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The Art and Science of Financial Modeling

Few aspects of a business plan disrupt the quest to raise capital more than a shoddy financial presentation. The financial component serves as the sole foundation as to why a potential investor invests in a company – to earn a handsome return on invested capital (ROIC). When the financial model fails to deliver enough information for an investor to formulate an opinion, it often becomes a deal-breaker. In fact, we highlighted “sloppy financials” as one of the Common Reasons Business Plans Get Rejected.

Financial modeling is arguably one part art and two parts science. Over the past 20 years, we have modeled hundreds of companies across a myriad of industries. Experience tells us that there is no one single tried and true method of creating accurate projections, but there are a number of best practices that drive better forecasts.

Perhaps the single most overwhelming aspect of modeling is the need to forecast the future in the face of considerable uncertainty. There are so many ‘what-if’ scenarios that can play out over the course of four or five years that it can leave many forecasters paralyzed in deciding how the underlying business may evolve. We encourage business owners to become as intimately familiar with their financial models as they are with any other facet of the business.

Another aspect that makes financial modelling challenging is the degree of variability that surrounds each input. The sum of the errors around each line item of an income statement can become magnified at the bottom line. The resulting inaccuracy then migrates its way through the other financial statements, potentially creating a sizeable miscalculation in the amount of funding a business requires. The implication of not raising enough proceeds is, of course, running out of cash at some point down the road.


Take it from the Top

In our view, an accurate financial picture starts with reasonable assumptions around the income statement. The primary considerations behind the profit and loss statement direct cash flows and ultimately, financial health. A bottom-up build of sales utilizing relevant drivers is an ABSOLUTE. When certain revenue catalysts are unknown or in doubt, incorporating percentage growth rates may be sufficient. However, such results could come under significant scrutiny at some point as savvy investors typically prefer unit-based forecasts. For that reason, we urge clients to have a detailed sales forecast that incorporates reasonable unit assumptions, productivity of sales staff, and some consideration regarding price inflation – an area that is often missed with financial practitioners.

Another red flag we observe from time-to-time is what we call the Round Number Syndrome. Round numbers (e.g., $1,400,000, $1,000,000, $2,700,000, etc.) at the sales, gross profit, total operating expense, net income, and EBITDA lines present an immediate warning sign to investors. They speak to a financial model that lacks sophistication and incorporates loose, top-down assumptions – or worse, guesses. In short, the Round Number Syndrome can quickly get your business plan disqualified with investors.

Equally as unappealing is what we call the Flat Percentage Syndrome. This involves applying the constant growth rates across multiple years to achieve a longer-term result. The worst offense occurs when someone figures their business will grow at 5% over the next 5 years, then applies a 5% growth expectation to all relevant line items: sales, cost of goods sold, sales & marketing expense, and general & administrative expense. Certainly the net result is 5% growth, but it lacks rigor, sophistication, and sends an immediate message of indifference and laziness. Further, it tells even a novice investor that there is absolutely no operating leverage within the business model. There are few things that will turn off an investor quicker than a business that lacks scalability and leverage.


Other Warning Signs and Pitfalls

Aside from a balance sheet that does not balance, the two mistakes that will cause the greatest consternation with potential investors are: revenue growth assumptions that are too aggressive; and expenses that are too lean. The result of either of these infractions is over-inflated profitability. As noted earlier, inflated profits can migrate their way through other statements and lead to a sizeable miscalculation in the amount of funding a business requires.

Conservativism is the foundation of practical and useful financial models. It makes the story of your company and your pitch believable. While some business owners try to woo investors with sensational projections, the truth is they want to see REALISTIC assumptions and REALISTIC expectations. In part, it is what they are basing their investment decision on. Overly aggressive forecasts are yet another quick way to get your business plan eliminated from an investor’s reading list.


A Lesson of Exuberance

Roughly 20 years ago and during the rollout of Internet funding (an era many called Internet 1.0), fast money chased crazy business concepts and sky-high valuations because investors bought into their absurd financial projections. It was a time when the term “hockey stick” was in vogue and was frequently used to describe exponential revenue and income growth trajectories. Financial models depicting year-over-year (Y/Y) revenue growth rates in excess of 1000% were in abundance. Under normal circumstances, and during just about any other time in history, these excessive forecasts would have been laughed at. But this was the advent of the Internet age and a certain belief that just about anything was possible seemed prevalent. In the midst of all the hype, elements of logic became twisted.

During these somewhat heady days, hysteria surrounded metrics like “page views,” “eyeballs,” and “clicks.” This served as the undercurrent and few people, regardless of their level of sophistication, questioned these assumptions because the math worked.

In hindsight, it is easy to see that the over-exuberance was mere folly. Many of the underlying business concepts ultimately failed as the excessive spending that was supposed to be supported by lofty revenue projections never materialized.

Due in part to the Internet 1.0 era, as well as the need for pragmatism, we are advocates of the old adage that it is far better to “under-promise and over-deliver.” Few companies have ever been penalized for doing better than expected, but there is a balance that must be struck. Huge margins of outperformance can create an image that the owner may not fully understand the business they oversee. The bottom-line when it comes to financial modelling is: be conservative, be realistic, defend your assumptions, and execute.