What should be in your financial model?
Mar 17, 2020
I would like to talk about the essential parts of any financial model, but also want to point out that one structure doesn’t fit all circumstances, and what works for one company doesn't work for others.
The financial model should be simple and clear especially when you’re at the seed stage. The model should be up to 3 years with a monthly breakdown. You could forecast a longer period only if you expect special events by the end of year 4 or 5.
2. What do investors want to see in our financial model?
They want to see the answers to three main questions:
- How many users will you get in 1,2,3 years?
- How the user growth will translate into revenue? 3️. How much money will you make after all variable expenses?
3. CAC - Customer Acquisition Costs
The simplest way to calculate is to take all your marketing cost for acquiring new customers divided by the total number of customers acquired in a defined period.
I recommend that you gauge your CAC for each sales channel.
Every investor will ask you a question about your sales channels and which of them the most efficient in terms of customer acquisition.
It’s so essential to understand your CAC.
LTV — it’s a long-term value of your product over an extended period of time. Sometimes it’s also called CLV - Customer Lifetime Value.
The easiest way to calculate is the Average Monthly Revenue per Customer * Gross Margin per Customer / Monthly Churn Rate. A Churn rate represents the chance the customer will still be around in future months.
But, I haven’t seen that anyone explains how to calculate this churn rate if your startup exists only a few months and you don’t have any kind of numbers. In this case, only one scenario left is to guess.
5. Revenue Growth
One of the most popular mistakes I see in a financial model is when user growth isn’t correlated with marketing expenses.
It could be only in two cases where you attract users or clients with word of mouth or through partnership. Other than these two cases you have to incorporate marketing expenses in your financial model.
The easiest way is to calculate your CAC first, then figure out how much money you want to spend on marketing monthly, and then you will arrive at a certain number of users that you will acquire monthly.
6. CAC Part 2
One more thought about CAC (Customer Acquisition Costs) - for some reason a lot of founders think that they will reduce their CAC over time.
But in reality, when you’ve just launched your service you have the lowest possible CAC and it will increase over time as you grow your user base. It’s not vice versa as a lot of founders think in the first place.
It happens because you’ve just launched your service or product and your users make up mainly early adopters. They want to try new products and they aren’t afraid of downloading new apps or services.
When you reach a certain number of users you will deplete this cohort of early adopters and you will have to work with a much more “difficult” kind of users when you need much more effort to persuade them to use your service or product. It translates into higher CAC.
When you calculate two numbers you will be able to calculate the LTV/CAC ratio. Investors want to see your LTV/CAC ratio is above 3x.
Why should it be at least 3 times?
Basically, if you have LTV/CAC around 3x it means you spend 33% of your revenue on marketing and anything above this figure would mean that your business model isn’t sustainable, especially, if you have such an LTV/CAC at the very beginning.