Why we are talking about this:
As early-stage investors, we have seen plenty of financial models, balance sheets, budgets, & forecasts. Surprisingly, considering the importance of cash for any company, it doesn’t seem like there is a consistent “best practice” for financial modeling at the early stages of building a company.
This post is for entrepreneurs who are just getting started. Maybe you have an idea, an MVP, or even one or two customers. If you already have significant revenue then the finance function of your business will look very different than what we present here, as it should. So with what appears to be an endless amount of advice for budding entrepreneurs, we wanted to create something that would help you cut through the noise and focus on the one thing that truly matters: cash.
We have seen pre-seed startups doing everything from 5-year models, discounted cash flow valuations, and complex scenario analysis. But for a business with little to no revenue, and maybe an MVP, do you really know what your finances will look like in 5 years? How confident are you in that model?
As investors, the most important things we look for in pre-seed financials are 1) where the cash is coming from, 2) where it’s going, and 3) how that translates into progress towards meaningful milestones. We believe that as an entrepreneur, those three things should resonate with you as well.
Where is the cash coming from?
The title tells you everything you need to know. The first section of your model should be all about what cash is coming into the business and where it’s coming from.
Cash sources could be revenue, investment, grants, loans, or any other substantial funding. Breaking out the sources of all your cash line by line helps provide a clear picture of what is really keeping the business alive. Is revenue your main source of cash? Investor capital? non-dilutive funding or grants?
A common pitfall we have seen is the desire to lump everything into “revenue”. From the accounting perspective, this may be correct in some cases. But it doesn’t provide the insights you need to properly manage your cash.
For example, a business with $500,000 in revenue being sourced by selling products to customers is much more sustainable than a business with $500,000 in “revenue”, with no customers.
Where is the cash going?
It’s important to get a grasp of where your spending is coming from. Creating a balance sheet and listing all your major expenses line by line can help give you the visibility that you need.
It’s important to use “fully loaded” costs here. For example, with employees, you must also pay the employer portion of CPP, EI, vacation pay, benefits, etc. What this means is that the software developer you hired with a monthly salary of $7,500 can end up costing more, depending on your local labor laws.
When it comes to expenses, don’t feel obligated to list every expense item. Some things like software subscriptions you can lump together to make it easier to read. Especially if the amounts are small. Once certain expenses get over a certain monthly threshold perhaps revisit breaking them out (i.e. paying $2,500 a month for HubSpot).
Understanding the end result: Your cash balance
On a monthly basis, you want to understand how much cash you are forecasting to have at the end of the month, as well as how much runway you have remaining. The math is simple: (cash in – cash out) + previous month’s balance. If you’re not yet profitable, you will notice your cash balance continues to decrease. For profitable businesses, this number will increase.
As the months go by, filling in the “actual” numbers for your cash-in and cash-out items on your balance sheet gives you a glimpse of how your cash balance will change in the future. For example:
- Slow revenue growth may mean that cash-out is closer than anticipated. Perhaps you hold off on hiring that SDR and customer success rep to help extend runway.
- In a tight labor market, the cost of great talent may have been higher than you planned. Again, this will reduce the time you have until cash-out.
- A favorable scenario – perhaps revenue growth exceeded expectations and you want to know if you can hire the customer success rep 3 months sooner. How will this impact your cash?
Milestones are what define the progress your business is making. Proper milestone identification is a topic on its own. At a high level, it’s important to lay out your roadmap alongside your financial model.
Being able to see your milestones on the same page your budget allows you to ask some key questions:
- Am I spending money on the right things, at the right time?
- Will I run out of money before achieving all my milestones?
- Do I have extra time to achieve milestones if things take longer than expected?
This also helps both you & investors understand how spending ties back to milestone attainment.
As your business grows, revenue tends to become more predictable. When that time comes, you can start to plan on longer time horizons, which increases the complexity of your modeling. Picture driving a bus, when going slow you don’t need to see too far ahead of you. But once you are traveling at 100km/h you need to see pretty far ahead. The same can be said with financial planning.
For a pre-seed company with little to no revenue, it’s almost impossible to predict where you will be in the next 24 months. Sure, it will look nice in the spreadsheet and give you some confidence, but will you be right? Unlikely. Will you need to make significant changes? Almost certainly.
Planning for the next 12-18 months is what most early-stage investors are looking for. Answer the question, “what gets us to a seed/series A round?” and then show that from a numbers perspective.
You don’t need multiple tabs, with tons of variables and complex calculations, and you certainly don’t need a discounted cash flow valuation.
In addition, you don’t need to plan 3-5 years out, not yet.
At the early stages of your business, all you need is a bulletproof understanding of where the cash is coming from, where it’s going, and how that translates into progress.