Numbers really count: Why financial modelling is key for startups

*This article is adapted from * The Business Times

Access the print version here.

THROUGHOUT my professional career, I have held different technical and business-focused operating roles before coming to early-stage investing. The domains and work have been varied, but one fact has remained consistently very present – financial modelling.

When I first joined the workforce, financial modelling was a new skill set to be learnt, and I approached it with gusto. After I had somewhat picked up the skill, it became a chore that needed to be dealt with. Over the years, I churned out many models while wondering what value they brought to my stakeholders.

Now, as an early-stage investor, I analyse startup financial models and collaborate with founders to refine and augment them, and have developed a newfound appreciation for the art and science of financial modelling. Even for a young company without an extensive track record, a financial model can be so much more than a budgeting and performance monitoring tool.

Showcase of the founders’ vision and ambition

As a venture capitalist, I seek investment opportunities that have the potential to deliver outsized returns. While it is certainly impossible to accurately predict the future, during the due diligence process, I do my best to understand the founders’ vision and ambition for the kind of company they aspire to build.

Are the founders aiming to disrupt the current market incumbents and win market share? Or, is the goal to define a new category and become a first mover in the new market segment? Are the founders expecting to maximise value creation and position the company for sale within a fixed time frame, or do they wish to build an enduring enterprise that will eventually be traded publicly on a reputable exchange?

Beyond knowing where the founders want to get to, I also try to gain insights into the founders’ key strategies in realising their ambitions. For example, how will the business make money? On whom does the company rely on to make money? How will the company optimise between cashflow and growth? How much more capital do the founders intend to raise?

There are no wrong answers to these questions. However, entrepreneurship can be a long journey, and founders must consistently have the fire in their bellies to keep fighting for their dreams. Knowing what fuels that fire helps investors such as me visualise the founders’ ambitions through their lens, and understanding their strategies and mindset helps us evaluate each given opportunity more holistically.

Demonstrates founders’ rigour and provides clarity on value drivers

Vision without action is futile. A sound financial model will guide founders in putting the right actions to bring their vision to life.

To build a coherent plan, the founders must first identify and quantify the base assumptions relevant to their business. These assumptions may relate to the company’s pricing philosophy, business development strategies, expected sales volume, cost of goods and services, operational efficiency, working capital needs and organisation structure, just to name a few.

More often than not, multiple iterations are required to calibrate such assumptions against a company’s past performance, ongoing market dynamics and future risks. The process takes time. Far from being a burden, a thoughtful financial model can help founders gain clarity on the true value drivers of their business, as well as identify blind spots that can derail growth plans.

The discipline and the rigour that founders place in undertaking a financial modelling exercise can also better prepare them for variables and enhance their sense of confidence in dealing with uncertainties ahead of them.

Facilitates constructive discussions

Financial models are not only made for fundraising. They also exist to support management decision-making.

One of the most rewarding aspects of being a venture capitalist is to be able to work closely with founders to navigate critical decision-making to support their companies’ growth. All startups go through ups and downs during their lifetime, and founders will – more often than they like – be faced with difficult choices that can alter the trajectory of their businesses. These decisions are often made in consultation with their interested stakeholders – such as co-founders, key management, shareholders and the board.

Without a good discussion framework, high-stakes discussions can trigger strong emotions, making it difficult for the parties involved to remain objective and rational. While the art of negotiation is a whole separate domain in its own right, founders can proactively facilitate constructive discussions among relevant stakeholders by using their financial model to objectively illustrate the hard truths, debate opportunities and trade-offs.

In my experience, even during good times, a robust financial model can provide a strong foundation for collaborative and creative brainstorming among investors and founders.

A pro tip: formatting matters. When crafting a financial model, formatting and visual consistency should not be trivialised. Suitable choice of font style, colour scheme, and table formats can significantly enhance readability, while the elegant use of dynamic formulas and cell references can allow easy adjustments and minimise human error. A readable financial model shortens the time required to decipher it and ensures that time is well spent on analysis and decision-making.

A model is a living document

What has rivers but no water, forests but no trees, cities but no buildings? The answer to this riddle is a map.

In many ways, a financial model is exactly like one. Like a map, a financial model is an abstraction of a much more complex and nuanced reality. It represents its writer’s view of the world at a given point in time. It requires constant updating to reflect the latest terrain. Hence, founders and investors should be careful not to be chained to their models, but rather treat them as navigation guides. When underlying assumptions change, stakeholders must exercise careful judgement on whether to stay the course or pivot to survive.

For early-stage startups, assumptions can shift quickly and frequently. Precisely because of this, as tedious as it may get, embracing the art and science of financial modelling can give power to early-stage founders and investors.

It is an art because it demands creativity and imagination from both its authors and audience. It is also a science because it requires rational thinking and discipline from all parties involved to give it meaning. For founders, a good financial model is a formidable vision board for manifesting and communicating their ambitions. For investors, analysing a company’s model is probably the next best thing to gazing into the crystal ball to get a glimpse of the company’s future.

For the latest news on Vertex Ventures SE Asia and India and our portfolio companies, follow us on Linkedin or subscribe to our monthly newsletter.