I’ve often wondered why founders struggle so much to explain and defend their startup’s financial projections. Then I sat in on a financial modeling workshop for founders and immediately understood why.
The session started with a simple lemonade-stand example and quickly moved to the mechanics of financial projections. As it progressed, I was dismayed to see that there was no mention anywhere of how to develop and test the assumptions that go into credible financial projections. It’s no wonder founders stumble when explaining and defending their models – they’ve never learned what makes them tick.
Without rock-solid assumptions, the most intricate financial model is worse than worthless – it can lull you into a false sense of security. It won’t fool investors – they can smell a phony model a mile away. Instead of wasting time building fancy spreadsheets, you’re much better off focusing on the invisible but essential foundations: its assumptions.
Financial models are like school exams: your answer may be wrong but you’ll get a lot of credit for showing your work. Articulating a strong set of assumptions is what convinces investors that you understand your business at a very deep level. You can always hire an analyst to build a great model but no one except you, the founder, can articulate how the pieces fit together and why they will work.
The Foundation of Great Assumptions: The “Build, Sell, Run” Framework
Founders go astray in building assumptions because they take a “one size fits all” approach to modeling vastly different activities that make up a startup’s story. It’s like using just one method to cook every part of an elaborate meal – it makes for a terrible dinner. There’s a better way to not only make it easier but also build more defensible assumptions.
Think about it like this: everything you do in your business falls into three categories – building products or markets, selling products, or running operations. The specific activities involved and how they behave is very different in each category.
Build: Development Costs and Milestones
“Build” activities are what you undertake to develop and launch a product or market. They’re driven by specific milestones unique to your business. They occur irregularly based on specific events like creating a product design, building a prototype, or filing for a patent.
So the assumptions in the “build”category will depend on development tasks, resources required, and your projected timeline. To accurately define these assumptions, break down your entire development process into milestones. Identify the tasks and resources needed for each milestone, and then estimate the timing and costs involved for each.
Sell: Revenue & Channels
You’re in business to sell a great product to a hungry market. The end goal is sales and revenue. So the anchor for “sell” assumptions is units sold, not dollar revenue. You sell these units through multiple channels, investing money and resources to attract and convert prospects from your market.
So when developing sales assumptions, start from the investment in your channels, activities needed and the expected conversion yield from each channel. Done right, your sales estimate will be like a potluck table where multiple channels all bring their own contribution of sales and revenues. The key here is to get your investment, timing and the yield for each channel right. Once you get that right, estimating other unit-driven elements like cost of goods sold becomes much easier.
Run: Time-Driven Costs
Like the staples of a fulfilling meal, some expenses are essential to running your business smoothly. These are items like rent, salaries, lawyer fees, insurance premium – expenses you traditionally associate with financial modeling. While these are important to get right, they rarely tip the scale in the decision to invest.
The key with these costs is ensuring you’ve captured all of them, and using the right basis to estimate amounts. The rest of the work will almost do itself. For example, if you correctly estimate office square footage needed, and the rent per square foot, your rent assumption will pass the smell check. A checklist approach is valuable and efficient for this category – just remember to include all items that are unique to your industry or business.
Once you approach your assumptions from this angle, you’ll find it easier and faster to develop a credible story you’ll have no problem explaining or defending.
The Making of a Killer Assumption
Having a handle on the barebones assumptions isn’t enough. They also need to be in the right shape and form to make your financial projections stand scrutiny:
Clarity and Completeness
If every assumption isn’t clear and complete, your investors will be forced to guess what it means and how it impacts your model. Here’s what helps:
- Specificity: What’s the exact item it stands for, and how specific is it? For example, in modeling electric vehicle battery manufacturing, the assumption isn’t just “materials”, it’s “Raw material cost – Nickel”.
- Measure: What’s the right yardstick to measure this item? e.g., pounds per battery
- Value: What’s the money equivalent for each unit you specified? E.g., $7.24 / lb
You’ll know you’ve got it when your model specifies 62.2 (lbs) of “Raw material cost – Nickel (lbs)” at $7.24 / lb, instead of “Materials: $450.33”
Logic and Links
Investors also want to know the rationale behind your assumptions and its domino effects on the rest of the model. For example, they’ll test:
- Source: Where did you get this number from? Your own experience (e.g., past purchases)? Market quotes? Talking to experts?
- Rationale: Why is this appropriate? For example, your cost assumption is higher than current price because nickel prices are rising.
- Links: What’s the impact this assumption has? For example, your nickel cost assumption notes: “Used in cost of goods sold calculation”
Whether it’s you or an investor reviewing your model, you’ll be able to understand and evaluate this assumption at a glance.
Realism, Impact and Refinement:
Your startup is new so investors understand that you may take some leaps of faith on key building blocks. Maybe there’s no comparable item, or important numbers aren’t yet known, like production efficiency, for example. That’s okay provided you effectively clarify these issues:
- Realism: What’s your confidence level in this assumption? For example, you may indicate a 75% confidence level for nickel cost, so investors understand the level of uncertainty behind the number.
- Impact: How big is the impact if your assumption is wrong? Highly impactful assumptions draw greater scrutiny. For example, if nickel prices are very volatile and it’s a key ingredient, this assumption will be tested heavily because of its large impact on margins.
- Refinement: For numbers that may change, it’s important to clarify how often you’ll update the model. For example, you may indicate monthly updates for volatile nickel costs.
The commentary you provide around assumptions will help you focus on the heavy hitters that impact your results. More importantly, it will bump up your credibility significantly in the eyes of investors.
Putting It Into Action
A strong grasp on the what, how and why of assumptions will take you most of the way to building a defensible model you’re not ashamed to take out in public.
Here’s how to put it into practice:
- Develop itemized lists for each category of “Build, Sell & Run” for your startup
- Build out each item in full with the right representation, measure and value
- Document sources, rationale and links to key outputs or results, assumption by assumption
- Think through your level of confidence, its impact on the big “R”’s (revenue, risk, return) for the business and capture your thoughts in the model
- Organize and document all the assumptions in a single place.
Voila! You’re done! This is the hardest part of building financial models. Once you have this right, the actual building of the spreadsheets is a mechanical exercise. It definitely needs to be done right, but you can outsource it to a spreadsheet guru. That’s not what you’re graded on as CEO.
The big bonus is you’ll cruise through model explanations, ‘what-if’ questions and scenarios effortlessly because you’ve nailed the most critical part of financial models.
What assumption will you start architecting today?
