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For many start-ups developing a financial model is a daunting task. Why are they necessary? How do I build one? What should it include? Geoff Simonett, Investor, Advisor, Entrepreneur-in-Residence and formerly one of the founders of GreenSky Capital, and currently the President of Pinelands Capital, joins us to tackle this challenging topic for many startups: the importance of building a financial model; the fundamentals, and what it means as the foundation for their business.
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Tech Uncensored, Crucial Analysis in Tech, is a weekly podcast brought to you by Altitude Accelerator. Hosted by Hessie Jones, we explore emerging news, and relevant topics that startups care about. We speak to subject matter experts, founders and advisors in Investment: Venture Capital, Equity Crowdfunding, and across Industry: Clean Tech, Biotech, Generative AI, Blockchain, Web3, Privacy, Security etc. who weigh in on the challenges that startup founders face today, as well as the profound opportunities that come with emerging tech and market adoption.
Samie Husain
Okay. Good afternoon, everyone, and welcome back to another edition of Tech Uncensored. My name is Sam Husain, and today we're going to talk about financial modeling. Sometimes this is a daunting task for startups and one of the questions we have is why are they necessary? How do I build one? What should it include? So for these and many other answers, I've got Geoff Simonett, who is the Entrepreneur-in-Residence at the Altitude Center. But he has a long history and track record in startups as a founder, investor, and as an advisor. He was formerly one of the founders of Green Sky Capital and he's currently the president of Pinelands Capital. Geoff, thank you for taking the time to join us.
Geoff Simonett
Pleasure. Thanks Sam. Looking forward to it.
Samie Husain
So why don't we just start off. Do all startups need financial models? Is the model just for investors?
Geoff Simonett
Well, I'm a numbers guy primarily, so I'm a little biased in this question and I like to boil down difficult problems and projects into an equation if I can. So for me, it's a non-starter. You got to have a financial model. Technically, the answer is no. Businesses are built without financial models, but I would look at it akin to building a house without architectural drawings. Can you do it? Of course. Could it turn out successful? Yes, but there's likely a lot more chance of running out of money. Maybe not building a great foundation, maybe forgetting to leave room for the plumbing. Maybe the whole thing collapses. This is what I tell entrepreneurs a lot the biggest investor in the company of time and of reputation and probably of money is the entrepreneur, especially if it's early stage. So the financial model is really a tool for them. Forget about it being for investors. They need these tools to run their business, I believe. And why not? It's not that difficult to build something and update it. It will give you a huge edge in understanding your business. And then when the time comes to find an investor, or maybe it's even just a loan from a bank or it could in some cases even be a partner that you're bringing on. You need some basis in numbers to be able to talk with them.
Geoff Simonett
Finally, I will say I started a number of companies and I've had what I thought were great ideas. And for me, I always start with the financial model and I put them down in a spreadsheet, did all the work to think about what this looks like, and then re-thought and said, maybe this isn't a great idea. It takes too much time, it takes too much resources, something I might not have recognized before. So I say everybody should definitely do it. If they haven't already, get one going now.
Samie Husain
Okay. I like the fact that it is a foundational thing that you need to do. I'm full agreement of this as well. I'm also a numbers person. But how do founders whose skill set is not in finance tackle building a financial model? I mean, I've seen financial models where, let's say it's a tech founder who's got a complicated software and then all of a sudden their financial model is also complicated and hard to understand. And then some are just too simple. So what's the best approach to this?
Geoff Simonett
Well, first, I think every founder needs to have or get some financial acumen. As you point out, quite often there are scientists or innovators that have specific deep knowledge in their technology and that's great and that's why they built it. But now they're building a business. And whether they bring in investors or not, they want that business to be successful. They want to build value. They want to hire people. They need to have some financial acumen. They need to get that. They don't have to be an accountant. They don't have to be an expert. By the way, I'm not an accountant. I do lots of financial audits and I'm not an accountant.
Geoff Simonett
Do they need to have all of those skills? No. Is there lots of places you can get them? Yes, there's plenty of resources. Of course, on the internet, there's lots of sample templates for financial modeling. There's lots of accelerators like Altitude accelerator, which are here to offer that kind of help. You can hire if you have the capital person to build it for you, or a fractional CFO, your accountant. And most companies have some kind of accountant, at least at the end of the year, who probably has the knowledge to guide you through this kind of thing.
Geoff Simonett
So you need to learn a certain amount, and not just in financial modeling, but of course, as soon as you're building a business, you need to have a small knowledge of a lot of things. But there are a ton of resources out there that can help them along the way.
Samie Husain
So I guess that really kind of answers our next question in a way. How do pre-revenue startups build a model? How do you validate that model? I guess what I'm getting at is that when you start to build that financial model, it can be large numbers, small numbers, but how do you validate it?
Geoff Simonett
Yeah, I think the 'how do they do it?' is you're right, it's no different in the answer. They acquire or hire those resources as necessary. I don't look at this any differently for pre-revenue. In fact, a lot of the companies I work with are pre-revenue, and I would say it's almost more important at that stage. As mentioned, I come up with some great ideas. I thought, and even before doing anything, put down the financial model. It's not just me picking some random numbers and putting them on a spreadsheet. It forces you to do the research. And let's be honest. If you're going to start a business, you probably already have a great idea. You probably have already some idea that you can sell this product or service. You probably already have an idea of how much you can sell it for or why it might be profitable. You wouldn't go ahead unless you had some of those things, like you were going to make money from this idea. So you know a lot already. You'd be surprised, really. This is just a discipline to put it down over a timeline in a spreadsheet and then go and actually evaluate your assumptions, at least as a starting point, by talking to other people, by doing research, by talking to customers, by talking to partners. And when you put it all down, what actually does this show me? And can I now adjust if it doesn't show me something that's very compelling.
Geoff Simonett
So even at the pre-revenue stage, the effort is not much different. It's extremely important. It forces you to do your homework. And it is something that when you start off on a monthly basis, if you want to look at it, you're probably going to be far off what you predicted. That's okay. You'll learn something, you change your predictions, you keep getting closer to reality over time, and then you probably make a pivot along the way and your back out to something else. But it gives you some basis for measuring what you're doing and setting your direction and evaluating where you're going.
Samie Husain
Okay, so that's interesting. So I like that, that you keep validating the numbers as you go along and you make changes. Is it better to start off being conservative in your numbers or...>
Samie Husain
I've seen both, and I'm sure you have too, is where there's conservative numbers and maybe they're kind of under-reporting those numbers or they go to another extreme. And what's the purpose of that? Is it to get a better valuation and all these things?
Geoff Simonett
Yeah, that's a good question, and I grapple with that all the time. There's not a right or wrong answer necessarily. I like to look at it as being optimistic but realistic call it optorealistic. Why do I say that? Well, first of all, as mentioned, the financial model is primarily initially for your use to run the company and will continue to be. So you might be using it to attract investors and other things, but you are building something to evaluate your own business. There's no point in lying to yourself because if you do, your cash position you're looking at several months ahead might be, of course, relying on your revenue generation. And if you way over predicted the revenue generation, then you're probably not going to notice that you're going to run out of cash way sooner than you thought you would have.
Geoff Simonett
That said, because it becomes a tool that used for lots of things like setting people's compensation plans, deciding when to hire people, your marketing budget, etc. You need to be somewhat optimistic because these numbers do permeate throughout your company for other reasons. You may just be sharing the financial model with your company or pieces of it and you don't want to really underestimate what you can do and always overachieve as you want people to be pushed to achieve things.
Geoff Simonett
So it needs to be optimistic but realistic. I would say when you get to the point of where you're going to show it to investors, one mistake I see people make is there's usually a large period of time between when an investor first looks at your financial model. Might actually even be right in your deck.
Geoff Simonett
First time they see you and you are like 'Here's our projections", and when they actually make an investment. And if you are wildly wrong in that six month period of time or four month period of time, well, there's a lot less chance that you're going to get the investment. However, if you beat those numbers the whole time that looks fantastic. It can't be a pessimistic number. It's got to be optimistic, but it's got to be potentially achievable.
Samie Husain
When you advise companies, do you tell them to create multiple scenarios or do you just say stick to one? Like should I create a best case scenario, worst case scenario and then kind of like in the middle optimistic scenario or achievable scenario?
Geoff Simonett
Yeah, I mean part of the reason we're having a model is to be able to test scenarios. What happens if we change our pricing? What happens if we can significantly improve our customer churn? What happens here's a good one that people wouldn't necessarily notice unless I had a model. What happens if we can get all of our customers? This is especially relevant for SaaS software companies to pay a year in advance and it doesn't show up as revenue, but it does show up in cash, of course. So you may not notice that on a minimum model that people often build, which is just an income statement, but these are all important things. So you want to be able to test scenarios. It's difficult to do with a model unless you build it well because you can't just change one variable in a scenario unless you've built a model so that it reflects through a whole bunch of other things which I would highly recommend and I won't get into the details. I would say at a minimum you have your model, what you think is going to happen, your optorealistic, look at the world and test it with a scenario that's far worse.
Geoff Simonett
So you know what the downside is. You can also, for fun look at it. "What if we really overachieve?". And which sometimes brings jumps out of other problems. But yeah, I think it's a worthwhile practice and you may in fact have a slightly different version when you first go to investors. But generally, it's certainly a lot easier to maintain one model and one model you can play around with a bit as opposed to having multiple models, especially when time passes and you're putting in real numbers from the past and having those flow into future numbers. It gets complicated when you have multiple models, or multiple checks for that matter. So easier to have one and the ability to test narrows on it.
Samie Husain
Okay, so then as an investor, what do you look for? What do you look for in a financial model?
Geoff Simonett
Yeah. Well, at a high level, first of all, I look to see if they have a financial model that's checkmark number one. But I want to understand that entrepreneurs really they understand their business and they understand the levers that drive success. It's not just about predicting hockey sticker revenue, which of course every financial model will show. But do they know specifically what drives that? And are there KPIs in the model that makes sense going forward?
Geoff Simonett
So at a high level, look at that and make sure that they understand what runs their business and what success is. And again, just having it, I think, checks off the box. They're disciplined. Maybe they understand the efficiencies of their company, that they can manage resources, people money in some cases, other larger resources at full expenses. A little more specifically, I want to make sure there's sufficient growth. Investors are looking for growth. Once you bring in an investor, it's not just a pastime anymore or a lifestyle business. They're going to want a return. So I gotta look at it and of course, especially the technology companies the most important thing is that there is sufficient growth to meet the returns that I, as an investor might need.
Geoff Simonett
I want to look at it and make sure that there's sufficient resources to run the company. Generating a whole bunch of revenue isn't that useful if you don't have the proper support team and you aren't spending the right marketing dollars to actually get there? So I'll look at it and make sure it's believable and real. I'm very curious to see if and when they are planning and running out of capital and if we have to raise capital again, how soon that is and how much they think that needs to be. I also want to know when do we expect the company to get to cash flow positive, for example, all of these things, we can create a model.
Geoff Simonett
I really want to understand how they're generating revenue. So what their revenue model is. Are we selling widgets? Are we selling a service? Is a recurring revenue? Is the growth really generated by leads and marketing referrals, et cetera? And as mentioned, there's a lot of KPIs that we could dive into that I'd also be looking for. But at a high level, it's more about do they really understand their business? Do they know the levers that are going to scale this business?
Geoff Simonett
Do they understand how to efficiently use resources? Can they get to somewhere meaningful, a milestone on the investment that they're asking for, such that we could go back to the market if necessary and raise capital at a higher valuation?
Samie Husain
As an investor, Geoff, when you look at the financial model, do you look at and say, all right, how are you going to achieve these numbers? And do you go to a granular level? Like, do you say, how are you going to achieve these numbers on a monthly basis, on a weekly basis? And then do you hold them to the fire? Do you say, all right, every quarter I'm going to be sitting on your board and I want to see if you're tracking to this or not, and if you're not, why not? Or if you're going well beyond it, what's the reason? Did you not accurately forecast?
Geoff Simonett
Yes and yes. Initially, you're just going to look at their overall projections and their financial model at a high level to know "Is this a good fit with me as an investor?"
Geoff Simonett
I mean, there's lots of different companies and then there's lots of different types of investors and you can often see at a pretty quick glance whether it's a good fit for you, the stages are at, the money they need, etc. So passing on an opportunity might be a very quick decision. If you like what they're doing and you like the people and all of the other hurdles you want to get by to potentially making investments, then, yeah, you're going to challenge their assumptions because for the investor, great returns are great, but you're managing risk.
Geoff Simonett
You need to look at the details and say, okay, I see what you've predicted here. How are we actually going to do that? And is it believable? What I like in a model is when they have the actual numbers for however long they've been a company, or at least a couple of years, that are actually part of the model and the predictions just flow from there.
Geoff Simonett
And where they start forecasting. If suddenly everything is two or three times as much, it's not really believable. Things take time. You can have a great product, but you may have to hire and train salespeople and support people. I look at it and certainly test it. And then to your second question, am I going to hold them to it? Yeah. Well, I'm hoping they're going to hold themselves to it because this is their measure of what they can do. This is their reputation; this is their success. They're going to be spending the time on it. So we have this shared model that we can both look at and they're working against. But whether if I'm on the board or just an investor, hold them to it is an interesting term. I can't actually hold them to it. I can keep pressing them to refine how their business works such that we continue to hit the numbers. And it's really hard to predict in an early-stage company. So if we don't hit the numbers, well, let's at least look at it and say, why not? And what can we change either to fix something or what do we need to change in our forecasting, perhaps?
Geoff Simonett
Because that might be the answer to maybe just forecasted wrong, which is fine, everybody does. So let's fix the forecasting because we don't want to make another resource decision based on a bad forecast. One other thing I'll say to that, I mean, occasionally this often comes down to a question of valuation. You might be making an investment in a company who has very grand expectations, and perhaps even the structure of your investment has something to do with what the entrepreneurs said they were going to achieve. For example, I may make my investment in tranches. And I'm not going to release the second tranche until you hit certain numbers or partnership or some major milestone or maybe I'm issued more shares or options. There are warrants if you don't hit certain numbers because arguably it wasn't as valuable as you said it was. If you don't achieve what's in the model. So that is a very direct way of pulling the feet to the fire. But either way, you're going to work with an entrepreneur and continually refine this process and say, okay, we either have to predict the future better and plan around that, or we have to improve our practices and our resource allocation and more ideas if we're going to generate leads in order to increase our growth.
Geoff Simonett
And likely both of those things, of course, and more.
Samie Husain
When you look at financial models of startups or have some kind of traction already, what are the biggest mistakes you see? What I find is it's in the cash flow. A lot of founders don't understand cash flow properly. They'll have this number that they're going to achieve in two years, and then my next question will be, well, how are you going to fund that? And you're going to run out of money a lot sooner than you think? Do you find that that's the case?
Geoff Simonett
Yeah. Arguably the biggest sin of a startup is running out of money. You might have a great opportunity idea, a great business, but anyone can potentially run out of money if they don't manage it properly. So if the question you're asking is, what do I see as the big mistakes in the modeling, I think when people start building their own models, first of all, they just focus on the income statement. So they will say, okay, we're going to sell and we're going to sell at this price, and here's what it costs us to make this, and I got to hire some people and pay some rent. There's probably a lot of mistakes made in that as well but at a minimum, people generally have an idea of how to do that and a good idea of what the business will look like.
Geoff Simonett
But when I see the models, they don't build in a balance sheet. Part of that is just not having the knowledge or the understanding and they probably don't have a proper cash flow analysis in there as well. So, as mentioned, there are a lot of other things that can affect your cash flow that are not evident on the income statement, such as deferred revenue, meaning you're getting paid for a year in advance and then deferring that revenue over a year, but you're getting the cash upfront.
Geoff Simonett
Depending on your business, you might have inventories, you might have a big gap between when you actually have to purchase and build a product when you sell it, and then even a bigger gap as to when you collect the money. So accounts receivable, accounts payable are big things. These can have massive effects on your short term cash flow. So much so that you may run into trouble, or conversely, you may actually have more cash at your disposal than you're aware of and perhaps you shouldn't have gone out to raise that much capital or taken that loan. So those are some of the mistakes I see a lot. It's just not a complete picture of the business and especially when we're talking about cash flow. I'd also say that frequently people don't put in any of the history. They just start off, "okay, here we are today, I want to get an investor, so here's where we're going to go."
Geoff Simonett
But I would highly recommend building your history into the model as well, partly because you're going to want to look at KPIs over time. You actually have a couple of years of maybe real KPIs that you're going to flow into that data right into the next month, in the next quarter and the next year and allow you to build a better set of data to manage your own business one over time as the model itself.
Geoff Simonett
Another problem is they just don't make them very flexible because they'll hard code in a bunch of numbers. And then you can't change something without actually knowing a where everything is hard coded and even if you do, it's a huge effort to go and do that. So sure, it makes the spreadsheet a little more complicated when you started, but a lot easier to manage if the formula for this month is the same as every month moving out to the right. The formula itself might be complicated and you might have a dashboard where you're changing variables, growth rates, turn rates, et cetera. But the actual formula in the cell in the spreadsheet is the same so that there's no hard coded numbers or things that you can't manipulate easily and especially when you get to adding more time onto the model because as I say, these are living documents that go forever and you're only predicting probably three years. Three to five years, time passes and you add more time to your model.
Samie Husain
I mean, what's the optimal time to predict out, actually? What do you like to see?
Geoff Simonett
Well, there's two answers to that question. I think entrepreneurs should have a very good understanding and view of their company, especially when it comes to cash flow for the next six months. Pretty good understanding for the next twelve months. And a model that goes out at least three years gets pretty hazy when you're at three years, and I would say three to five years. I like to see them monthly, especially in the early days because with the early days with tech companies, cash flow problems wouldn't even be recognizable if you look at a year at a time. You never know when the dips and the increases happen, and things change so rapidly. So I like the model to be at least as many years backward as you can. That's meaningful. And at least three years forward, if not five, recognizing that when you get three to five years out, "yeah, they're probably just formulas and who knows?"
Geoff Simonett
But at least it gives you some overall picture, especially for the investors. If we actually follow this path and we put in the money that the model suggests and maybe there's another round so we can measure how much would I be diluted, "what would I expect this company to look like in a few years?"
Geoff Simonett
What would an exit price be and how much could I make on my investment?
Geoff Simonett
I like that 'as many years backwards' actually. That's very important and in fact I didn't even think of that myself. I think that's amazing that you're looking at. So whatever companies you look at, you say, well tell me what, even if they haven't raised any money and they've been bootstrapping it themselves, you say, give me the previous statements.
Geoff Simonett
Well, hopefully those are just months and years and quarters in the model itself. But yeah, if I'm going to make an investment, I'm going to look at their financials anyway from previous years. But I prefer that it was in the model. There's only so much you can do with a financial statement if you really want to look at the KPIs over time. But also remember my view is they should have built the model right from day one and therefore they keep updating it monthly with what actually happened. So ideally a company has been collecting this information in their model all along, but that's not frequently the case. Hopefully they've been using QuickBooks or something and it's pretty easy to dump the historic information out of QuickBooks and put it into your model. I highly recommend that.
Geoff Simonett
It's easier as time goes on too with you and your management team or you and your investors to be looking at and manipulating a model. With a spreadsheet, you can do whatever you want. I can define whatever measure I like and put in a row in my spreadsheet. A little harder to do well, impossible to do if you're just giving them financial statements, but hard to do in QuickBooks unless you dump everything out and move it somewhere else.
Geoff Simonett
So that's the beauty of a model is you can glean a lot of information out from it by adding in, making a page in it of whatever KPIs you want and those get automatically populated as data is added to the model, both historic and future.
Samie Husain
Okay, so I'm going to ask you a couple more things here. One is you said earlier that you can quickly realize whether you're going to be interested in a company or you're just going to quickly pass on it. What is it that you see specifically that makes you make that decision?
Geoff Simonett
Well, I guess what I meant is an investor, especially if it's a fund, they usually have a set of parameters that they've sold to their LPs, their investors saying, "this is the type of deal that we invest in". We write checks of a certain size and we invest at this stage. I meant each investor has their own parameters and usually there's not perfect communication between a potential investment investee company and a fund when they first meet. So you might find out pretty quickly it's not a good match.
Geoff Simonett
When I mentioned that, I meant some obvious things are just, well, how much money do you need? Do you need to do multiple rounds? Have you already got investors? Because maybe I prefer to be one of the earlier investors. What stage are you adding your revenue growth? I can see these things pretty quickly and make a quick no or it's not a good fit for me. Might still be a great company, but it doesn't fit my parameters. It wasn't specifically saying what my parameters are. I meant just any investor has their own set of parameters. So what do I like? I like companies that are early-stage, probably before there's venture capital or any institutional money in the company. But they have third-party validation, which for me usually means they have some customers, although it could mean users or it could mean significant partnerships.
Geoff Simonett
But I like fascinating new technologies and I can't be an expert on all of them. But if they have people who are buying them, buying the product and service, they probably know more about it than I do. So I'll look at a model, if it comes to me. It's probably not the first thing I'm going to see. I'm going to see a deck. But I quickly determine, okay, "How much money they need? Is this a very capital-intensive company? Do they have to buy a lot of equipment to do what they want to do? They have inventory requirements? Is there a long process before they get to revenue?" And for me and for any other investor, there's some obvious things that might quickly raise some red flags for you. Again, it doesn't mean it's a bad company, just not necessarily a great fit for me.
Samie Husain
Okay, I'm going to ask you one last question, Geoff, and that is when you go in and when you're saying you're going at an early you like to come in at an early stage, and you know that there's going to be successive rounds of financing, so you're going to get diluted. But do you look for the stage that you come in at to be diluted at a minimal level, or you expect that it's going to continue to go and your value will keep going up?
Geoff Simonett
Well, that's not a yes or no question, so it depends also on my belief of the market size and how unique and how valuable their product is. I might have a different view. If a company I was convinced had a drug that would extend your life by 100 years, well, yeah, it's going to take more money, but perhaps I'd like to be part of that party. Early on.
Geoff Simonett
Then if it was a SaaS software company, that is interesting, but, you know, not all that different than somebody else could or has already built. Maybe it's a question of execution. Then I'd like to see that. Okay. It's not going to take a ton of money to get where we're going. We often, when I'm working with companies, find out we were wrong, and it is going to take quite a bit more money, and that's okay. But usually the ones I'm looking at for me just, for me, require money. Otherwise I probably wouldn't have been talking to them in the first place. But perhaps they're not really capital intensive, and there's not going to be a whole lot of ground.
Geoff Simonett
I don't mind the dilution as long as we are moving up through significant valuation changes and can continue to expand in a large market.
Samie Husain
Okay, that's great. So it all depends on the individual scenarios. Well, that's it for us. Yeah. We're out of time here. I really appreciate this, Geoff. I know we could keep talking about this, but maybe we'll have another session at some time down the road. So, once again, thank you for coming on. And that's tech uncensored for this Friday the 13th. We'll see you guys next week.
Geoff Simonett
I didn't realize that.
Samie Husain
Okay, have a great weekend.
Geoff Simonett
Take care. Bye.