As 2011 ends, I’d like to make an appeal that will help aspiring entrepreneurs make money. Get your financial model in investor-ready shape before sending it to potential investors.
I recently met with a newly minted entrepreneur who left a successful corporate career to launch a company that he believes will disrupt a $100 billion industry. I went over the business pitch and, more importantly, the business model. It was a good meeting. The opportunity is compelling and it can make money today, not 10 years from now.
But I was concerned that the founder didn’t have a firm grasp of the numbers behind his business model, even after six months of working on his startup. I questioned some of his core assumptions and asked him to e-mail his Excel model. When he did, I opened a package of Alka-Seltzer.
The model he sent, which had been presumably sent to other potential investors, was not investor-ready. The financial model had key problems, but it was a teaching opportunity for an otherwise talented entrepreneur with potential.
Revenue projection not linked to sales model
At our meeting, the entrepreneur had explained how he planned to acquire customers. Yet, the model contained no calculations for customer acquisition. Instead, the number of new customers each month was hardcoded. He assumed that the budget for marketing would generate X number of customers each month. It doesn’t work that way.
A good model starts with a projected estimate of the number of potential customers per month. Then, it makes a defensible assumption for capturing each customer and details the costs of doing so. For example, if you plan to capture customers with telemarketing sales, you would detail the following for each month (with sample numbers in parentheses):
- The number of salespeople working for you (10)
- How many calls per day each salesperson makes (50)
- How many calls it takes to convert a caller into a prospect (25)
- How many prospects convert to customers (10)
In this example, each salesperson finds two prospects a day. So, after five days, each salesperson is able to convert a prospect into a customer. This process varies tremendously by industry, so you need to know what is realistic for your industry. Don’t show something that is radically different from what every other company in the industry is able to achieve.
No support for key assumptions
You have to support any assumption within a financial model. I like models that include the source within the file. If this isn’t feasible, then include a reference to the source for a potential investor’s future review. This model did not include any support for assumptions.
Every assumption was evenly rounded to the thousandth place. If you have done the research, your model should have actual costs, not rough rounding. Investors don’t care about 25 cents here or there, but if every assumption is rounded to the nearest $1,000, it could signal that some of the assumptions are guesses.
Model did not allow sensitivity analysis
When entrepreneurs present financial models, they typically include the projection that they feel is “realistic.” That usually means it’s wildly optimistic. To counter this, I run a sensitivity analysis by changing combinations of assumptions to see what impact it has on the overall financial picture. Many models fall apart if I lower the price assumption by 3 percent. That’s a problem.
An even bigger problem is sending a model that isn’t built for sensitivity because most of the numbers are hardcoded. So changing numbers on one part of the model doesn’t flow through completely to the rest of the model. I won’t take the time to rebuild a model for someone (at least not for free!).
These problems don’t mean that a company is a bad investment. But they do make it harder to get the right investors to express interest in you. If you don’t have the skills to build a model, show investors that you are smart enough to recognize your weaknesses and work with someone who does.