What you Need to Know about Startup Financial Modeling Before Raising your 1st Round of Funding
A few weeks ago a I received a call from a cousin. He had seen I was working at a seed-stage investment firm and wanted some help with his startup financial model. He told me:
- “Enzo, I have this great idea I’ve been working on with some friends and need to raise some funds to launch our company. I’d like your help in building our startup’s financial model.”
I said: “Wait, hold on” and asked:
- “Do you have customers?” — No.
- “Do you have an MVP?” — No.
- “Then why are we having this conversation?” — We need the funds – isn’t a financial model what investors ask for?
They were even willing to pay for it! So I decided to write down the little piece of advice I gave to my cousin as a first-time founder. My response had 2 sections:
1. When should I raise funds for my startup?
This is all about timing and needs. Identifying when is the appropriate time to raise the funds your startup needs to get to the next stage is key.
In my cousin’s case, his startup idea was still being incubated. It probably wasn’t the best time since he had almost no traction. An investor would’ve suggested more bootstrapping and applying for grants from public or private institutions.
Bad timing could mean running out of cash (if it’s too late) or having trouble raising funds (if it’s too early) in the form of a low valuation or many no’s from investors requiring further traction.
As a general rule of thumb, raise funds when you have an MVP, some early traction (users or buyers) and a robust diagnosis of what are your startup’s scalability challenges. Then, raise funds and use them wisely to address those challenges.
For example, Geoff Ralston, Y Combinator’s new president, says “you should raise your 1st round when you can make a persuasive case that your startup will become a billion dollar company”. Startup investors would not bet on you unless they see a possible outsized return. Building that case requires having strong arguments like an innovative MVP and traction.
If your well-thought answer to 1) was yes, then proceed:
2. Do potential investors really ask for a startup financial model?
This is all about the investor’s profile. As a seed-stage startup, you could approach your Friends and Family, an Angel Investor or an Accelerator. Each of them has a different background, education, and experience investing in startups. Thus they will probably ask for different things.
Angels and Accelerators usually understand that the decision process behind investing in a startup is quite different from the one for a mature company (You can read about my own process starting as an Angel, here, and how applying to an accelerator is, here). The latter usually have enough historical data to back financial forecasts (aka Financial Model), in comparison to the first one. Venture Capital funds also understand this. Thus they might not ask for a financial model, but will definitely ask for:
- Revenue in the last 3, 6 or 12 months (rapid growth month over month is persuasive)
- Unit Economics like CAC and CLTV (you can Google both terms, but here’s a fast guide)
- Use of Funds and Milestones, where you show how the money will be spent monthly vs the key tasks you expect to achieve
Since startups have little traction, the assessment of qualitative aspects like the team, the problem and the solution tend to weigh more in the decision.
If your startup continues growing and you reach the required milestones to raise Venture Capital, meaning a Series A, B or plus, then you will need to build a more thorough financial model. However, you probably have some time left till you reach that stage.
Unless you’re lucky enough to have angels or venture capitalists among your Friends and Family — in which case you wouldn’t be reading this — the loved-ones who would bet money on you will probably have little experience investing in startups. If any.
In this case, a financial model could have 2 effects:
- Illustrate your growth plans and use of funds: If the target investor has some degree of expertise in traditional finance.
- Show you thought well your business idea: If the target investor has a little business background.
Bear in mind that since these investors tend to be less used to risky investments, confidence and belief in you rather than in your idea is key to a successful startup fundraising. Even if you were 1st place in college and had a great job, some crystal clear financial projections will make you sound more credible.
Take Away: Focus + Simplicity
As a first-time entrepreneur in the first 6 to 12 months, you should focus on figuring out what’s most important for a strong startup thesis: an MVP, some recurrent customers, and how to scale. (I love this article on founders’ focus)
Don’t spend your precious time and money worrying about fundraising requirements like a financial model for a first round. You don’t need to hire a financial advisor nor a CFO. Be simple.
A one-page spreadsheet with simple and well-formatted monthly projections like revenue, cost of sales, selling and administrative expenses is more than enough. If your solution, business model and market are good enough, then the spreadsheet will reflect just that and the investor will believe the numbers. No financial engineering required.