Approaches to Strategic Financial Planning for Startups
Originally posted on September 7, 2022
I want to turn to a different topic: approaches to strategic financial planning for startups, a timely topic now that we are in September! A few weeks ago, I wrote why starting financial and strategic planning early in 2H of the year is important. Now, I will discuss best practices in constructing a strategic financial model that will guide the business operations of a startup.
The challenges with strategic financial planning in a startup are often the below:
- No clear consensus of the exact milestones to back solve (Board members can have different ideas or vague ideas due to their prior experience). Publicly traded companies or companies of larger size have milestones that are, in general, clear because they have benchmark and/or baselines (analysts consensus on revenue growth and EPS, profitability, debt to equity ratio etc). Early startups do not. Rule of thumbs around SaaS metrics are general, and many non-SaaS deep tech and/or new category companies do not have clear benchmarks and baselines.
- Linear financial modeling does not always work. Customer count and size do not grow with a predictable slope. Adding more sales headcount doesn't always translate to more ARR. More budget on marketing doesn't always translate to top of funnel growth.
- Skilled finance leadership skills are not always available. Also finance teams are not always able to translate traditional FP&A to strategic financial planning for startups (esp. early stages ~ stages Seed to C...).
Despite these challenges and barriers, it is highly critical for startups to have a clear financial planning even if it is 80% right. At least the company will have a logical and validated direction to row, and everyone in the company will operate on the same financial plan.
Two main approaches to strategic financial planning and modeling:
Type 1: Top-down financial model
Must-have or major financial milestones are used to help set the targets and direction. Extrapolate based on prior year performance (actuals) to see whether the milestones are impossible or potentially feasible (but challenging). Evaluate the target's aggressiveness based on what the company can possibly do and what the "market" expects. "Market" being prospect investors investing in similar companies at similar stages and the macroeconomic environment.
Example: business needs to achieve $X ARR and/or bookings and desires a new financing event (equity, acquisition, IPO) in x months, or achieve profitability in y month, or achieve cash flow break even in z months. Finance builds this model with a set of assumptions based on contract size, contract type, duration of the contracts, sales productivity and ramp, sales cycle, customer acquisition cost, R&D expense, G&A, other expenses, account receivable and account payables, and other variables.
- Top-down approach helps to see where things break based on targets.
- Top-down approach helps answer simple but fundamental questions: What does it take to get to _____? Are the assumptions realistic? This modeling approach is helpful for major goal setting while keeping everyone grounded.
- CEO and the Board can use the top-down model approach to set target when there is misalignment among key functional leaders. This approach helps facilitate a data-driven/finance-driven tie breaker to ameliorate or end misalignments.
Type 2: Bottom-up financial model
Building the model from the ground up: solicit operating inputs from each department and build these into the model to first see what happens. Then iterate and synchronize with the departments to refine.
- Bottom-up financial modeling facilitates conversations about how business should be run and a synchronization process between functional leaders and finance.
- Based on historical metrics and what sales, marketing, R&D, product leaderships think they can achieve, construct a dynamic set of P&L, balance sheet, and cash flow statements. The bottom-up model is the basis of an operational plan that tie to financial metrics.
- This approach, in general, requires a finance-literate CEO and/or a skilled CFO who has strong understanding of the business strategy and operations.
Startups need to model in both approaches
Top-down and bottom-up models do not converge on their own. A key reason to construct the financial model in both ways is to calibrate when many unknowns exist. Then tweak the bottom-up model to make it a realistic plan to implement.
A combination of target setting that tests the limit of of the model and incorporation of department-level budgetary requirements will help unveil flawed assumptions, misalignment (either over allocation or under allocation of budget), weakness in assumptions, and overlooked revenue and expense synergies.
The additional insights from two approaches enable CEO and CFO to run additional scenarios and further evaluate whether changes in business performance levers such as expense management, productivity, talent & skills change, and additional capital would bring two views of the models closer.
The converged view that is a combination of target setting and bottom-up is right financial model to operationalize and enable performance accountability. But it takes a lot of work to do this due to the challenges I mentioned above.
The most operational investors will most likely appreciate this combined approach, both for financial due diligence and for portfolio management.
All writings reflect my personal views. Not investment advice or advisory.