Are financial models for early stage businesses of any value?

It’s not a surprise that CEOs of early-stage companies can have little regard for financial models. Possibly made by someone not full-time in their business, the financial model is viewed as being of limited value in decision-making; as something that is created predominantly to satisfy investors.

Business models for early-stage companies that I have seen frequently have one or more of the following characteristics:

  • It’s not easy to see what the key assumptions and drivers underpinning the business model are
  • Costs and revenues are not linked, which means you can’t see what happens to the business if the revenue assumptions are changed
  • They fudge the answer to ‘but when do we get the money?’
  • They are not at all easy to read through
  • They’re over-elaborate: there’s too much conjectural detail relating to revenue streams that might happen some time in the future

Above all, I see models that are not aligned to the business narrative and objectives. It is no wonder that management don’t feel like their models are relevant in how they understand their own business.

So what then should a good model for an early stage business be/do?

Much is uncertain in an early-stage business. To quote Steve Blank, ‘the primary objective of a startup is to validate its business model hypotheses’ – i.e. they are just that, hypotheses. Yet it can feel to CEOs like they have to depict certainty in a financial model in order to give investors assurance.

An early stage business model should contain just enough detail to represent the central cash-generating dynamics and dependencies of the business.

At a minimum (and probably a maximum!), the model should set down and link:

  • What the key revenue and cost drivers are for the business
  • What needs to be true for the business to succeed – i.e. the key assumptions
  • What determines the timing of money into and out of the business

If the model does this, then it can help the management to understand the relative magnitude of the different drivers and assumptions on the development of business, see what scale they need to be as cash-generative as they aspire to be, and understand how long their cash runway is.

Above all, a financial model should mirror the way that management describes its business and objectives and better enable the management to articulate – for both internal and external consumption – the flow of their business model.

In my next post, I will start to set out some fundamental steps for building such a model.