Investors seek the familiar; they seek investments that are analogous to companies that they admire. They would like to believe that you can be successful because you are like another company that has been successful, which is understandable and provides proof that it can be done. Create your plan around a successful like-company and make that your model. Use these words, “We based our model on ______________. Where blank equals a successful, preferably public company (so that you have access to their model) to which you can realistically be compared. Then, here’s the recipe:
Building a five-year financial model:
- Create A Model Based on Ratios – Pick a model company that is public. Find their SEC public filing document (S-1). The advantage of the S-1 is that it reveals financial information for years prior to when the company went public. These numbers will be useful in building your model. The company should be similar to yours in terms of business model, potential margins, capital efficiency, human capital costs, etc. Ask yourself if you can rationalize those kinds of margins and other important financial ratios. If the answer is yes, then that is your model
- Unit Economics and Drivers – Use unit economics which includes, revenue per customer sale, customer acquisition cost, Cost of Goods Sold (COGS), number of employees, cost per employee, and understand how the revenue and cost drivers change with scale.
- Determine Your Realistic Top-Line Revenue 5 Years From Now -Size the market. What is the total addressable market for your product? How many potential users? What can you charge? How much of that market can you realistically expect to capture in 5 years?
- Create A Five-Year Plan – Now, using the 5-year revenue number, apply the ratios from the model to determine what your financials would look like in year 5. That includes Revenue, Salaries & Bonuses, Cost of Goods, Marketing & Advertising, Number of People by Department, etc.
- Create A Year One Financial – Build a bottoms-up plan based on what you believe you will do in year one. This is a complete bottoms-up plan based on your knowledge of how many people you must hire, rent, capital equipment, and customer acquisition costs and revenues.
- Fill In Years 2 – 4 – For each year after year 1 and before 5, rationalize each line item to get to the model number of year 5. In each succeeding year, you should make realistic changes to the expense ratios closer to the year 5 target.
Every experienced investor will discount your projections. They will give your revenue projections a haircut, and they will increase your expenses. The proverbial hockey stick is as much of a start-up pitch cliche as a win-win, google-killing, uber-like, thought-leadering, paradigm-shifting, game-changer. Yet the key to the execution of a plan is to have one. The key to reaching a goal is to set one. This method enables an entrepreneur to sign up for a target, and monitor progress against that target. Having a sound financial vision based on a model company allows you to set goals, monitor progress, and adjust to reality.
A company should build a financial plan based on a target model, whether they are pitching for venture capital or just trying to execute a plan. Without a model, you don’t have a destination, and without a destination, you’ll never know whether you got there. Now go get there.
Having a good plan based on sound judgment prepares you to defend your business assumptions and portray you as a thoughtful, intelligent, strategist, who has a vision of you will execute your plan.