Finance model of your startup: what is it, and how do you apply it?

One of the most significant factors for a startup’s success is a thorough business plan that includes reliable financial projections for startups. The more accurate economic predictions you perform, the higher is the chance of success. Also, it makes it easier to ride out the market storm caused by the COVID-19 pandemic and other instabilities.

In this article, we give you an understanding of the following points:

• Essential purposes of financial projections for startups
• The prime purpose of the financial projections
• Two main methods of financial projections preparations for startups 

• Methods of creating realistic projections
• Types of statements which financial projections include
• Final thoughts on how to create a starting advantage

The importance of financial projections

Choosing the right financial model and creating financial projections are a crucial aspect of the core small business plan, especially for newer companies. By considering factors like production costs, market prices, and demand for your services, you can clearly understand your financial situation and discover your full profit potential. When you have projected expenses and income, it becomes significantly more comfortable with making business decisions.

Financial projections help you plan your startup budget, forecast the break-even, and set benchmarks for achieving financial goals. If you’re already running the business, creating brief financial projections every 6 or 12 months will help you keep your startup on the right track.

Besides, a defensible financial projection model can reassure investors that the entrepreneur has analyzed the business’s potential, and there is a path to earning a return that justifies the early-stage risk significantly. It’s always best practice to create a robust financial projection model before pursuing a business venture. 

Two main approaches to creating financial projections for startups

There are two methods of making financial projections for startups – top-down forecasting and bottom-up forecasting.

What’s the difference?

Top-down forecasting

The top-down approach assumes that you work from a macro/outside-in perspective towards a micro view. Usually, industry estimates are taken as a starting point and narrowed down into targets that fit your startup. In fact, the top-down model helps you define financial projections based on the market share you would like to occupy within a reasonable time. The most straightforward way to precisely perform top-down forecasting is the TAM SAM SOM model.

The TAM SAM SOM model reaches the market size on three levels:

• TAM (Total Available Market) the section of that market you approach with a specific offering (your startup niche) adjusted for a particular geographical reach. 
• SAM (Serviceable Available Market) – The part of SAM you can realistically capture, given the existing competition. 
• SOM (Serviceable Obtainable Market) is equivalent to your sales target. It defines the value of the market share you aim to achieve.

Based on the sales targets you set using the TAM SAM SOM model, the next stage is to evaluate all costs needed to build or deliver your product or service. All expenses are necessary to perform sales and marketing, research and development, and general and administrative tasks for your startup to stay afloat. Evaluating these indicators keep in mind that you need to aim for profitability within a reasonable timeframe. 

Bottom-up forecasting

The top-down approach’s trap is that it might seduce you to forecast too optimistically, especially sales estimation. To avoid this unpleasant moment, you should consider combining the top-down model with the bottom-up approach. As opposed to the top-down method, the bottom-up strategy begins with an inside-out view. 

With the bottom-up approach, you calculate expenses, costs, revenues, and investments based on the research and assumptions. The problem with this method is that it might fail to show the confidence needed to convince others of your startup potential. If you are a startup founder and are looking to raise funding, the bottom-up strategy might not help you. Remember that most investors usually expect startups to grow fast and gain significant market share quickly. The bottom-up approach might fail to indicate that.

Which method to chose?

It is almost impossible to estimate factors such as virality or word of mouth with the bottom-up approach. Further, the whole reason why external financing is needed is often to expand capacity and grow faster than a startup would do organically. That is why when you build your startup’s forecast, you need to combine both the bottom-up and top-down methods – especially when you plan to achieve a healthy growth curve utilizing external funding. For the best financial estimation, use both models. The bottom-up method is mainly used for 1-2 years of forecasting. While a top-down approach is more suited for the longer timeline of 3-5 years.

This way, you can complete and secure your short term objectives very well. And your long-term targets will show the desired market part, and the ambition investors are searching for. 

How to make realistic assumptions

No matter what approach you choose to build your startup’s financial model, it is essential you can prove your numbers with realistic assumptions. The main problem is that previous data is not available, so you need to find a way to present the proof behind your estimated numbers. When you start discussing with investors, they are interested in knowing the argumentation behind your numbers. They are considering putting money in your startup, so you do not want to give them the feeling you are selling baloney! Assumptions can be anything that validates your numbers:

• Market research
• Web search volume
• Contracts with suppliers
• Pricing validation 
• Conversion rates

Okay, that is more than enough to get started. Let’s get to it, then! We will begin with questions that reflect the challenges behind creating financial projections for your startup.

What statements are included in financial projections

Financial projections combine three financial statements that are necessary to better understand the financial performance of your startup.

Income statement

It is also known as a profit & loss statement, and it focuses on the startup revenue and expenses generated during a particular period. The four estimates included in the income statement are:

• Revenue
• Expenses
• Gains
• Losses 

Combining these four gives you the net income, which is a metric for your startup’s profitability. In the first year, you need to create a monthly income statement. 

In the second year, quarterly statements, and in the years to come, you will just need an annual income statement. 

Cash flow statement

A cash flow statement aids you in understanding how startup operations will run. It will show more detail on how much money will flow into and out of your startup business in income and expenses.

A cash flow statement’s three fundamental components include cash flows from operating, investing, and financing your startup activities.

1. Operating activities include any changes made in cash flow, accounts receivable, inventory, depreciation, and accounts payable.
2. Investing activities include cash inflows for sales of assets and cash outflows for any fixed assets, such as property and equipment.
3. Financing activities show a business’s cash sources from investors or banks and cash paid expenditures to shareholders. 

The cash flow statement and income statement are both tightly connected by net income. 

Balance Sheet

A balance sheet presents a general overview of your startup’s financial health. It includes assets, liabilities, and owners’ equity in a specific period of time. 

Here is an overview of each balance sheet component:

• Assets are resources with a financial value that a startup business owns and estimated to provide a future benefit. That includes generating cash flow, enhancing sales, and reducing expenses. Assets usually include property, inventory, and cash.  
• Liabilities are, in general, obligations to the third party. They are monthly expenses that occur during business operations. It usually includes accounts payable and loans. 
• Owners’ equity is any amount left over after paying all liabilities. It’s usually categorized as retained earnings: the sum of all net income earned minus all paid earnings since inception.

The balance sheet is split into two parts – with assets on one side and liabilities and owner’s equity on the other side. Projecting three years into the future could make it possible for you to estimate a break-even point. When your startup ends performing at a loss and begins to turn a profit. The break-even point for most of the startups is in about 18 months. However, that threshold will fluctuate based on your business model, industry and niche involved.

How to create an advantage 

Planning financial projections for your startup when it’s not yet up and running can be a challenge. At that point, you do not have any real data to give you a better understanding of future projections. Still, with a little market and industry research, you will have a lot of data to work with, helping you to create realistic financial projections for your startup. Here are some things to have in mind.

Use your own industry experience

Before striking out on your own, consider the industry you have been working in and have experience working in. That way, you will have a better idea of what realistic financial projections look like, what growth rate is ideal, how long it will take to scale, and what profit margins are average within your industry niche. 

Be a realistic optimist

Potential investors know that your startup’s financial projections can’t be 100% accurate, but you need to make sure they are realistic. Lending institutions and investors have seen too many entrepreneurs who are overly optimistic about their businesses. So as a future startup owner, you need to make sure your projections are reliable, and your business has the capacity to grow.

Start making your financial projections today and pursue your dreams with passion since they will not come to pursue you!