Mistakes that Startups make in a Financial Model

Financial modelling is a critical element for startups at any stage. It guides them right from ideation to scaling and seeking investment opportunities. A well-versed financial model forecasts future performance including revenue and expenses. Along with that, it helps founders to make the right business decisions based on data and attract potential investors.

However, financial modeling for startups is not an easy task.It is more challenging to make financial model for startups as compared to mature companies. It carries many challenges and ignorring those challenges can leads to severe consequences. Startups lack historical data to base their financial models as normal companies do. Along with that, as a startup starts its journey, it is in new waters. The market is volatile for it. Evolving business models also present a challenge to design a well balanced financial model. These factors combined complicate accurate financial forecasting and planning.

For startups, financial modelling can be a daunting task. Understanding basic principles of corporate finance is essential for startup founders to develop models that accurately forecast financial health and guide strategic decisions. Mistakes in financial modelling can result in skewed financial projections. Wrong model projections can lead to wrong strategies for startups and may also have a bad impact on investors. To avoid these mistakes, a thorough understanding of possible mistakes in financial modelling is very important for startups.

The goal of this article is to guide startups about mistakes they may commit in financial modelling. Even corporate finance professionals happen to overlook these mistakes sometimes. With the knowledge of pitfalls to avoid, a startup can then make a resilient, sustainable financial model to lead its finances in the right direction. A well-designed financial model can improve the chances of success for startups in acquiring funding and sustained growth.

Key Financial Modelling Mistakes Startups Make

Lets deep dive into all pot holes in financial modelling for startups to avoid. Below are some mistakes that startups can commit while financial modelling.

Wrong Assumptions, Over-optimism & Under-optimism

Mistake

Every financial planning starts with future revenue projections. This means you figure out the chances of the product’s sales. Every entrepreneur believes that their product will change the market dynamics, and eventually, every customer will start buying their products. Unfortunately, this assumption is wrong. There are other competitors operating in the market who are striving to increase their market share. Overly optimized revenue can not only lead to problems in business at later stages. It will have a bad impact on investors as they will be scrutinizing your startup for revenue estimation. Over-estimated revenue can also make business owners take undue risks that they may fail to handle later on.

On the other hand, under-optimizing or pessimism can also have a bad impact on financial modelling. Under-optimization means low business valuation. Which in turn leads to low revenue estimates, which in turn results in undervaluing the startup. Low revenue estimates may deter potential investors or lead to underfunding for startups. Shortage of funding can cause problems in growth and scalability in startups in the long run. Overestimating risks and costs in financial modelling can also make startups less viable. A pessimistic view of point can also lead to avoiding crucial calculated risks for startup success.

Solution

In short, a well-balanced revenue forecast is required in financial modelling. As a startup founder, you need to be realistic about the market and current business conditions. You can use scenario analysis to include all three possible situations: realistic, optimistic and pessimistic. For revenue estimations, you need to study the market very carefully. Moreover, you need to understand the size of the addressable market, the actual demand for the product and the achievable market share in a specific time span. You should do a thorough analysis of industry trends, competitor benchmarking, and consumer behavior studies.

Misaligned Financial Model Formatting

Mistake

There are many formats of financial models, and every model has its own uniqueness and compatibility. These formats change as the industry or business changes. Entrepreneurs use the most generic form of financial model template, which is not usually the best one for the startup industry. Generic financial models often fail to capture specific key performance indicators (KPIs), financial ratios, and operational metrics specific to the startup industry. This can result in misrepresentations or overlooked variables that have a significant impact on the business forecast as well as operational planning.

An entrepreneur must understand the type of business under which they are operating and make the model according to norms, and patterns, which segregate every head and deliver proper meaning. i.e. SaaS industry has a totally different financial model as it has to calculate the MRR, Churn rate, CLV, and bounce rate, but these heads will not be used in the real estate industry. So, both industries have entirely different dimensions and metrics.

Solution

As a startup founder, you should pick a financial model that is tailored according to your industry specifications. You must research the metrics for your industry and build a model accordingly. There are many financial modeling templates available that you can search and find one according to your needs. If you can not find one as per your requirements, you can opt for custom financial modelling services.

Along with that, startups also need to customize their models according to business stages. For example early stage startups may focus more on burn rate and time to become profitable. While a more established startup may be more interested in scaling and market penetration. You need to consider the stage of your business and work accordingly.

Lack of Dynamic Financial Modeling

Mistake

Static financial models are rigid by default. They do not update automatically when an input variable changes. In startup, things used to change quite rapidly. You can not make a new financial model every time anything changes in your business. As a result, you may be relying on an outdated financial model for your financial decisions, which can lead to bad consequences.

Solution

You need a dynamic financial model for your startup. An effective and efficient financial model is one that is interconnected with statements i.e., Income Statement, Balance sheet and  Cash flow statement, also known as 3-statement model. If we change one input assumption, the whole financial model will be changed instantly. In dynamic financial modelling, a single change in every variable is reflected in every place where that variable is further used in the model. In this way, you are never making any wrong decisions based on outdated assumptions, as your model will be getting updated regularly. Along with that, dynamic financial modelling allows startups to conduct scenario analysis too. Startup founders can change any variable and can observe the impact of that change on finance in a jiff. Dynamic models will make your life easier, but you also need to update them regularly. Set up a schedule to update your model so that you have updated information every time you need it.

Unrealistic Profit Expectations

Mistake

Sometimes, an entrepreneur is eager to get a big profit chunk and expects that the company will be in profit from day one. They deliberately show high revenue and low expenses in order to manifest high profit to attract investors or banks. However, investors and banks are aware of the market norms. They can easily identify over-estimation during company analysis. Over estimations come up as a question to the credibility of the complete financial model. Therefore, entrepreneurs don’t get the investment. Overly favored profit projections result in poor strategic decisions. Which can impact the business growth rate very badly. Accurately modeling the rate of return on investments is critical. Overestimations can lead to unrealistic profit expectations and strategic missteps.

Solution

As a startup founder, you should gather data related to profit margins from industry reports, competitor financial statements, and market analyses to assess what is achievable. Understand the detailed cost structure of the business as it is proportional to the profit margins.  Go through future cash flow projections. You also need to have a dynamic model that changes easily when profit stats change.

Vague Capital Needs

Mistake

How many funds do your business require, and how will you utilize these funds? These questions must be at your fingertips. Overfunding can result in capital wastage. While underfunding can be a hindrance to a startup’s growth. Investors and lenders need to know how much capital a startup requires and for which purpose. If you can’t explain it properly in your entire model then most probably you can’t secure the investment from the investor and can’t build the trust level.
Every entrepreneur wants cash for their business, and they want to take out maximum capital from the investor’s pocket even when they don’t need it. Eventually, this breach comes out and affects the founder’s credibility very badly.

Solution

A detailed explanation of funding requirements and publishing improves the credibility of the startup as it shows that the founder is well-versed with his market conditions. Startups seeking investment should clearly articulate their capital needs to potential private equity firms, demonstrating a deep understanding of how the funds will be utilized to drive growth.  As a startup founder, you need to include a detailed budget model while financial modelling that shows where every penny is getting spent. Categorize expenses into critical areas like marketing, operations, manufacturing etc. If possible go for month by month financial forecast of capital needs. Along with that, you can present scenario analysis in a financial model to investors, which shows different capital needs as per realistic and pessimistic cases. Along with that, if possible, you should create milestones to represent to the investors when the capital will be used for which person.

Disconnect Between Business Plan and Financial Model

Mistake

Most of the time entrepreneurs often forget to consider the business model while building a financial model. Both terms are different but it’s like two tires of the same vehicle. Business plans and financial models are must-haves to represent the startup vision. They need to be aligned with each other. Investors and lenders need to understand both the documents. Lack of alignment in the document is an off-putting thing. While building a financial model, founders usually forget to consider their business model. 

Solution

As a startup founder, you need to consider your business plan in the financial modelling process. Your financial model must be dynamic, and when anything changes on the business plan, make sure to include that change in the financial model. Ensure that your financial model reflects the business plan using appropriate valuation models to estimate the economic value of your startup effectively.  For example, a business plan includes a list of proposed new products and features. When you start working on any new product or feature, you need to include that information in the financial model. Frequently update your financial model.

Irrational Growth Projections

Mistake

When business magnates prepare financial models, they put the irrational growth rate while forecasting revenue. Overly optimistic projections can lead startup founders to make poor decisions, such as over-aggressive business expansion plans and immature scale-ups, which can lead to financial strain later on. When a startup fails to meet its projected growth, it can lose investors and lenders confidence. Investors will be skeptical to invest in someone who is not clear about his numbers. Along with that, an overly optimistic profit rate, when not achieved, affects morale and operational efficiency not only for the founder but for employees, too.

Solution

It is very necessary to find out the real and logical growth rate for the company, and growth always depends on the market. As a startup founder, you need to carefully assess the market and include possible profit projections in the financial model. You need to study industry trends and historical growth rates in your industry. Benchmark your profit projections on the industry average. An entrepreneur should not expect a higher growth rate than the industry rate. Factor in the macroeconomic situation and competition in the industry. technological changes, regulatory impacts, and shifts in consumer preferences can impact your business. You need to factor those, too, while projecting growth potential. As already suggested, you can use scenario analysis in financial modelling to account for all possible changes. Continuously review your business and market and keep your growth projections up-to-date.

Overestimating Market Reach

Mistake

Entrepreneurs sometimes overestimate market research in financial models, especially in terms of Total Addressable Market (TAM), Serviceable Available Market (SAM), and Serviceable Obtainable Market (SOM). Overestimation can lead to unrealistic business projections and strategic misalignments. Startup founders need to understand these metrics accurately. Utilization of these metrics appropriately in market projections is crucial to setting realistic growth targets. Along with that, it helps to allocate resources effectively. On the other hand, overestimating these metrics can have a very negative impact on business financial performance. Startups may invest heavily in production and staffing due to misunderstandings in market size. That may eventually result in wastage of resources as they are not according to the requirement. In short, as a startup decisions are highly influenced by market stats, and wrong assumptions can have diverse impacts on them.

Solution

The solution is to understand market-related terms thoroughly.

• Total Addressable Market (TAM): TAM is a business metric related to market. It represents the entire revenue opportunity available for a product if 100% market share were achieved. It includes everyone in the potential market who may buy the product, irrespective of the current realities of the market.

• Serviceable Available Market (SAM): It is a subset of TAM. It is market share within your access i.e. within your market capabilities and geographic location.
• Serviceable Obtainable Market (SOM): SOM, on the other hand, is a market share that you can capture. It considers the current and projected competitive environment and the limitations of your marketing and sales capabilities.

As a startup founder, you need to do thorough research to understand demographics, along with the preferences and needs of the market. Use reliable data sources. Conduct thorough competitor analysis. If you can find historical performance data related to the product, try to include that in your research, too. Break data into customer segments according to their needs and choices to target them properly. Remember, financial modelling is not a one-time process, and you need to refine your model every now and then to keep it updated.

Ignoring Working Capital Requirements

Mistake

Ignoring working capital requirements is the biggest mistake that most entrepreneurs make while venturing into business. Keep that in mind: “Cash is King”. A company can run at a loss but can not run without cash, just like a human can’t live without blood. Working capital is the difference between startup current assets and startup current liabilities. It is a financial buffer used to meet the short-term liabilities of a business. Ignoring working capital requirements can lead to financial difficulties, cash flow shortages and reduced operational efficiency. Proper management of working capital is crucial for work management. Keep that in mind: “Cash is King”. A company can run in a loss but can not run without cash, just like a human can’t live without blood.

There are many companies that require high working capital to run operations effectively. If you are an e-commerce vendor on Amazon, when you sell, Amazon will deliver the product. But there payment terms say that Amazon will reimburse the sale amount after some period of time. Which means you have accounts receivable but need to wait for the cash in hand. Meanwhile, you should have extra cash in reserve for re-ordering inventory in order to make sales. Or in a peak season, a business may need to order raw material for production but lacks cash to do so.  Without proper consideration of capital requirements, financial modeling can lead to financial strain in business. It can further lead to poor inventory and credit management.

Solution

To avoid this mistake, you should properly forecast capital requirements in the business. Conduct a proper cash flow analysis. Effective forecasting helps anticipate future needs. Additionally, you can utilize effective inventory management techniques such as Just-in-Time (JIT) or Economic Order Quantity (EOQ) to optimize inventory levels. Moreover, you need to include predictions about cash inflow delay. Also keep track of cash outflow. Additionally, some businesses have seasonality and trends too. Make sure to adjust that while financial modelling. Keep on adjusting assumptions as you get new data to make your model reliable and up-to-date.

Inaccurate Expense Forecasting

“Beware of little expenses. A small leak will sink a great ship. “

Benjamin Franklin

Mistake

Accurate expense forecasting is necessary for effective financial modelling. Accurate forecasting ensures that you have control of the complete situation. Without proper expense estimation, startups may fail to manage cash flow effectively. They may face financial pitfalls in their journey. Precise expense forecasting helps in budget control and cash flow management and guides toward informed decisions. Ignoring all important factors can lead to bad expense estimation that will lead to financial suffering later on.

Solution

To avoid this mistake, you need to analyze historical data to identify trends and patterns. Include all types of expenses, fixed costs, variable costs, overhead expenses, everything. Include macroeconomic factors such as inflation rate, economic growth, political issues etc. Along with that include microeconomic issues such as contractual increases in rent or salaries that can affect expenses later on. Keep into account all financing activities. Use scenario analysis in financial modelling to better assess expenses in different situations. Update the financial model regularly to keep it up-to-date.

Lack of Comprehensive Timeframe Analysis

Mistake

Sometimes, entrepreneurs build a financial model on a monthly basis but don’t give importance to the yearly model. You should compile the monthly financial model on a yearly basis so that it may highlight the cost and return on a yearly basis. The financial model must contain both monthly and annual projections of financial conditions. Without annual views, resource allocation may be misaligned with needs. It can lead to resource scarcity or wastage. Looking just on a monthly basis can lead to misjudged perception of financial health and strategic missteps.

Solution

To avoid this mistake, adjust your financial model to show results on both an annual and monthly basis. Monthly projections will show the short-term view of cash flow and revenue etc.  Moreover, it will show whether the startup was able to acquire its term targets. Whereas an annual model projection shows long term growth and the work potential of the company. Many businesses have trends based on seasonality. In that case, monthly projections will show company performance for the on-season and off-season. While yearly projection shows performance for the whole year.

Underutilization of Graphical Data

Mistake

We have to admit financial models are boring and difficult to understand. Most of entrepreneurs only build a financial model and forget to make a graphical representation of their model. It is suggested to make a separate dashboard section. Graphs speak louder than numbers, as it is more understandable and very helpful in analyzing and decision-making. Grasping different numbers is tough, and equity investors do not have time to analyze each number.

Solution

Use graphs and charts to represent your numbers in financial modeling techniques. A well-formed financial model with proper formatting according to startup branding has a positive impact on investors. Visual elements like dashboards and graphs make financial analysis much easier. They help in decision-making and save a lot of time as you do not have to observe and think of all numbers one by one. Graphs are best for effective communication. They can be used to provide a comparison for any financial metric under consideration in a better way, too.

Frequently Asked Questions

How Is a Financial Model Validated?

Validating a financial model involves ensuring accurate input data, testing under different scenarios, comparing with historical data, and conducting sensitivity analysis.

How to Structure a Financial Model?

To structure a financial model effectively, define objectives, organize data logically, build accurate formulas, document assumptions, and maintain consistent formatting for clarity.

Conclusion

Navigating financial modeling can be complex for startups, given their lack of historical data and the volatility of markets. This discussion outlined common mistakes, such as over-optimistic revenue projections and underestimating working capital needs, along with solutions to mitigate them. By aligning financial projections with market realities and implementing best practices, startups can enhance credibility with investors and improve their chances of long-term success. Maximize your startup’s potential with Oak Business Consultants’ specialized financial modeling solutions. Take charge of your financial future today. Contact us to tailor your startup’s financial strategy for success.