Get ready for the new financial year with fundamental tips from the SME Centre of Excellence.
1. To build an economically viable business, you need one. Why? The reason for this is that by quantifying (and then validating) your business plan and business model, assumptions, and vision, you can determine whether or not your ideas can be turned into a sustainable operating business. In addition, if you build different versions ("scenarios"), you are better prepared for the future, especially if things do not go as planned. What if you launch half a year later? Or what happens if there is a Pandemic? When you answer such a question in your "worst-case scenario," you can anticipate how your cash flow, profitability, and funding requirements are affected.
2. You need one as part of the fundraising process. When you engage with a financier to raise funding, whether angel investors, venture capitalists, banks, or subsidy providers, they will usually ask you for a financial plan. It is wise to create a model even if you only need to provide high-level data to certain investors. Why? When a financier dives into your business case, you can answer the tricky questions that may arise. Additionally, how are you going to raise funding if you haven't calculated how much funding you need?
3. You need one to inform yourself and shareholders. If you don't have any targets to aim for or steering information to compare with, how can you know how your company is doing? Without a financial plan to benchmark against, how can you update your shareholders on how you are spending their money and whether you are performing as promised? 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.