Tech Cocktail is happy to share three keys to building a great financial model by guest author Taylor Davidson, creator of Excel template financial models for startups.

Financial models are always wrong, but it’s important to create one anyway. Creating a financial model forces you to outline very specifically how your business “works”: how a company creates their products, how users and customers find and use their products and how those processes create revenues and costs. The result, a set of operational metrics, financial statements and the “equation of the business,” creates a map for you to explore how your tactical product, marketing, organizational and strategic decisions impact your company’s profitability.

Developing a financial model creates the type of thought and data that helps you figure out what you are betting on and how likely your bets will pay off. Instead of focusing on the bottom-line income statement and the hockey-stick growth you’re projecting in year 3 of your venture, focus on your processes, assumptions and key drivers, and build a detailed month-by-month model that you can modify and update over time.

How?

1. Build your model from the bottom-up.
Start by outlining how your product or service is built, marketed, sold and delivered to one person.  Focusing on a single user and building a model based on a per-person/user/customer basis creates a foundation for a bottom-up financial model that creates deep insights into how the business works.  A top-down financial model (i.e. “if I capture x% of the market, it’s a big business”) is good for a simple check on market size and allows you to verify if your projections are reasonable, but it gives no insight into how the business works.

Build from the bottom-up; verify the results from the top-down.

2. Outline how the product or service is built, marketed, sold and delivered.
Start with the big idea, and then start breaking down the details at every stage.

Create your revenue plan with a very concrete, tactical, bottoms-up look at the entire chain of events necessary to take your product or service from a concept to the customer.

How long will it take to develop your product and build the organization? How will you get people to see, test and buy your product?

Think about your sales staff, website and marketing plan and how your budget for each channel translates to impressions, click-throughs, visitors, trials and sales. Outline the potential viral hooks built into your product, and show (in detail) how trial and usage will result in more people seeing, testing, using and paying for your product.

Once you’ve outlined your marketing ideas, create your user projections.  For each period, create a simple loop: users at beginning of period, users acquired, users lost (churn), users converted to paid customers (if applicable), users active, users inactive, and users at the end of period.  If you have different user segments or customer segments, create a separate loop for each. This allows you to understand your user acquisition and activation at the granular level, which is key to running an early-stage business.

Consider your revenue model.  B2B or B2C?  Freemium?  Different service levels and price points?  One-time or subscription-based? How long will the average customer keep using your product? What is your discount, coupon and trial strategy? Consider what’s relevant for you and model out your different options.

At this point, outline your expenses. Start with your hiring plan and project the types of positions you’ll need to hire, when you’ll need to hire, and how much you’ll have to pay them (salary, benefits and equity). Estimate office expenses, rent, insurance, legal, accounting, taxes, equipment, and travel and entertainment costs. Create space in your model for your marketing, hosting, sales support and delivery costs and match them to the user and revenue projections you’ve already built.

This tie between user/customer acquisition projections, revenue model, and cost structure is more important for an early-stage company than full financial statements. Once you’ve done the hard work, creating the financial statements is just math.

3. Analyze your assumptions and scenarios, and benchmark your projections
Once you’ve build this map, start figuring out what it all means.

Verify your bottom-up results with a top-down view. How big is the addressable market for your product or service, and is it growing or declining? Who are your major competitors and what portion of the market do they currently have? What percentage of the market are you estimating you’ll be capturing within 3 months, 6 months and a year? Is it reasonable?

Then, analyze key metrics and drivers. Which assumptions have the most impact on your projections? Will a small change in price have a big impact on profits?

Think about scenarios: what are best, worst, and most likely scenarios?  Model out scenarios by looking at the impact of your key assumptions on their own (univariate analysis) and in tandem with other key assumptions (multivariate analysis).

Just like you build products, iterate and refine your financial model by testing, analyzing, benchmarking and running your model by people you trust. Remember, it’s the process of building a model that is important, not the final results, so spend time thinking about how your product and business choices impact the final results.

How can one learn how to build a financial model?

Learn from those who have tread before you. I have created, modified, and delivered hundreds of custom financial models in Excel for a range of clients over the past decade and learned a lot about how to create and use financial models in decision-making.

Therefore, I created two template financial models for entrepreneurs to use and learn from, the Simple Financial Model and the Complete Financial Model. Both are fully-functioning Excel templates to help entrepreneurs create projections and financial statements for their startups.

I split them out into two models to serve two different needs: the need of the entrepreneur to estimate the basic costs and revenue of a business idea (Simple Model, and the need for complete financial statements and cap table to build a more robust model for investors (Complete Model).

The two models are very compatible: if you download the Simple Model and use it extensively, but later decided you need to add financial statements and a cap table, you can purchase the Complete Model and quickly integrate your projections in the Complete Model.

Just remember: they are fully-functioning templates, but they will require customization to fit your business. Start using them by plugging in numbers, but understand that they will take a bit of customization to fit your revenue model, your viral loop, your sales strategy, and your cost structure. Customizing and modifying is how you’ll learn to build financial models. Learn how to build financial models and you’ll make better business decisions.

Taylor Davidson (@tdavidson) is an early-stage venture capitalist at kbs+p Ventures and a mentor to a range of early-stage ventures. Over 6,000 entrepreneurs have downloaded one of his Excel template financial models for startups.  Tech Cocktail has partnered with Davidson to offer this important tool on an ongoing basis (look in the right rail under Sponsors and Partners).

Act fast! The first 100 Tech Cocktailers to download either one of the models using code “TechCocktail” will get 25% off.