The ongoing market downturn and layoffs at tech companies have caused a great deal of alarm across the startup and venture capital worlds, but growth-stage startups are expected to bear the brunt of the impact.
Early-stage startups have an opportunity to capitalize, as investors with dry powder will eventually need to deploy it to secure their management fees. Investors are moving focus toward earlier deals, which may be less risky in the short term compared to investing in growth-stage companies at larger average check sizes during a downturn. This is because the closer a company is to an IPO, the more investors establish its worth as a function of public company valuations.
Even when times are bad, good businesses will get funding. The key to proving your business is solid to an investor is to adopt a data-backed approach when telling your company’s story.
To start off, founders first need to figure out how much capital they need to hit business goals.
As many funding rounds reach eight or nine figures, the details that go into those deals can seem abstract to new founders or sound like companies are playing with Monopoly money. For many founders, especially those from nontraditional or under-resourced backgrounds, it can be daunting to even say, “I’m looking to raise $20 million,” out loud and feel like you’ll be taken seriously.
Although simplistic, you can think of pitching as simply getting an investor to buy into your model.
A solid financial model is critical to bridging the expectation gap between founders and investors, and it will allow both parties to cut through the hype and focus on the fundamentals.
Here are eight steps to developing a financial model to accurately project your fundraising needs:
Understanding your magic number
Before we build a financial model to find the magic number your business needs to raise, we first need to understand what a good model looks like.
Your model should project your needs two years in the future and include a 2x margin of safety.
A two-year time frame puts enough pressure on the startup team to execute, but not so much that they can’t be thoughtful and strategic. If your business is not making significant progress in driving up your valuation or revenue every two years, it’s likely that there are problems with the business model.
It’s hard to establish projections beyond two years with rigor, and you risk going down an analytical rabbit hole. Founders should avoid doing so for investor presentations. That said, founders should also make a long-term model (10-plus years) to think about overall strategy.
The human brain is notoriously inaccurate when planning, and a margin of safety is a great tool to account for this. Additionally, we live in uncertain times, which makes it critical to account for unexpected future macroeconomic shifts. Building a buffer into your model helps provide a cushion that you can use to get over any unforeseen roadblocks between rounds.
Once you find the amount you need to operate for the next two years, multiply that number by at least 1.5 (2 to be extra safe) to get your magic fundraising goal number.
Building the model
The data points we’ll use to determine overall fundraising needs are:
- Revenue: The total amount of money generated by the sale of goods and services related to the primary operations of the business.
- Gross margin: The difference between revenue and cost of goods sold (COGS), divided by revenue: Revenue – COGS / Revenue.
- Contribution margin: Revenue minus sales and marketing spend (S&M): Revenue – S&M.
- Operating expenses (opex): Ongoing costs for running a business, including payroll, marketing, and research and development.
Step 1: Determine your LTV/CAC ratio
Sales and marketing will account for the largest share of cash in a growing business. The lifetime value (LTV) to customer acquisition cost (CAC) ratio explains the relationship between spending on S&M and generating revenue.
To understand how much money is required to keep the business running as it grows, founders need to have a clear picture of how spending on growth converts to revenue. The LTV/CAC ratio is a key tool in these calculations, so you should determine this ratio first.
Founders need to understand both the gross margin LTV as well as the unit LTV to get a better sense of how efficiently the business can grow.
Step 2: Estimate monthly S&M investment
Founders should ask themselves how much they can invest in sales and marketing on a monthly basis for the next two years without seeing their LTV/CAC curve relationship decay wildly. This last part is critical: You can spend $1 billion a month on sales and marketing if you want to, but your performance will be inefficient.
You should evaluate the way you currently sell and market, and think about increasing that by three to 10 times. Your growth limit is the multiple of your current efforts that you can see yourself executing without plunging into chaos. For some growth companies, that is 2x per year, and for others, it is 10x in the early days.
It all comes down to whether you can see yourself running an organization at that scale — as measured by the number of sales and marketing employees and the total spend on marketing campaigns.
Step 3: Project revenue
Multiply the S&M time series by your LTV/CAC curve shape to project revenue. At this point, you should have S&M and revenue tightly defined.
Step 4: Estimate gross margin percentage over the next two years
Multiply revenue by this percentage to plot your gross margin curve. This margin will either be flat, contract or increase based on factors like potential pricing pressure, which raises it. Supplier costs can also increase gross margin if they fall and decrease gross margin if they rise in an inflationary environment.
Some factors are impacting gross margin right now. For example, a year or two ago, we would not have been able to accurately predict the increased labor costs and inventory pressure we’re seeing now due to the Great Resignation and supply chain disruptions. That’s why having a 2x safety margin is so important to future-proof a startup fundraise.
Step 5: Calculate your gross margin curve
Multiply revenue by this percentage to get your gross margin.
Step 6: Calculate contribution margin curve
Subtract S&M from gross margin to get contribution margin.
Step 7: Project operating expenses
Think about the staff needed to run the business at scale versus the staff you have now, and how those costs will evolve over time. Operating expenses should ramp up and then flatten out as you achieve scale.
Note that this flattening is often imperfect, but by growing operating expenses at a far slower pace than revenue, companies produce cash flow. This is called achieving “operating leverage.”
Step 8: Talk to your team
The work is not over once the initial model is finished. Once it is developed, the founder or CFO must bring the model back to the team to gather additional context and execution knowledge that may impact the inputs.
It is critical that the executive team comes to own the assumptions in the model. In a well-run company, these assumptions become your quarterly targets, and you track performance against those targets as leading indicators of whether you will hit your goals.
The fundraising team should do this exercise a few times to ensure everyone — top-down to bottom-up — believes in the model before approaching an investor.
With a believable model, you now have a conversational tool that diminishes bias and focuses the conversation on whether your assumptions are realistic. Although simplistic, you can think of pitching as simply getting an investor to buy into your model. If they do, you can successfully raise the capital you need.
Scaling your model
The fundamentals of your financial model will remain the same as you scale, but over time, all four inputs become more predictable as your LTV/CAC shapes the amount you can spend.
When a company is small, every prediction will be volatile. As companies grow and collect more data about the business, it becomes easier to anticipate gross margins, S&M and LTV/CAC precisely. The experience of hiring staff will also make operating expenditure projections more accurate.
As a result, the model will become more precise at later stages as overall risk decreases. This also allows for higher valuations.
Overcoming financial anxiety with data
The basics of a financial model are relatively straightforward, but, much like managing personal finances, people struggle with anxiety and discipline when it comes to money.
For founders, this often manifests in the tension between the wider vision for their company and the need to be realistic about finances. Most companies begin without a CFO, leaving many founders deeply focused on product development and clueless about financial best practices.
Early-stage founders can stand on surer footing in investor meetings by leaning on hard data to project what they need to raise in the first place.