Why a rock-solid financial structure is crucial to your startup’s success
Wout Bobbink, 9 January 2018
NOTE: guest post specifically written for Silicon Canals.
Finance Navigator is the first corporate startup of consultancy firm EY. Its founders, Alex Matthiessen, Lars Vereijken, and Wout Bobbink are aiming to solve a complex predicament amongst fellow startups; how to create a rock-solid financial structure for your newly founded company when you as founders (might) lack financial expertise? In this guest post, they address the four principal reasons why it is crucial to have a proper forecast in place for your startup from the get-go.
Engaging with investors
Based on research amongst our own startup customer base we can conclude that about 70% of the startups involved were triggered to start working on a financial plan because they started engaging with investors or were preparing for that. However, this is relatively late.
Of course, it is crucial to have your company’s financial plan in top shape when you start engaging with investors, but your forecast serves a bigger purpose than just that. It should be the basis on which you are running your company, as it provides the insights whether you should start your company at all or whether you even need to raise capital.
Lack of time and knowledge
We see that many startups are triggered to start working on a financial plan by an external event, instead of by intrinsic motivation, because of two reasons: lack of time and lack of finance knowledge. Building a proper financial forecast is a challenging task. It is not easy to calculate when your company will be profitable, whether you need investment and how much exactly, and how your cash flow will develop over the years to come; especially when you do not have any finance background whatsoever.
Not the sexiest topic ever
And let’s be fair: finance is not the sexiest topic ever. Many entrepreneurs prefer to work on product and customer development, instead of building Excel models.
However, you cannot start forecasting early enough and for that purpose, we present the four principal reasons why every startup should care about financial planning and provide guidance on how to start. Believe us, doing so will tell you more than how rich you will become when your business succeeds!
1. To determine whether your idea is not just an idea, but also a business
A good idea is not necessarily a healthy business! Let’s say you have just started a new venture and you have validated to the extent that you are quite convinced there is demand for your industry-disruptive idea.
In that situation, it is extremely helpful to create a high-level forecast using market-size data, your revenue streams, main cost drivers and capital investments. No need for huge spreadsheets yet, keep it simple and use for instance the process we describe in one of our blogs where basically all you need is a Business Model Canvas.
You might find out that even though your idea might be great, your business model sucks or that your costs might be so huge the idea will never be commercially viable, meaning you have to reconsider your business model or cut costs.
2. To convince others of the potential of your business
One of the things you might figure out by doing exercise 1 is that your idea can be turned into a business, but that you need to raise investment to do so. You can raise funding using family, friends & fools, via crowdfunding, angel investors, a VC, or maybe even from the bank. But the further you go from left to right in this list, the more risk averse the investor will become and the more detailed your financial structure needs to be.
When engaging with an investor, do not share your entire financial model upfront, but start with some highlights, including a profit & loss forecast for the first 3-5 years, pricing, sales targets, and margins of your different sales offerings, team size development, large expected (capital) investments, and, of course, the funding you need including the major costs driving the required funding needed.
Based on these highlights investors might want to request more detailed information, such as a forecasted cash flow statement, a balance sheet, and company and/or sector-specific key performance indicators (KPIs).
You have to be able to back up your claims with more detailed info in later discussions, so make sure you capture the assumptions behind the claims you make in your forecast. The challenge of building a convincing financial plan is finding that thin line between being realistic yet ambitious. You want to give the investor the feeling that you are not selling baloney, while you also want to convince him or her of your company’s potential.
Keeping track of your assumptions is key to achieve the latter, especially when you have just established your company, and you do not have a financial track record yet. It helps to create a Google Drive folder where you simply save your market research, letters of intent, bills of material, etc. that help back up the numbers you present in your forecast.
3. To monitor and show whether your business is on track
Now let’s say you have gone through step 2 as well and have succeeded in raising funding. In that case, financial planning becomes even more important, because now you carry the responsibility of managing the secured funds towards your investors, but also towards yourself and your co-founders.
How do you know how your company is performing if you do not have any targets or steering information? How will you update your investors about how you are spending their money and whether you are performing as promised, without any financial plan to benchmark against? You will need a forecast to do so.
A cash flow forecast comes in handy to deal with these questions. Create a forecast of cash inflows (in what ways are you earning money?), define the major costs that drive your cash outflows (how are you spending money?) and present your actual cash in- and outflows against these targets. Explain large deviations from the targets. Create a monthly overview of the 12 months ahead and, if needed, a yearly one for the years thereafter (e.g. 3 or 5 years ahead).
If you add a forecast to your profit & loss statement and balance sheet, your milestones, the cash you have left, the burn rate, and runway, and perhaps some company-specific KPIs, you have built yourself an investor-proof shareholder report. If you want to learn more about shareholder reporting, here’s a great article explaining more on this specific topic.
4. Prepare for scenarios where your startup performs better than expected or, more likely, worse
Entrepreneurs can be overly optimistic, which is a good characteristic to have to keep up the energy and push through when others might quit. Unfortunately, in many cases, the life of an entrepreneur tends to be a bit more disappointing in practice than it is on paper (at least from a financial perspective, don’t get too depressed now).
Therefore, it is prudent that next to your default financial plan (called your ‘base case scenario’) you also prepare a scenario which is a bit less optimistic (your ‘worst case scenario’). What if you launch 6 months later? What if sales do not ramp up as expected? What if your costs turn out to be double of what you expected? Answering such questions helps you anticipate how your cash flow, profitability, and funding need are impacted in a less optimistic scenario.
Oh and by the way, do not forget to create a ‘best case’ scenario as well. Why? You can give potential investors a sneak preview of the upside potential of your company and most importantly: it is fun to see the financial impact of aiming for the moon!