Early stage startups should have a financial model

I met recently with an early investor in Deliveroo, a current darling of the UK tech scene, who cited their financial model as one of the things that made her invest. The model she said was well thought through and covered all the important elements of the business without being too detailed. And it didn’t have any mistakes.

That struck a chord with me mostly because what we’ve seen over the last two years of working with idea stage companies is it works best when they have a financial model from a very early stage (we’re sufficiently convinced of this point that we are going to add it to The Path Forward). The other part of the story is that I’m a bit of a modelling geek myself. I love a bit of Excel 🙂

All of this is a bit counter the ‘modelling is something that bad investors make founders do’ meme which is prevalent in some parts of the startup community. I think the difference comes down to what’s in the model and why it’s built. What I’m talking about is model for the next twelve months which charts the path from today to where the company wants to be. Done well a monthly model like this does three important things:

  • Forces the company to define it’s goals in hard metrics
  • Shows how feasible the goals are by breaking the path there into monthly increments
  • Gives a plan which can be used to set targets and monitor progress

The other, bad, type of model that some investors ask for (and I think fewer and fewer these days) is a five year plan with lots of detail in the out years. Having a notion of where you expect to be in five years is a good thing, although it should be done fairly quickly, but trying to work out lots of detail is premature because everything will change.

It’s also true that a lot will change during the twelve months of a one year model, but in this context the model is helpful because you know earlier when you are off track and have more to time adjust. If the business gets off track to the point that it won’t get back on track then it makes sense to update the model. That should only happen every couple of months at most and shouldn’t be a big exercise because unless something has gone dramatically wrong most of the logic will still hold and the changes will mostly be changes to assumptions.

This post explains why it’s important to have a model. In the New Year I will follow up with a post explaining how to do it.

  • r3i

    Ditto that. It’s a great way to pulse check startups and understand the company at a deeper level.

  • Aristotelis Xenofontos

    I was reading the post about unicorn valuations and noticed this one on the “Also on…” recommendations at the bottom of the page. I appreciate the topic is a bit old but I think it’s always relevant.

    I had the exact same conversation last week with someone who has invested in an early-stage start-up that is raising again now. The company still doesn’t have a model. I raised it with him and the management team but the response I got was that models at early stage don’t make sense so they don’t have one. I disagree.

    For disclosure, I have to say that I have a Maths and investment banking background, so I am bit prejudiced with regards to the need of financial modelling in business. However, it is not about the model. It’s about understanding how the management team thinks, how much they have worked to set their assumptions and how much they will work on validating them and how able they are to manage a company in a disciplined manner. As an investor I have gotten to the point that I think it’s almost due to pure lack when startups end up being exactly on plan, because of frequent changes in the business or perception of their customers/market along the way. However, no one can take away from me one of the best proxies for the founders’ financial and often commercial acumen.

    My final addition to the topic: No model is better than a very poor model. Also, no model is better than a model that the team doesn’t own. I have seen models that simply have current revenues and a fixed monthly growth rate on the top-line. I have also heard a few times that “this is not my model, my mentor/advisor did it”. I think both answers are actually worse than having no model at all.

  • http://www.theequitykicker.com brisbourne

    All good points, especially agree that poor models are useless and that the CEO needs to own the model.

    The single best reason for making a model is that it forces clarity on assumptions like cost of customer acquisition, conversion rate, pricing and margins. That clarity gives you an early idea on feasibility, which is priceless.