Note: this was originally published at https://alexoppenheimer.substack.com/
For the last 10 years I have been working in startup finance. This has taken a few different forms, but has recently been focused on helping early stage (and occasionally late stage) companies with their business models. I also do financial models, budgets, forecasts, company analyses, projections and even some accounting. But for me, modeling is the most important and interesting part of the startup finance puzzle and should be the bit of finance that every executive and manager understands. So what is modeling?
To understand the role of modeling, I go back to my education in mechanical engineering and the 3D CAD (computer-aided design) models we built before we started manufacturing a device.
What is the purpose of these models?
- Create a digital representation of a physical device
- Run digital simulations on it and understand how it will react in the real world
- Guide the manufacturing plan
The most important aspect of any model is that it accurately reflects the physical reality. Think about a model of a bicycle - it is critical that it looks like a bicycle but also that the wheels spin and that when you turn the pedals it makes the chain move the sprockets to turn the rear wheel. If that does not happen, it is a pretty useless model. It might be visually accurate but does not represent the mechanics of the device, which is the purpose of a model.
Inputs → Mechanics → Outputs needs to make sense for how the device actually works in order for the model to have value.
A business model needs to work the same way. Inputs, mechanics and outputs need to accurately represent how the business functions.
- Inputs should be in two groups:
- Things that we control that impact our business (i.e. advertising spend, pricing).
- Things that we do not necessarily control but that we can measure and potentially influence that impact our business (i.e. taxes, churn).
- Mechanics of the business then need to flow logically based on the operations and strategy. Operations are a combination of people, technology and process. The people include executives, managers and individual contributors.
- Outputs are the key success metrics for a business. These can be top line metrics (i.e. users, revenue), bottom line metrics (i.e. net income, cash flow) or ratios (i.e. sales efficiency, growth).
Stringing all of this together in just the right way and at the right level of detail is the art of modeling.
I always start modeling exercises on a piece of paper in order to visually map out how the business functions before talking numbers or taking it into a modeling tool.
A good model answers questions like "what will this business look like at scale?" "will we ever be profitable?" "if we spend X on marketing, how quickly can we grow?" "how much funding do we need to achieve our goals?" "How many sales people do we need in order to grow to $X of revenue?" "If our efficiency decreases by X% can we still make money?"
A good model starts with a strong product vision and clear ideas about how the business operates and aims to quantify them.
A good model does not need accurate input assumptions to be a useful exercise, though it definitely helps. This is what the phrase "garbage-in garbage-out" comes from - a great model cannot compensate for weak inputs. I have seen some businesses where there is gold going in and gold coming out despite the model being a mess, but these are very rare. I have seen many more businesses that have gold going in, a weak model and then the gold that is initially coming out devolving into garbage. (Happy to discuss this dynamic in more detail as it usually a result of not understanding the aforementioned business dynamics.)
The power of a good model is understanding how changes in the inputs will impact the outputs and how operational changes impact the model itself.
A model is a top-down tool you can use in order to set goals and build effective budgets from the bottom up.
A company at the ideation stage can benefit from a model and so can a fully scaled business, albeit in different ways. Often the model building exercise is more important than the specific outputs or conclusions. The process should give the operator clarity on the key levers in the business, how they interact and what the company can do operationally to achieve company goals.
Understanding the nuanced relationship between these financial tools and exercises is a huge asset to any operator and the specifics can vary widely for different companies and at different stages. This is the short answer for why I focus on bringing a sophisticated financial approach to early stage companies - to unlock the power of the financial and modeling perspective as an operating asset that improves efficiency and visibility by empowering data-driven decisions.
It wouldn't be a SaaS Engineering post if I didn't talk about Causal.app: Causal is a tool that allows people to focus clearly on modeling. By separating inputs, calculations and outputs, having visual references and straightforward visuals, the product makes it clear to the user how the inputs flow through the model and into the outputs, which is the purpose of a model. It opens up the power to quickly build an accurate and useful model to any operator instead of limiting it to excel whizzes. Nobody understands a business as well or as intuitively as its founders.
Giving founders without finance backgrounds the ability to quantitatively represent their businesses provides them a valuable decision-making tool and method to validate their instincts. The beauty of Causal is that it is built for business modeling, budgeting, forecasting, financial modeling, and even accounting, and allows you to integrate all of these tools in one place, comparing projections vs. actuals and bringing in historical data for real-time updates.
As always, feel free to reach out directly with any questions or comments and take a look at this operationally-focused SaaS model in Causal: https://my.causal.app/models/1378
Causal also allows you to input ranges like “10% to 15%” as assumptions and then see how those ranges flow through the entire model.
I have found there is some confusion about the different tools in a the finance toolbox and what purpose they serve. Four other important tools are:
- Budgeting. The detailed exercise of figuring out how much money is going out of or into the business (usually in the near term). Budgeting includes things like detailed hiring plans, line-item expenses, by-channel ad spend, etc. Budgeting is like the manufacturing process plan that I mentioned above. I have found that budgeting revenue is not super valuable outside pipeline analysis exercises.
- Accounting. This is what the government needs to see and is the official record of a business. Accounting rules do not usually map well to a company's specific business metrics and should rarely be used to guide the business. Accounting should generally not involve an "artistic" element like I mentioned before with respect to modeling (the government does not like art in its financial records).
- Forecasting. The projection of where the business will land. It is often a combination of the model and the budget, and then figuring out where the business will be compared to pre-determined goals. This is a regular exercise that gives clarity to operators on how they are doing. It should also help uncover operational issues.
- Financial Modeling. This is a specific type of business modeling that generally involves income statement, cash flow statement and balance sheet, and illustrates how they interact with each other. A financial model is most valuable in the context of a transaction - equity, debt or change of control. In many ways, it is a combination of modeling and accounting.