April marks the beginning of the new financial year, and what better time than to review (or create) a financial plan for your business?
Almost all companies perform some kind of financial planning or budgeting, but there are particular reasons why a financial plan is important for start-ups specifically:
You need one to build an economically viable business. Why? Because by quantifying (and then validating) your business plan and business model, assumptions and vision you are able to find out whether you can turn your ideas into a sustainably operating business. Moreover, if you build different versions (“scenarios”) you are better prepared for the future, especially if things do not go the way you planned. What if you launch half a year later? Or what happens if there is a Pandemic? Answering such a question in your “worst-case scenario” helps you anticipate how your cash flow, profitability and funding need are impacted.
You need one as part of the fundraising process. Financiers will typically ask you for a financial plan when you engage with them to raise funding, whether them being angel investors, VCs, banks or subsidy providers. Certain investors will require more details than others, but building a model is wise even if you only need to provide them with high-level data. Why? Because it helps you answer the tricky questions a financier might have when he or she dives into your business case. Moreover, how are you planning to raise funding if you did not properly calculate how much funding you actually need?
You need one to inform yourself and shareholders. How do you know how your company is doing if you don’t have any targets to achieve or steering information to compare against? How are you going to update your shareholders on 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.
There are two different ways to look at your financial model. You could use the top-down approach to forecasting which typically takes industry estimates as a starting point and which are then narrowed down into targets that are fit for your company. This creates a forecast based on the market share you would like to capture within a reasonable timeframe using the TAM SAM SOM model. To narrow your potential sales target from the total worldwide market for your product/service (Total Addressable Market or TAM), to the part of that market that aligns with your niche and location (Serviceable Available Market or SAM), and finally to the part of this market that you can realistically capture and serve (Serviceable Obtainable Market or SOM). SOM is therefore equal to your sales target as it represents the value of the market share you aim to capture.
Based on the sales targets you define, the next step is to estimate all costs that are needed to build or deliver your product or service and all expenses that are needed to perform all sales and marketing, research and development, and general and administrative tasks for your company to stay alive.
The other method to create a financial model is Bottom-up forecasting. This focuses less on industry statistics than on those already produced by your company, for example, sales data or internal capacity, to estimate sales targets and costs.
It can be useful to do both of these methods when you build your start-up’s forecast. Use the bottom-up method for your short-term forecast (1-2 years ahead) and the top-down method for the longer term (3-5 years ahead). This makes you able to substantiate and defend your short-term targets very well and your long-term targets demonstrate the desired market share and the ambition an investor is looking for.
Contact SME CofE for more information or support on this topic.