The Key to Building Your Startup Financial Model: Forecasting
Originally published in AffinityLive.
One of the most important things you can to ensure the financial health of your business is to create your revenue model. Your revenue model gives you a necessary understanding of your cash flow and needs and is your way of demonstrating—to yourself and to potential investors—how you plan to earn revenue and maximize your profitability.
The key to creating your revenue model is through forecasting—that is, projecting revenue estimates, even if you’re currently pre-revenue. Forecasting is an ongoing process that will help you to manage your cash and continue to grow. There are two general approaches to financial forecasting: top-down and bottom-up forecasting.
To be honest, top-down forecasting is a bit bogus in terms of giving you realistic numbers, but it’s still a necessary exercise when seeking funding. With top-down forecasting, you start with the overall market size and use this to identify your particular segment. You extrapolate from total market to predict how much you can hope to capture; you then use this to calculate your total potential revenue.
Conversely, with a bottom-up financial projection you flip your forecast upside down. Instead of starting with the total market, you identify key variables to project your revenue over the next year or so. You calculate the spending necessary to achieve your revenue and development goals and identify what’s driving your revenue. From here you can predict how quickly you can scale based on headcount and milestone projections.
We’ve worked with many clients to help them through the process of creating their revenue model. This has enabled us to synthesize the key considerations for developing your revenue model. Here are top seven:
1. Choose a revenue model approach that is best for your company and background.
For example, if you have a team of engineers with good business sense, a technology model—where you identify where you are in your R&D model and where you expect to be in the next phase and into the future—will be a good fit for your company. Depending on your company type, it may make sense to have revenue projections that are linear in nature or ones that are exponential (in other words, do you want to mitigate capital risk and start small and build from there or prove your revenue model at scale?). Ultimately, you want to choose a model that helps you to direct your development efforts.
2. Your revenue model should allow you to communicate your value.
What is special about your offerings? Your revenue model should show what is unique about you. For example, if you offer the kind of service that customers will subscribe to, this is a selling point.
3. Identify potential investors strategically based on your revenue model.
If you’re looking for funding, it helps to identify strategic investors who are knowledgeable in your space. Make development choices that speak strongly to investors and build your pitch around these choices. Think big picture and long-term and try to find like-minded investors, financiers who aren’t just looking for profit short-term but are willing to wait for ROI to be realized.
4. Project out into the foreseeable future.
Investors want to know what the time horizon looks like, when there is going to be money to be seen, what the next major milestones are—bottom line…when are you going to start making revenue? And this is important information for you too, of course. But you you can’t predict with any level of certainty too far out—no further than 12-24 months. Farther out, it just becomes a ludicrous exercise where you have meaningless numbers on the page.
5. Understand that your revenue model is always evolving.
The overall architecture of your approach may not change much over time, but you should continually be refining your model and reforecasting. There are many revenue models to choose from. For example, if you’re a service-based business, you can sell services individually or offer a subscription model. Just keep an open mind and accept the fact that you may need to pivot your revenue model at some point if it’s not working to support your business.
6. Identify the key variables for your company.
Your variables will be process specific and will depend on what stage you’re in. Basically you’re looking to find those variables that have the most impact on your revenue—and figure out what they are most sensitive to. You need to be able to isolate these particular variables so that you can address them individually. Analyze input and research values to identify if they are good where they are or if they need work. A sensitivity graph is a great tool for looking at each separate value and graphing its potential impact on revenue as that value changes. Charting this enables you to see at what point revenue improves or worsens as the data is manipulated.
7. Mitigate for variables.
The goal is to get your variables to a point where you can mitigate them. You want to be confident in your numbers—this means seeing them realistically. There’s no sense in hiding from risk; you should identify it, understand it, and directly address it. Mitigating for variables leads to transparency which is good for your own understanding as well as for investors (who are always going to find something even if you try to hide it!).
There is a lot of choice when it comes to developing your revenue model—but not creating a revenue model is not a choice. From helping you to stay focused to helping you to develop your service, your revenue model is the necessary foundation for your company’s success.
What are the challenges you face in developing your revenue model? Tell us about it in the comments section below or contact Early Growth Financial Services for strategic financial guidance and day-to-day accounting support.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.