The Venture Capital Blueprint: Unlocking the Power of Financial Modelling (2024)

In the first article of the Venture Capital Blueprint series (link), we delved into the foundational framework of investment deals, exploring the intricacies of sourcing, screening, and the initial elements of investment analysis.

Among these elements, financial model is a connecting link between actual and projected financials, unit economics, potential returns, and other critical facets of a business.

A robust financial model is not merely a spreadsheet pulled off the shelf during fundraising rounds; rather, it’s should be founder’s handbook — an indispensable instrument for experimentation and for providing nuanced answers to “what-if” questions. A well-constructed financial model is instrumental in understanding how business operates; it serves as an essential tool for investment analysis, business planning, budgeting, and beyond. And the more advanced a business is, the greater the importance of having and utilising a high-quality financial model.

As a VC we would normally request the financial models from a startup. And it’s not a matter of laziness in building one ourselves; rather, businesses usually already have these models in place, and there’s little sense in reinventing the wheel. But how we use these? Well.. The financial model aids in addressing a significant portion of the Evaluation Map’s elements (more in Venture Capital Blueprint: Navigating Sourcing, Screening, and Beyond) proving invaluable tool for the initial pre-due diligence review of performance (including historical traction, growth, unit economics, etc.), planning and projections analysis, and ultimately, the evaluation of potential investment returns.

As we navigate through the labyrinth of financial modelling intricacies, it’s essential to remember one thing: financial model should never be an enigma machine. On the opposite, it serves as the founder’s handbook and an almost daily-use tool, one that the founder should intimately understand, inside and out.

So, follow the white rabbit! Hope this read will gear you with useful knowledge and tools … and let us check some assumptions!

Template of the financial model we will be discussing is accessible via this link.

Instead of disclaimer

The model described in this article is an exemplary template illustrating elements of investment analysis and is intended to be used for informational purposes only.

It is constructed to illustrate different mechanics connecting model elements; approaches to modelling and building-up revenue depending on monetisation model; etc., on the example of imaginary pre-seed stage b2b fintech platform. Assumptions are replaced with illustrative examples as well as calculations are made solely for the purpose of illustration. To be used as a template, model have to be adjusted to accommodate particular business specifics.

Assumptions: The Bedrock of Financial Modelling

Financial models commence with a set of inputs and assumptions, projecting sales (e.g., number of new users, prices and monetization model, retention, etc.) and expenses (e.g., CAC or marketing budget, cost of product, etc.). To enhance the accuracy and reliability of these projections, several key considerations should be taken into account:

• Grounded in Historical Data
  All assumptions should be firmly grounded in and aligned with historical data. In cases where such data is unavailable, such as with new business lines or early-stage startups, market statistics or other reference points can serve as substitutes;
• Non-Financial Parameters
  A comprehensive financial model includes non-financial parameters and assumptions. This encompasses user retention or engagement metrics or any qualitative factors influencing business outcomes;
• Granularity and Business Sense
  Maintain a sufficient level of detail and granularity in assumptions. Define the ‘unit’ driving the business (e.g., number of paying customers) and base assumptions on parameters affecting and defining this unit. This ensures the financial model reflects the nuanced dynamics of the specific business context;
• Avoid assuming key metrics
  Rather than assuming key metrics such as GMV or revenue directly, define and focus on parameters affecting and defining it (e.g., marketing budget, conversion rates) to build up the revenue;
• Separation of Assumptions
  Ensure assumptions are clearly separated from calculation results. Consider creating a dedicated assumptions section for each spreadsheet or a separate assumption page for clarity;
• Sanity Check
  Always conduct a sanity check of assumptions to ensure they align with business logic and industry norms.
• Stay Conservative
  Plan for contingencies by assuming that something will always go sideways. Even if it doesn’t, it’s better to outperform the plan.

Revenue: The Art and Science of Projection

Projecting revenue is both a creative and critical task, involving a meticulous examination of products or services, pricing strategy, and expected market demand. Two primary approaches — top-down and bottom-up — can be employed:

• Top-Down Approach: Begin by estimating the serviceable addressable market and narrow it down to projected revenue based on the target market share and other parameters.
• Bottom-Up Approach: Focus on the ‘units’ and fundamental factors driving the business, working up to sound assumptions about projected revenues. This approach, often the most suitable, facilitates the testing of assumptions behind revenue projections.

How to employ the bottom-up approach? The crucial factor is granularity: ensuring that every pertinent revenue stream (such as products and business lines) and monetization model (like subscription, take rate, consulting, etc.) are individually and thoroughly modeled. Subsequently, the key revenue drivers for each component are specified, and a link between assumptions and revenue is established.

Points to Keep in Mind:

• Conduct sanity checks to ensure business sense behind each metric;
• Compare results with both the market size (as in the top-down approach) and historical data;
• Ensure projections maintain consistency across the model.

Expenses: Demystifying the Cost Structure

The financial model then meticulously breaks down critical cost items, explaining their link to the revenue line.

Frequently revenue is modelled as a function of expenses such as marketing costs (e.g., if number on new customers calculated via CAC and conversion rates for b2c products with digital distribution) or overhead (e.g., salaries of b2b sales managers for businesses relying on direct b2b sales).

Other expenses are projected based on the company’s operating plans and historical performance. Similar to the income side: consistency and connectivity of model’s elements are the most important here.

Points to Keep in Mind:

• For most early-stage businesses, personnel expenses are the most significant item. Make it granular, detailing each significant position, salary, growth rates, and other compensation factors;
• Ensure all relevant costs are included. Often, taxes are overlooked, and other costs may be underestimated.

Cash Flow: Summarizing the Analysis

The results are synthesised into projected financial statements, offering a comprehensive overview of the business’s financial performance and position.

In essence, the financial model of a startup revolves around cash, culminating in a cash flow line and calculation of runaway period. Grasping these parameters, along with their interrelation with assumptions, is pivotal for crafting and fine-tuning business and operational plans, refining fundraising approaches, and strategizing for scaling, among other considerations.

Sensitivity and Scenarios: Exploring Connections and Mitigating Risks

Financial models often include sensitivity analysis to evaluate the impact of changes in key assumptions and understand the level of risk and uncertainty associated with the projections.

Points to Keep in Mind:

• Identify Critical Variables
  Start by pinpointing the crucial variables or assumptions within the financial model — those parameters wielding significant influence on outcomes. It’s crucial not to cast the net too wide; typically, for most business stages, the optimal approach involves concentrating on 3–5 key parameters.
• Change them
  Then systematically tweak each such variable while maintaining the constancy of other variables. Observe how these alterations impact the output metrics.
• Assess the impact
  Scrutinize the results to comprehend the extent to which each variable affects the model. Some variables may exert a substantial influence, while others might exhibit minimal sensitivity.
• Test scenarios
  Execute “what-if” scenarios by concurrently adjusting multiple variables. This practice aids in comprehending the collective impact of alterations in various assumptions. In our usual practice, we customarily formulate three scenarios (negative; base and blue sky), focusing primarily on the base scenario and evaluating outcomes in alternative cases.

Sensitivity and scenario analysis serve as valuable instruments for enhancing the resilience of financial models. Through methodical testing of the model across diverse conditions and evaluating the sensitivity of critical assumptions, stakeholders can attain a profound comprehension of the risks and opportunities linked to the business or investment. These analyses facilitate decision-making by offering insights into the potential ramifications of different strategic choices, enabling businesses to plan for contingencies and make more informed decisions.

Investment Returns Analysis: Decoding the Game

The foremost concern for a potential investor center around whether a startup’s financial model showcases the potential to achieve the targeted return on investment. Indeed, it’s a bit of founders-investors game where first construct models to demonstrate the outcomes second are looking for. Yet these models must be realistic, cohesive, and comprehensive to substantiate, for example, a 10x return potential.

ROI analysis is typically undertaken by venture capitalists themselves. Each fund may employ distinct approaches and methods to project and assess ROI, with target returns varying significantly based on the VC’s investment strategy. Herewith, some basic principles would be quite similar with outputs of the financial model become inputs for ROI calculation, e.g.:

• A fundraising plan and schedule are developed based on funding requirements according to the cash flow. Each subsequent funding round before the anticipated exit triggers relevant dilution (subject to the VC’s follow-on strategy and other parameters), which can be modelled via the CapTable;
• Financial projections serve as a foundation for valuation, or as a basis for comparison with peers, for both interim funding rounds and potential exits.

We firmly believe that CapTable Modeling, Valuation, and ROI analysis merit a dedicated article, which we will be developing soon. Stay tuned if sounds interesting for you!

Points to Keep in Mind:

• Ensure that valuation, fundraising schedules, and other parameters remain consistent with traction as per the financial model;
• Don’t forget to account for all terms and parameters affecting the final ROI such as dilution, liquidation preferences, potential increases of option pools, etc.;
• Employ more than one valuation method to ensure a comprehensive view;
• Test ROI Sensitivity: Assess ROI sensitivity to key assumptions affecting valuation (revenue, growth rates, etc.).

Closing Thoughts: Beyond Templates

The financial model accessible via this link serves as an exemplary illustration of the mechanics connecting model elements, but not a plug-and-play template. The financial model constitutes the core and driving force of any business. Therefore, it is imperative that founding team delve into its intricacies while developing proprietary model, rather than relying on a generic template. It’s not a mere routine; the financial model serves a multitude of purposes, allowing to:

• Define and understand revenue drivers of business;
• Consider the evolution of costs over time as compared to revenue growth to ensure business model is scalable and can be profitable;
• Build and examine projections for achievability and realism;
• Develop a fundraising strategy;
• Identify areas for operational improvement or strategic shifts.

In essence, a financial model brings numerous benefits that should not be overlooked. It’s not just a tool; it’s a strategic compass guiding businesses through the complexities of planning, fundraising, and sustainable growth.

Whereas this guide is a general overview of the key elements of financial model and approaches used, we hope to keep developing VC Blueprint Series and will complement it with a set of specific models suitable for different stages and monetisation models common in b2b marketplaces space, so stay tuned, more insights are coming!