Building a financial model for a startup is an intimidating undertaking. At this stage of a business, there is little to no data and most metrics are educated guesses, at best. And once a business or product launches, the reality will most likely not match earlier projections. At the pre-seed stage, investors are first and foremost accessing a founder’s leadership capabilities, management, and business acumen as well as testing assumptions for reasonableness.
Pre-seed investors don’t expect founders to be seers, psychics, or mediums when it comes to predicting possible outcomes of a startup. Financial models are not used to cement in promises, rather, they are one of the better vehicles to best evaluate a founders ability to think through business models, unit economics, and future scenarios of a startup. It is an essential aspect – together with a pitch deck, investor interviews, and due diligence questionnaires- of an investor’s evaluation of a founder’s vision.
At Temerity, we have reviewed pre-seed financial models for nearly 30 early-stage startups. Here are the three elements that help us determine who and how to invest in a startup:
1. Headcount Waterfall
A headcount waterfall demonstrates a founder’s ability to realistic estimate the undertaking of building a company and excercise forethought and research into the type of talent necessary to achieve a startup’s vision. An ideal headcount model details the expected number of team members a founder plans to hire assuming succesful pre-seed and seed raises. Many founders include a general salary budget without mapping out the roles and timelines of their ideal team.
- Be specific with roles and level of seniority. To keep things clear, place each hire in the following hierarchy: support, analyst, associate, manager, director, or executive.
- Make sure the model demonstrates the next three years and scales according to revenue or funding.
- Include formulas that automatically build in salary overhead costs (like benefits) of 25% and 3% annual salary increases.
2. Clear Unit Economics
Include detailed assumptions behind key unit economics – LTV, CAC, churn, and COGs. Don’t make the investor hunt across multiple tabs to find the data points needed to calculate your CAC or LTV.
If an investor senses information is purposely withheld, this will only increase skepticism.
If an investor senses information is purposely withheld, this will only increase skepticism. Display unit economics prominently on the main model or in a dedicated tab. Always provide a clear breakdown of what is part of the costs of goods sold (COGS) and what is just an operating expense. Presenting unit economics in a clear and clean manner demonstrates a founder’s ability to value the same metrics as an investor. Bonus: making the case for an investor quicker helps speed up the diligence process.
- Include a note explaining the customer lifespan number. Customer lifespan, which is part of an LTV calculation, is impossible to know before you’ve been in the market for years, but it is critical to a startup’s chances for profitability. Investors pay close attention to this number. Providing a thorough explanation justifying a customer’s lifespan distinguishes a founder from the crowd.
3. Highlight Profitability Drivers (or, Don’t Make Investors Hunt for This Information)
Each startup will have one element – or several – that impacts margins and profitability.
In recent due diligence, we discovered the path to profitability for a particular startup hinged on reducing costs to deliver its service by 80%. The founder flagged this in their financial model and shared their plans to integrate offshore and automated measures. Knowing that they understood how to impact key profitability drivers demonstrated keen business acumen and a business model that would be hard to replicate.
Call attention to the core differentiator(s) of a product or service by noting it directly in the model and dedicating a tab breaking down the financial assumptions behind the key driver. Don’t make investors hunt for it. Make sure the profitability driver(s) of a business is obvious and easily explained. Highlighting key drivers of cost and revenue displays confidence in the solution, increasing the likelihood of investment.