Convertible Notes and Startup Funding
February 12, 2025
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Planning is an essential function that the founder of a startup company needs to perform. However, this planning is often done informally. If a startup founder is not reaching out to investors to raise funds, there is a very low chance that they will have a well-documented financial model in place. However, empirical data shows that companies that have financial models in place have a significantly higher chance of succeeding as compared to other companies.
In this article, we will understand the basics of financial models as well as why they are important for startup firms.
A financial model is a way to clearly and unambiguously describe the goals of the startup enterprise. Startup models are mechanisms to create what-if financial statements which help in understanding how the company will serve its customers and what will be the cost of providing this service. The main purpose of a financial model is to allow the startup founders to check how the financial prospects of a company are impacted if any of the underlying assumptions are changed. This helps founders to foresee several possible scenarios and then be prepared for managing them.
There are two common methods that are used to create the financial model for a startup company. The details about these models have been listed below:
There is a model called the TAM SAM SOM model which is widely used for creating top-down financial models. Total Available Market (TAM) is the total worldwide market for a product. This is considered to be the starting point of the analysis. The next step is to determine the market which the company can serve given its geographical and regulatory constraints. This is called the Serviceable Available Market (SAM). The last step is to find out the amount of market which can be realistically captured based on the competitive position of the company. This is called Serviceable Obtainable Market (SOM). Once the top line is available using this method, other details such as cost of goods sold as well as overheads need to be calculated in order to derive a financial forecast.
The bottom-up approach to forecasting helps companies identify the key value drivers which lead to the growth of the company. The bottoms-up approach errs on the side of caution. It may not be the appropriate approach to make an investment pitch to potential investors who are very interested in the ability of the startup to quickly gain market share.
There are some distinct advantages of having a ready financial model. Some of these advantages have been listed below:
The bottom line is that a financial model is an important part of a startup’s overall plan. It helps the entrepreneurs gain a lot of insight since it leads them to question the validity of their assumptions.
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