This is a brief Six Minute Strategist introduction to the objectives behind preparing a financial model for a funding round.
What are you trying to achieve?
A critical part of any financing is the preparation of a financial model of the business. Management teams need to deliver this as part of their financing package and have a detailed grasp of its contents. This does not replace the financial modeling done by the VC themselves. However it is important for the management team to “own” the numbers.
In order to get started we need to have some clear objectives of what we are trying to achieve.
The model needs a straightforward core structure.
2. Profit and Loss Account
3. Balance Sheet
4. Cash Flow
Model your business
Each business is unique so, in my opinion, off the shelf models don’t work. This needs to be a bespoke model of YOUR business. While the core P&L, Balance Sheet and Cash flow should conform to your management accounts, the input, output and Dash Board and Metrics section can be as simple or as complex as you want to make them.
It is important that you capture the key drivers of the business and as much detail as is required to end up with a flexible financial representation of your actual business. Remember though the [80:20] rule; it is very easy to build in masses of detail which in the event has a relatively minor impact on the business. I find what works best is to start with relatively high level assumptions, build the rest of the model and then insert additional detail and complexity later and on a highly selective basis.
One of the key purposes of the model is scenario testing. With this in mind it is important to design your inputs to give you that flexibility. Identifying the key variables and drivers that affect your business is one of the essential elements of this whole exercise.
You should also ensure that you can make global and specific changes. For instance, you might want to change the entire inflation assumption across the whole model. However, when modeling the revenue growth you may prefer to input a range of values across the entire timeline of the model.
This model should belong to the management team and be part of their funding package. This is important. The management team must be able to argue their own world view and valuation in the discussions with investors. The financial model is the key tool for this. GIBO is a well known acronym – Garbage In, Garbage Out.
If you allow the VC to own the financial model (and they will still have one), you put yourself at the mercy of their highly accountancy trained, junior analyst. This individual will certainly have been to good schools and be well trained but is unlikely to have any commercial experience. As a result his financial assumptions and modeling are unlikely to have the same quality as that based on the collective experience of the management team – in my humble opinion. Enough said?
Do not expect the VCs to surrender the modeling high ground to you. They will almost certainly prepare their own model. This will be used as part of their internal process for evaluating their risk in funding your business. It is not likely that they will allow you unfettered access (a working copy) to this model but they will definitely discuss the inputs with you and share the outputs. Their model will also include a complex funding structure element which will enable them to evaluate deal structure and returns. The management team model can build the ROI element into their model but does not need to duplicate this element of the VC model into their own model.
One useful benefit that can be gained is to ask the associate who prepared the model to show you how he has put it together – this is an opportunity to get some advanced excel training and to use some of this knowledge to improve the quality of the management model.
The importance of this model does not end once the financing is complete. The management team should continue to work with it, improve and update it. As the business develops, the quality of the forecasting will become apparent. It is likely that the management team will be judged on their performance according to their forecasts so achieving milestones, identified in the modeling, will be an important factor in the relationship with the VC going forward.
This will become a living document and part of the managements toolbox for their management of the business.
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