Mistakes that Startups make in a Financial ModelSadaf Abbas
Importance of Financial Model
Dear Entrepreneurs, whether you are working on your idea, or about to start your venture or you need investment or lastly, you’re already running your startups successfully. Whatever the position of your business is, you can’t ignore the importance of financial modeling and avoid mistakes that Startups make in a Financial Model. A lot of entrepreneurs build models of their business but failed to interpret their values in front of investors or lenders. In my career, where I have gone through various financial models of startups and growth companies, I have found the same mistakes in every model that all startups make.
This article will let you know, the mistakes that an entrepreneur makes in their business journey.
1. Wrong Assumptions, Over-optimism & Under-optimism
Every financial planning starts with revenue projection, which means you figure out the chances of the products’ sales. Because every entrepreneur believes that their product will change the market dynamics and eventually every customer will start buying their products, this assumption is completely wrong. There are other competitors operating in the market who are striving to increase their market share.
Being an entrepreneur, you must do intensive market research regarding your products and measure the actual market that you can capture in a period of time.
You can find out the perfect way to measure the actual market size for business as well.
2. Formatting of Financial Models helps to avoid mistakes that startups make
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 models, which is not actually interpreting any meaning to the investor. An entrepreneur must understand the type of business under which they are operating, and make the model according to norms, 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. So you must know the industry’s metrics and build a model accordingly.
Check out our article to build robust financial modelling
3. Lack of a Dynamic Model and you’re will make mistakes that startups make in financial model
Obviously; Not all entrepreneurs are experts in finance or financial modelling, but also finance guys often make this mistake as well. An effective and efficient financial model is one that is interconnected with all 3 statements (i.e. Income Statement, Cash flow, and Balance sheet). If we change one input assumption, the whole financial model will be changed instantly.
If your model is not dynamic, trust me your life will be ruined just to find out the errors.
4. Too High-Profit Margin
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 the high profit to attract investors or banks, but investors and banks are aware of the actual cost or time to be in profit. Therefore, entrepreneurs don’t get the investment.
Every entrepreneur must know and figure out the actual expense that is expected to occur in the business, besides that they must know the industry’s profit margin, therefore don’t expect higher profit than the margin line profit of the industry.
5. Inadequate Explicated of Funding Required
How many funds do your business requirements, and how will you utilize these funds? These questions must be at your fingertips. If you can’t explain it properly in your financial 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 they don’t need it. The breach comes when an investor sees the financial model that gives a clear abstract of the financial position. Investor easily finds out the real cash injections that business needs and investor evaluates the business accordingly.
It is advisable to think from the investor’s perspective while building the financial model.
6. The Discrepancy between the Financial Model and Business Model
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. While building a financial model, they usually forget to consider their business model. For e.g. when you are planning to upgrade your product features, you must consider R&D and marketing costs will go up in that period which has to reflect on the financial model as well. It is very usual that startups often forget to reflect the organization’s strategy in financial modeling.
7. Hallucinated Growth Rate
When business magnates prepare financial models, they put the irrational growth rate while forecasting revenue. It seems that entrepreneurs are immature. It is very necessary to find out the real and logical growth rate for the company, and growth always depends on the market. An entrepreneur should not expect a higher growth rate than the industry rate.
8. Over Optimistic Revenue compared to market size
This is something that also connects with the above heading. Many entrepreneurs used the TAM/SAM/SOM model to figure out their niche market. TAM (total available market) is the total worldwide market irrespective of your availability. SAM( serviceable available market) represents the geographic market where you can actually work on that. And the last funnel is SOM (service obtainable market) is a niche market that you expect to capture in a reasonable time.
This projection must reflect your financial model and your revenue model should exceed SOM.
9. Disregarding the importance of Working Capital
This is the biggest mistake that most entrepreneurs do while venturing into business. Working capital means a reasonable amount of cash has to be available in the business in order to run the operation smoothly. Keep that in your mind “Cash is King” a company can run in the loss, but can not run without cash, just like the human can’t live without blood.
There are many companies, which 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 and Amazon will reimburse the sale amount after some period of time, which means you need to wait for the cash against the sell that you already made, meanwhile, you should have extra cash in reserve for re-ordering inventory in order to make sales.
This is the perfect example that shows that you need cash reserves (Working capital) in order to run the company’s operations.
10. Arbitrary numbers for projecting expenses
Just like forecasting revenue, you also need to project real numbers for expenses. Don’t put a random number in the expenses. Every entrepreneur must gauge the expenses heads and calculate their amount accordingly, e.g in the financial model when the revenue increases, the Cost of Goods/Services will also increase accordingly. Similarly, employees’ needs will also increase as the company will grow. Hence, operational expenses will also increase.
11. Missing Financial Summary and you will make mistakes that Startups make in the financial model
Investors or lenders always want multiple documents along with a detailed financial model. The investor always wants the summary of a financial model that most entrepreneurs forget to summarize. Every entrepreneur must prepare the summarized documents that give the abstract of your business and financial model that the investor can read before he goes into a detailed model.
12. Shows financials on a Yearly Basis rather than monthly
This is the same as mentioned above but a little different. 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.
13. Inadequate Graphs and avoid mistakes that Startups make
Graphs speak louder than numbers, as it is more understandable, very helpful in analyzing and decision making. Most of the entrepreneur only build a financial model and forget to make the graphical representation of their model. It is suggested to make a separate dashboard section.
Life is full of experiments and learnings will never stop for anyone. This is a List of Mistakes that most startups do in their business journey. Hope you will find the best solutions.
Oak Business Consultant is specialized in helping startups and Running companies to grow. Our Bundle of the solution will make your life easy and give you a deep analysis which will help you rectify your model. We believe in long-lasting relationships and aims at serving every client to the best of our knowledge. Feel free to contact us for more assistance.