financed by either cash flow from the operation, equity investment or debt financing.
Use of funds analysis will show the investors where the focus of the spending will be and how the business chooses to finance them.
What if the cost of the product increases? Or what will happen if the price needs to be lowered because of competition? Will the unit economics still work?
Scenario analysis is a process of evaluating changes in business and forecast financial outcomes. It allows the entrepreneur to answer those questions by setting up a different set of assumptions, such as business operation cost, product pricing, customer metrics, and any other business drivers.
You can also devise plans depending on the amount of money raised on your crowdfunding campaign. Ie. If the campaign only raises £100k compared to if it manages to overfund to £300k.
A neat way to present this will be to use CHOOSE function (Excel) to switch between the different scenarios: base case, best-case and worst-case scenarios.
Image 3: toggle between base, worst and best-case scenarios
Valuation & Cap Table
There are already various articles written on Seedrs Academy on how you can value a startup. The method that we use here is the Venture Capital Method.
In simple terms, it takes the final year EBITDA, multiplied by a multiplier in your industry and predicts the value of the company if it becomes public listed or acquired. It then works backwards to figure out the correct valuation for investors in this funding round to get the ROI they are looking for.
The venture Capital Method is one of the most analytical approaches you can use to value a pre-revenue or early-stage startup. But be mindful that one should not assume that whatever the output is, therefore, the number to strive for. The benefit of this exercise is to sense-check the forecast and bring some validity to your narratives. If you are pitching to investors looking to 3x their return in 5 years, this confirms if your financial forecast is consistent with that investor’s expectation. However, if the forecast shows that the growth isn’t anywhere near the investor’s required ROI, you should either revisit the forecast assumption or reconsider your valuation proposal.
Finally, you can build your cap table into the model by integrating it with the three statements and the valuation module. It can show the shares’ price at a given valuation and the equity dilution to shareholders.
I hope this short introduction to the financial model helps you understand the value of financial planning. If you have good knowledge of accounting, you can purchase off-the-shelf templates and build your own forecast. If you prefer to have a model made bespoke to your business or to have an expert work with you on the assumptions, Inverse runs a crowdfunding accelerator and helps companies prepare their investor deck and financial models.
Ivan Hoo is the Co-founder of Inverse. He spent 4.5 years at Crowdcube as a Senior Analyst and has advised 68 companies in raising over £54m in equity finance. With a degree in Natural Sciences from Cambridge, he is also a certified Financial Modeling & Valuation Analyst from the Corporate Finance Institute.
If you would like to work together with Ivan, contact him at Ivan@inverse.fund.