Financial model: a key must-have for successfully navigating the fundraising process
Before diving into the technical details and the different elements that make up a startup’s financial model, we’ll look at why making business projections and having a financial model are vital for founders—especially those looking to raise capital.
Almost all companies do some form of financial planning or budgeting. However, there are 3 reasons why a financial plan is especially relevant for startups:
- Build an economically viable business. By quantifying (and then validating) their business plan and model, assumptions, and vision, founders can find out whether it’s possible to turn their ideas into a sustainable operating business.
- Speed up the fundraising process. Investors generally ask for a financial plan when a startup is seeking funding, whether from an angel investor or a VC.
- Demonstrate effective decision-making and keep shareholders informed. The model is key to showing how the startup is performing against its stated goals by comparing the results of each decision with actual data.
Often, building a financial model isn’t the problem. The REAL problem is answering questions such as: How do you arrive at the numbers? How do you forecast sales and estimate the size of your target market? How much should you invest in marketing?
There are two main methods for answering these questions:
- Top-down TAM SAM SOM estimate
- Bottom-up estimate
Top-down forecast
With the top-down approach, you work from a macro perspective: from the outside in. Generally, industry estimates are used as a starting point and narrowed down to targets that fit the startup.
Essentially, the top-down method helps define a forecast based on the market share the startup aims to capture within a reasonable period of time. The TAM SAM SOM model is a useful tool for making top-down forecasts.
The TAM SAM SOM model captures market size at three levels: the total global market for a product or service (TAM: total addressable market), the portion of that market the startup targets with its specific offering (its market niche), adjusted for its geographic location (SAM: serviceable available market), and the portion of SAM it can realistically capture (SOM: serviceable obtainable market), given the existing competition. Therefore, SOM generally equals the sales target, since it represents the value of the market share the startup aims to capture.
Based on the sales targets set using the TAM SAM SOM model, the next step is to estimate all the costs required to build or deliver the product or service, along with all the expenses needed for sales and marketing, research and development, and general and administrative activities to keep the startup operating.
Bottom-up forecast
The problem with the top-down approach is that it can tempt us to make overly optimistic forecasts (especially for sales). Startups often calculate SOM (the sales target) by taking an arbitrary percentage of the market, without really assessing whether that target is realistically achievable.
A small percentage of a market may seem insignificant, but it could still be overly optimistic—for example, in the launch year. Therefore, it may be useful to complement the top-down method with a bottom-up approach.
The bottom-up approach depends less on external factors (the market) and instead draws on startup-specific internal data, such as sales data or internal capacity. Unlike the top-down method, the bottom-up approach starts with a micro, inside-out view and works toward a macro view. This means making a projection based on the startup’s main value drivers.