Financial Model Mistakes

Forgetting Cash

Revenues are not cash. Gross margins are not cash. Profits are not cash. Only cash is cash.

For example, suppose you sell something this month for $100 that cost you $60 to make. But you have to pay your suppliers in 30 days, while the buyer probably won't pay you for at least 60 days.

Your revenue for the month was $100, your profit was $40, and your cash flow was zero.

Your cash flow for the transaction will be negative $60 next month when you pay your suppliers.

Although this may seem trivial, very slight changes in the timing difference between cash receipt and disbursement?just a couple of weeks?can bankrupt your business.

When you build your financial model, make sure that your assumptions are realistic so that you raise sufficient capital.

Lack of Detail

Construct your financials from the bottom-up, and then validate them from the top-down.

A bottom-up model starts with details such as when you expect to make certain sales or hire specific employees.

Top-down validation means that you examine your overall market potential and compare that to the bottom-up revenue projections.

Round numbers?like one million in R&D expenses in Year 2, and two million in Year 3?are a sure sign that you do not have a bottom-up model.

Unrealistic financials

Only a small handfull of companies achieve $100 million or more in sales only five years after founding.

Projecting much more than that will not be credible, and will get your business plan canned faster than almost anything else.

On the other hand, a business with only $25 million in revenues after five years will be too small to interest serious investors.

Financial forecasts are a litmus test of your understanding of how venture capitalists think.

If you have a realistic basis for projecting $50-100 million in Year 5, you are probably a good candidate for venture financing. Otherwise, you should probably look elsewhere.

Insufficient financial projections

Basic financial projections consist of three elements: Income Statements, Balance Sheets, and Cash Flow Statements. All of these must conform to Generally Accepted Accounting Principles.

Investors generally expect to see five years of projections. Of course, nobody can see five years into the future, but they want to see the thought process you employ to create long-term projections.

A good financial model will also include sensitivity analyses, showing how your projected results will change if your assumptions turn out to be incorrect. This allows both you and the investor to identify the assumptions that can affect your future performance, so that you can focus your energies on validating them.

They should also include benchmark comparisons to other companies in your industry - things like revenues per employee, gross margin per employee, gross margin as a percentage of revenues, and various expense ratios (general and administrative, sales and marketing, research and development, and operations as a percentage of total operating expenses).

Conservative assumptions

Nobody ever believes that assumptions are conservative, even if they truly are.

Develop realistic assumptions you can support, refrain from using the words "conservative" or "aggressive" in your plan, and leave it at that.

Offering a valuation

Many business plans err by stating that their company is worth a certain amount. How do you know? The value of a company is determined by the market?by what others are willing to pay?and unless you are in the business of buying, selling, or investing in companies, you probably don't have an acute sense of what the market will bear.

If you name a price, one of two things can happen: (a) your price is too high, and investors will toss your plan; or (b) your price is too low, and investors will take advantage of you. Both are bad.

The purpose of the business plan is to tell your story in the most compelling manner possible so that investors will want to go to the next step. You can always negotiate the price later.