The question that startups often face from Venture Capitalists is “what are you looking for in a seed-stage financial model?”

In answering the question, it is helpful to understand how venture investors use your financial model. There are a few things they are trying to gauge from the model:

1.What is the potential scale of the startup if things go well over the next 3+ years?

2. How well does the founder understand the unit economics of their business and the costs to acquire customers?

3. What are the metrics and milestones that a startup needs to achieve, to signal success and raise the next round of capital?

4. How do VCs get comfortable that there is enough liquidity maintained in the business in seed round to sustain the startup for the next 18–24 months under varying conditions?

Given these focus areas, what VCs look for is a relatively simple financial model for the next 3 years, broken down by month. Investors want to know what drives your costs as the business scales, along with the associated headcount and development costs required to support that growth. Therefore, they want clear assumptions in your model around expected revenue and expense growth that include:

Pricing assumptions: standard price of your products or services

Customer acquisition costs: cost of convincing a customer to purchase your product or services

Churn: percentage of customers or subscribers that stop purchasing your products or services

Sales Growth: how quickly you can grow sales and the resources that are required (sales team, marketing spend, etc.)

Expenses: Amount of people you need to develop and sell your product and other costs that are material to your business (hosting, 3rd party payments, etc.)

Output of financial model in the form of P&L statement
Imaginery example of P&L Statement

The output of the model should be a P&L statement (Profit & Loss Statement) that includes the amount of cash which will be used each month. You should be able to clearly see the inflection points in the startup and to utilize the financial model to set budgets and milestones with your investors to figure out when additional capital will be needed to fund the growth of the business.

What investors don’t expect is a professionally built model with 100+ assumptions and detailed balance sheets and cash flow statements. It is too early in your business’ life cycle for that level of detail to be meaningful.

It is significant to note that 99% of the models that investors review could be wrong. And it is quite uncertain to accurately forecast an early stage startup for the next 3 years. Although this may sound discouraging, the fact is, venture investors don’t need the model to be “right”. Instead they need it to build an understanding on how the founder’s vision for their startup translates into growth. Investors also need to know that the founder has a strong grasp of the unit economics. Additionally, any plan is always better than no plan; with a plan you can monitor performance and control deviation against your plan, but without one, you are just drifting. Therefore, a well thought out financial model like the above mentioned would help investors plan their investment.

Now that you’ve learnt how a financial model for startups should look like, you can also learn about financial waste startups could consider avoiding.

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