Analyzing Startup Financial Models
A look into my process & common questions
I often tell entrepreneurs that “your financial model is the quantitative version of your pitch deck. If the two documents don’t line up, then you have a big problem”.
For the purpose of this newsletter, we will be going through how I tend to analyze the financial model of a pre-seed startup. A company that is maybe at the idea stage, or has an MVP, but no significant traction as of yet.
The best models at this stage are simple ones. One of our best-managed portfolio companies had a model that was a single spreadsheet that projected out 12 months. From a financial management perspective, everything has gone to plan. Of course, as the business evolved they expanded the model and increased complexity as needed.
The key thing here is clarity. This company followed the plan because it was designed to be followed as they went from zero to one. In my experience, pre-seed startups that over-engineer their model with 5-year three-statement projections are the ones that never stick to the plan.
So, when I analyze an early-stage model I only focus on one thing: cash.
The Importance of Cash
For pre-seed startups I always analyze the financial model with the following equation:
Cash-in - Cash-out = Cash balance
It is simple, but that’s the point. Let’s dive into each variable:
Cash-in
You want to understand the sources of cash that a business has. All the big ones should be listed here, for example:
Product revenue
Grants
Investment (yes, including the current funding round)
You then want to evaluate the quality of all these cash sources. For example, do the revenue projections make sense? What assumptions are they built on?
If the company anticipates receiving grants or non-dilutive funding, you want to ask the same question. Is this confirmed? Or just “planned” funding?
The sources of cash coming into the business need to be solid. If your “cash-in” is shakey, then you will run into problems down the line. Which for you as the investor, is a big issue.
Now the important thing to remember is that the business isn’t required to have multiple lines of income. Many pre-seed startups won’t have revenue for quite some time! That’s ok when you are building out the product and just getting started. What isn’t ok is not having clarity on how the company is going to survive.
Cash-out
If cash-in represents all the cash coming into the business, then cash-out equals the opposite. This is the expense section of the financial model.
The big question I’m asking is: Does the spending plan align with the outputs the founder is trying to achieve?
For example, you can’t execute the product roadmap without a team to work on it. Are there salaries allocated for the right employees?
You want to analyze the sales & marketing spend. Does it line up with the GTM motions that the founder outlined in the deck?
The point of analyzing expenses isn’t to go line by line and critique the founder on their choice of product and weather or not they pay $8 or $12 a month for email (of course, you want to make sure things are reasonable). Rather, you want to ensure that the “cash-out” side of the model is funding the resources required for the business to execute on its product, revenue, or growth goals. You also want to understand how paying for these resources up-front (via VC funding) translates into significant progress months down the line.
Cash Balance
This is the most important part of the model. You need to have a good understanding of the projected bank balance at the end of each month. How many months of runway does this company have based on the cash-in & cash-out plans?
Running an Analysis
Now that we have established the monthly cash position of the company, how do we analyze this? Why should we “analyze” it?
At this stage of investing, there is no point in running complex scenarios that cover the next few years. Remember, early-stage teams zig & zag, and the company that you invested in today might look very different 6 months from now. How would the investors in Tiny Speck know that the team would pivot to what became Slack?
I focus my analysis on playing with the cash-in & cash-out variables and seeing what happens to…yes, cash-balance. The big question I’m trying to answer is: Will this team run out of money before they can either a) raise the next round? or b) reach break-even?
Cash-in
What happens if the company doesn’t hit its revenue projections? Cut revenue by 25%, 50%, and 75%. This tells you how much runway relies on revenue. If the company misses their projections, a cash crunch could emerge.
Is revenue growing? What is the source of that growth?
Dig into the sales funnel. How many leads does the company need to generate to hit its revenue goals? Is that realistic?
Are they including this current funding round? If not, why? How does that impact the model?
What is the quality of other cash sources the company is assuming they have access to?
Cash-out
What drives COGS?
I.e. compute costs for SaaS. We have seen some nasty AWS bills before… If the company is in the hardware space, do they have a good idea of what it will cost to build the product?
Are salaries market rate? Are all the roles in the hiring plan listed in the model?
Are there any obvious expenses missing? I.e., employee onboarding costs, and office rent.
Are there any liabilities against the company? Founder debt, lines of credit, etc.
Cash balance
What is the average burn rate? Does it increase or decrease over time?
How much runway does the company have based on the model? Does that seem like enough time for them to hit next-round milestones?
How much cash runway does the company have? I.e., cut revenue to $0. How long can the company survive?
Does the company have enough runway if things take longer than planned?
Closing Thoughts
Of course, there might be some other questions to ask. But my goal here was to give you an idea of how I might approach looking at a financial model. Depending on the industry, product, or experience of the founders, you might need to approach this differently.
The main point I want to drive home is that pre-seed models should be simple and abundant with clarity. You should be able to easily tie the model back to the pitch deck and see how the founder is going to spend the money they raise to execute their plan.
Relevant Reads
With AI being the new buzzword in venture, I thought this piece from Sequoia Capital helped shed some light on what the opportunities might look like: How AI Will Transform the Office Suite at Work.
Next, with talk of customer segments pulling back spending. B2B startups might find themselves in a squeeze. As the junior investor, it’s important for us to understand not only the customer pain points - but the budgets associated with them as well. Tomasz Tungz answered the question: Which Customer Segments are Healthiest During the Downturn?
Next Time
One of the biggest learnings for me over the years was how to run a pitch meeting / introduction call with a founder. So next time we will discuss just that.