Now About That Model…
As we approach the 10th anniversary of LaunchCapital’s founding, we often talk about how much the early-stage investment ecosystem has changed in the past decade. Ten years ago, there were few institutional funds focused on early-stage venture investing, and resources for aspiring entrepreneurs were sparse.
Since 2008, we have seen an extraordinary change in the market with the introduction of incubators and accelerators locally and across the country and a plethora of new funding options available to founders. This has provided access to unparalleled resources, programs, and mentors to help entrepreneurs craft their stories and hone their pitches. Today, I seldom see a pitch deck that doesn’t at least tell a credible story about a potential business.
The same cannot be said about the financial models that accompany these pitches. It has become cliché to hear that early-stage investors focus heavily on the team since there is often little demonstrated traction on which to judge a new business. While it is true that team is a crucial component of evaluating an early-stage opportunity, it is just one component.
At LaunchCapital, we look for companies that have a compelling product with a differentiated, sustainable value proposition and a sizable market opportunity. The result of connecting that product, value prop, and market opportunity is a financial model upon which the company will ultimately be valued.
My personal screening process typically works in this order:
- Is the team credible / backable?
- Is the product compelling and the value proposition viable?
- Is the market large enough to build a high-growth, sustainable company?
- Does the financial model make sense and enable a path to high growth, profitability, and exit?
How Models Fail
Many of the financial models I see during the pitch process fail to demonstrate a reasonable path to success – even for great businesses. Let’s look at some common mistakes and my tips to avoid them:
Drive your business model with bottom-up – not top-down – market projections.
I sometimes hear founders say, “the market is $2B, so we only need to capture 1% to have a $20M business in 3 years.” This is almost a showstopper. Revenue models should be built from the bottom up. There may be a multi-billion dollar market opportunity, but what particular sub-segment of customers will be the early adopters and why? While a top-down view of a market opportunity developed by a third party (which should be sourced) can provide validation that the addressable market is large, founders need to demonstrate a deep understanding of their target market. Their demand assumptions and revenue projections reveal a lot about the depth of that understanding.
Be very wary of characterizing your financial projections as “conservative.”
After 10 years of early-stage investing, I think I can count on one hand the number of models I have reviewed that I truly felt were conservative. The reality is that venture investments are expected to grow fast. Growing fast is very hard to do, and any number of circumstances can disrupt the best-laid plans of entrepreneurs. Schedule slips, longer-than-expected sales cycles, team issues, and customer churn can and will challenge the best assumptions about market adoption. Any model that projects revenue doubling or tripling year over year for several years is not conservative. That said, this is more of a pet peeve than a showstopper.
Show realistic operating margins as growth accelerates.
The out years in any early-stage company’s financial model are relatively unimportant, given the high degree of uncertainty. I do, however, look to see if the founders understand what type of team it will take to operate a high growth business. Many founders project operating margins of 80-90% in the out years, which is completely unrealistic. As your business scales rapidly, so will your team… in sales, marketing, engineering, finance, HR, customer support, client success, etc. For reference, Facebook is perhaps the most profitable large company on the planet today in terms of operating margin, and it runs at about 50%. If your model shows an 80% operating margin in Year 4, something is missing!
Getting to “Great”
So what should a good financial model look like? We like to see the following captured in a clean, concise spreadsheet:
A one-year forecast by month that captures the data typically found in an income statement.
This includes revenue, COGS, gross margin, operating expenses (R&D, M&S, G&A), operating margin, and cash burn. A separate line item for customer acquisition expenses can also be helpful for recurring revenue businesses, as this allows us to clearly see the money spent on acquiring new customers.
A second-year forecast by month – or at least by quarter – that captures the same information as above.
In total, we like to see a 3-5 year model, as this reveals the founders’ assumptions about their company’s growth. We also like to understand the founders’ views on what it will take to build a break-even business in that time frame. The out years of the model serve as a sanity check more than anything else.
Explanations of your assumptions about the key drivers of revenue and operating expenses.
For example, what is the sales model – direct, inside, channel partner, or some combination? What assumptions are made for each sales rep or channel partner? How quickly does a new rep or partner reach steady state? These assumptions should drive the revenue and OpEx lines in the income statement.
For recurring-revenue businesses…
The key drivers of LTV and CAC should be clearly listed and defined as variables. For example, the key drivers of LTV should include customer lifetime, ARPU, and churn.
For hardware and physical-goods businesses…
What is COGS today, and what will it be in the future? What are the most significant contributors to the bill of materials? How will you reduce costs in the future? For example, will you create cost efficiencies through volume, redesign, or component substitution?
Stand out With a Great Model
In the last decade, many founders have learned to build a great pitch deck to tell the story of their business. I would like to see more take the time and effort to build a solid financial model that supports their story.