Financial Modeling, a decision making tool for Social Enterprises
In the seven years that I have been mentoring social entrepreneurs in the Miller Center accelerator programs, I have noticed that financial modeling is the one aspect of the program that causes the most distress for many entrepreneurs. This is understandable since the concepts and terminology are often unfamiliar to social entrepreneurs and the type of model to be used can vary by the nature of the business — service vs product for instance. Multiple product lines and hybrid business models further complicate the modeling task. The finance experts at the Miller Center are available to help entrepreneurs with choosing the right modeling framework. My experience working with social enterprise has taught me a few things about the mindset necessary for financial modeling, which I believe have not been articulated before. This is what I am going to write about in this blog.
Two Views of Financial Modeling
There are two views of financial modeling. There is the accounting view, which is historical and views financial statements as reports on business performance. When public companies release quarterly statements, they are taking an accounting view. The other view is the financial view. This is forward-looking and views the financial model as a tool for decision-making. It is this view that private social enterprises must adopt.
Financial Model Makes the Business Plan Concrete
The financial model brings the various components of the business model together — the unit economics of the products or services, the choice of target markets, the go-to-market and sales strategies and the financing decisions. The income statement of the financial model captures the sales growth trajectory. The size of the target market, go-to-market strategies, sales process, the intensity of competition and production capacity will determine how fast sales can grow. The unit economics determines how operating margins will grow with sales. In short, a well-articulated financial model can demonstrate that the entrepreneur has a good understanding of her business.
Set Targets not Projections
Some founders are troubled by having to forecast their sales over multiple years. Yes, I understand forecasting sales is difficult to do especially for early-stage startups. The task for entrepreneurs is actually simpler than that. Entrepreneurs must view the sales numbers that go into the model not as projections or forecasts, but rather as targets they want to achieve. Targets spur action. Marketing and sales strategies, and production capacities should be geared to achieve those targets. Early-stage entrepreneurs should set modest targets for the near term (6 to 12 months) since during that period the entrepreneur is exploring product (or service)-market fit and it would be unwise to push for aggressive targets until there is evidence of product/service-market fit.
Track Actual Sales Performance
It is important to periodically compare your targets with actual sales achieved. This is how the entrepreneur learns whether her strategies are working and what adjustments are needed. Small deviations from the targets cannot be avoided however if the actuals are significantly short of the targets — either the entrepreneur misjudged the product-market fit or his sales/marketing strategies were inadequate to achieve the targets. If the actuals are higher — and it is not explained by an unusual event — the entrepreneur may have been too pessimistic in setting targets. Large discrepancies between targets and actuals should trigger reevaluation of the business plan and updates to the financial model.
Set Monthly or Quarterly Targets for the Near Term
For the near term — the first 12 to 18 months — entrepreneurs should attempt to model quarterly financials. For early stage entrepreneurs I would go further and suggest that for the first 6 months the targets be set monthly. This goes back to the point about learning by comparing targets to actuals. Setting monthly or quarterly targets allows the entrepreneur to quickly learn whether her strategies are working and allow for timely adjustments to the business plan.
Cash is King
Financial professionals focus on cash positions in preference to profits. And rightly so. An enterprise can operate unprofitably for years especially when they are spending large sums on growing the business. However, if it ever runs out of cash, the business will have to stop operating. According to CBInsights, the number one reason for startup failure is running out of cash and failing to raise new financing. Hence, careful modeling of cash flows — again quarterly for the near term — is essential. The cash flow statement is what tells the entrepreneur how much financing is needed. Even if the business is highly profitable, careful modeling of cash flows is important due to the time gap between when the business has to pay its suppliers and when it receives money from its customers. It is the cash flow statement that feeds the numbers that go into the “justifiable ask”.
Be Optimistic While Setting Targets, but Pessimistic While Raising Financing
The entrepreneur should be slightly optimistic in setting sales targets — it is good to have his reach exceeding his grasp. However, in calculating financing needs one should be a bit pessimistic — the unexpected can always happen, but the business should not run out of cash. The common advice is to typically provide for an 18-month cash runway.
Some entrepreneurs have the opinion that the financial model is done only for the purpose of fund-raising. I hope I have made the case that the financial model is primarily for the benefit of the entrepreneur and only secondarily for investors and the board of directors. For investors a summary of the financial model with annual numbers should suffice. With the right mindset the entrepreneur can approach financial modeling without trepidation.