November 8, 2011
Investors seek familiar investments that are analogous to companies that they admire. They would like to believe that you can be successful because you are like another company that has been successful. Therefore, when you create your business plan, base it on a successful, public company that is similar to yours. (Public is preferable, because you will have access to their business model.)
Here is how to build a 5 year financial model using this scenario:
1. Create A Model Based on Ratios
Find the company’s SEC public filing document (S-1). The advantage of the S-1 is that it reveals financial information for years prior to when the company went public. These numbers will be useful in building your model.
Make sure they are similar to yours in terms of business model, potential margins, capital efficiency, human capital costs, etc. Ask yourself if you can rationalize those kind of margins and other important financial ratios. If the answer is yes, then that is your model.
2. Unit Economics and Drivers
Use unit economics, which include revenue per customer sale, customer acquisition cost, cost of goods sold (COGS), number of employees, and cost per employee. Include how the revenue and cost drivers change with scale.
3. Determine Your Realistic Top-Line Revenue 5 Years From Now
Size the market. What is the total addressable market for your product? How many potential users? What can you charge? How much of that market can you realistically expect to capture in 5 years?
4. Create a 5 Year Plan
Using the 5 year revenue number, apply the ratios from the model to determine what your financials would look like in year 5. That includes revenue, salaries and bonuses, COGS, marketing, number of employees by department, etc.
5. Create a 1 Year Financial Plan
Build a bottom-up plan based on what you believe you will do in year one based on your knowledge of how many people you must hire, what equipment you will rent and buy, customer acquisition costs and revenues.
6. Fill in Years 2 – 4
For each year after 1 and before 5, rationalize each line item to get to the model number of year 5. In each succeeding year, you should make realistic changes to the expense ratios closer to the year 5 target.
Every experienced investor will discount your projections. They will give your revenue projections a hair cut, and they will increase your expenses. The proverbial hockey stick is as much of a startup pitch cliche as a win-win, Facebook-killing, thought-leadership, paradigm-shifting game changer. Yet the key to execution of a plan is to have one. The key to reaching a goal is to set one. This method enables an entrepreneur to sign up for a target and monitor progress against that target. Having a sound financial vision based on a model company allows you to set goals, monitor progress, and adjust to reality.
A company should build a financial plan based on a target model whether they are pitching for venture capital or just trying to execute a plan. Without a model, you don’t have a destination and without a destination, you’ll never know whether you got there.
Having a good plan based on sound judgment prepares you to defend your business assumptions and portray you as a thoughtful, intelligent strategist with a vision.
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