💰 Finance
Series: Day One

Setting up Your First Basic Financial Model

Sunil Nagaraj

Module Description:
Sunil Nagaraj talks through a simple but practical financial model appropriate for pre-seed or seed-stage startups that are at the pre-revenue, early pilot, or early revenue stage.

View/copy the Google Sheets template at https://bit.ly/3ZvKcIC

Full Transcript:
Welcome to our Ubiquity University session on building your first financial model. My name's Sunil Nagaraj and I'm with Ubiquity Ventures. We're a pre-seed and seed stage venture capital firm, investing in startups that are moving software beyond the screen. What that means is the companies we back are solving real world physical problems, often using smart hardware and machine learning to transform something physical into software.

For today's session, we're gonna actually dive right into an actual Google Sheets model to explore what a appropriate model would be like for a pre-seed or seed stage company planning the current operating plan or planning a model for a future fundraise. This is our suggestion and we're gonna have a lot of trade-offs in building this model and going through this model, but this is our recommendation to capture accuracy, precision, but also practicality. So with that, let's look at this model here. So on screen here, what you'll see is our Ubiquity financial model template. This is for a new company and we'll use the word proforma financials to talk about sort of the future and what may happen. As to orient you here, as we go across what you'll see is one month per column, and then as you go down, this would be a PNL, a profit and loss statement where we would talk about how much in revenue did you generate, what is the cost of that revenue, specifically cost of goods sold, we'll talk about what that means. How much in gross profit, operating expenses. And then finally, what is your total spend, your total gross burn, your net burn, and how does that impact your month to month cash? So we'll go through this very slowly and we'll talk about how we build it up. But the gist of this is how much money are you bringing in, how much are you spending, and what does that do to your month to month cash balance? As we think about every month, you very often in early state startups, your cash balance just goes down and down and down. You're building the airplane on the way down until you take off.

So with that in mind, let's dive right into the first piece of the puzzle here. So as we look at revenue, where we think that is great to model at the early stages is to think about this as how many customers do you have? And in particular, what type of customers are they? So what we'll do for a very simple model is to think about at the beginning of the period in blue, blue is usually used for inputs. Black means it's not an input, it's a calculated field. So for blue here, how many starting customers, how many customers did you add in that period, in the month of January? And then how many customers do you end with? You'll see this number kind of grows and grows. And then at some point we have this other category called churn customers. Here we lost a customer. So we have three at the start of period, three at the end of period, and we factor with that even along the way. So this is, we think, an appropriate level of detail to model very early on the addition/subtraction of customers. And what you can do then is think about how many new customers are you expecting to add in a particular period. You know, in this particular instance, we're hoping to add 12. I'm looking at the bottom right here. And within that figure 12, we can compare that to our pipeline, compare that to our market size. Do we think it's reasonable to add 12 in that period? So the net effect is that we're growing our cumulative sort of end of period customers to nine over that time period.

So now what we'll do is we'll dive into the revenue section now that we've talked about customers. And the way we turn customers into dollars is to dive into the pricing. So we'll start by saying an assumption again in blue, that the average MRR, the monthly recurring revenue per customer is $12,000. When we play that out times the one customer that we had at the start of this period, it's $12,000 of starting MRR. And then we can add on $12,000 of new MRR because we had one new customer. That's 24,000 of total MRR at the end of January, which becomes our starting MRR for February. And at this point it gets a little bit more interesting. We do model one additional customer, but then there's a new piece which is expansion. What this means is we're thinking about what happened with the January cohort of customers. The customers that were there as of the end of January, we're modeling that they grew, they expanded by 105%, so they grew by 5%. And that's what this is referring to. This could be 'cause of price increases, upsells, it's a very broad assumption, but when you model that out, now you have a total of 37,000 of total MMR of 24K was starting, 12 of new 1200 of expansion MRR. The next month we have something else even more interesting. So we went from three end of period to three starting a period, customers, we added one, but this time we lost a customer. So again, we'll take the MRR from last period, think about how much a new, how much an expansion, and this time we'll actually model in a churn customer. Again, lots of assumptions they could have churned from the prior price point, but this gives you a pretty good sense for modeling purposes of what's occurring here. So now we end with this similar looking amount of revenue, even though we added a customer, we lost a customer, there was expansion. So as we play this out over time, you know this model I think we've played out for 24 months, it's typical to have an 18 to 24 month model when raising capital at the beginning, earlier periods. Here, what we're doing is we're modeling this timeframe where we grow from being 24,000 of revenue all the way up to, let's say 18 months later, 295,000, 294,000 of MRR. These assumptions, again, we recommend kind of blue allows you to change the assumptions along the way. And then you end up with ending MRR and all the calculated fields are in black. So that would be the monthly recurring portion. And for most startups these days, the focus is on recurring revenue. But on top of that, there are two other potential sources of revenue, especially at the early stage. There could be pilot revenue. And here this is a simple input. You could say, you know, it may be the case that let's make some changes here that we don't expect to have any customers for a while. And what we'll do is we'll just put zeros in everywhere here. But what we do hope to do is to have some pilot revenue. So let's put in, you know, $10,000 of pilot revenue from an early customer, maybe another $8,000 in a few months. So what this lets us do is model in kind of the impact and it'll flow through to our cash down towards the bottom. There may also be services revenue, and that can be even after you have monthly recurring revenue turned on, when you have recurring customers, there might still be some, some customization and there's an ongoing debate as to how attractive services revenue is, but this is, let's say a $30,000 one-time fee for somebody because they want your product with a different set of customization. So we can model it in and it adds to your total revenue, but it does not add to your MRR if that makes sense. So that's, I'm gonna undo a little bit of this to go back to our original model that we had laid out with the inputs. So for now we'll close up customers and revenue and we've gone down so far to total monthly revenue.

The next piece here, after revenue, there are effectively direct costs and indirect costs of running the business. Direct costs would be COGS. So every incremental new customer requires an incremental new input. And so typically cloud costs and potentially other things, maybe inventory for a hardware startup, they would go into COGS, cost of goods sold. For now, a very simplistic assumption is that we think it's about 10% of the price of the product we spend on cloud. And what that kind of means is 12,000 of MRR per customer means 1200 a COGS. For every customer you sign up, it's about $1,200 in cloud costs. That may or may not be realistic. And what truly happens is at the beginning, you have a minimum provisioning size for your cloud. So it may actually be $12,000 of COGS and that's a fixed item that runs across. But you can model this in different ways. Simplistically though, we've said that it's always 10% of the recurring revenue is your cloud costs. We've left out inventory and inventory can be modeled relatively simply as a percent of the price. If you are doing a smart hardware product and you're charging $12,000 a month and you know that it costs you 5% of that or 30% of that, you could model it that way as inventory or you could model it 'cause this is a hybrid between a cash and an accrual model. You could model this as sort of the bulk purchases along the way and put 20,000 here and 20,000 here. It continues to be a tricky thing to try to model perfectly accurate in cash or accrual at the early stage. But generally we default to cash 'cause we're trying to build this model primarily to understand how long we can run the company. So when you have the total COGS here, so now we know that we had 25,000, 26,000 of MRR and about 2,600 of COGS. The difference between those is the gross profit. And this is now a figure which allows you to spend money on running the business, right? This is not a direct cost. These are indirect costs to running the business and it results in a gross margin. We put in here in italics some of these calculated helpful metrics, but they're not core to the model. So that's why they're in italics. Continuing down, what we have here is operating expenses. So again, running the business, you need to have a team to run the business and there's administrative and other costs. We'll go into what that means in just a second. When you do that, let's go back to our figure here of 25,000. We're looking at March for example. We had 23,000 of gross profit. And then when you layer on the number of people, the RND the management, et cetera of salary and then administrative and other, you end up with a monthly gross burn.

When you look at the total monthly gross burn, you're adding the COGS that you had to spend money on, the salary and the administrative cost. So that's $206,000 you're spending and that would be called your gross burn. That's in contrast to your net burn. Net burn is after you factor in the impact of revenue. So what you see here is the net burn is gross burn, which is a negative figure plus the monthly revenue. So net burn and really net burn, what that refers to is the difference in your cash balance. So this month we went down by $180,000. And so the beginning of period cash and the end of period cash will have a difference of the net burn. So when you play all this out, you can kind of see a couple of things start to become more obvious here. Your cash balance end of the month is slowly going down. It's going down by your total net burn. If you wanted to stretch out your runway, how many months of cash you have, you could either reduce your gross burn that is spend less, maybe less people or other save on costs, or you could increase your monthly revenue. So this is how we're looking at the basic cash model. And when you run it all the way out, you may find that at some point, this is pretty typical, you end up with a zero cash date, you know your cash out date when you finished spending all the cash in the bank, and very often you rewind six months and that's when you start to raise capital.

Let's touch on one element that we skipped over here, which is when we talk about revenue, now that we have it modeled with regard to typical SaaS modeling of starting new expansion in churn, what we can then do is also compute some metrics. So we can look at something as simple as monthly growth from this month to last month, how much did it grow? And this is not particularly indicative of what will actually happen. It's a rough model, but this gives you a sense of along the way, you know, what I might look at is sort of think about what the average growth is over the period. You can also do this with a proper CAGR formula. But the key here is that it's an interesting data point that might be useful as you think about the reasonableness of a model. Another figure that is very important to VCs looking at your business is the net dollar retention. And the idea behind there is if you look at the start of the month, how much did that cohort grow and shrink? So what you're leaving out in here, you're starting MRR, you're skipping your new MRR, just your expansion and churn divided by your starting. And so what this means is the last cohort grew 105%. In certain months where there's churn, it's 81% net dollar retention, sometimes called NDR, sometimes called NRR, net revenue retention. So what this is is a sign of your business health, removing user acquisition, removing new customer acquisition. It's sort of the health of the existing business and that's why it's an important metric. Finally, a really simple metric here is to take your MRR multiply by 12 and you get your ARR. So at this point in March, we're at 310K ARR business. At the end of this model, we're a $5 million ARR business, which is synonymous with saying we're a 420,000 MRR business. So those are some helpful metrics that we've italicized again, because they're useful to look at, but they're not independently new calculations per se, independently new inputs for normal PNL. We've also included the average contract value. Many folks will want to see that you're raising contract value, raising pricing, either by virtue of more customer leverage or by virtue of adding additional features or new offerings. So moving down, that's kind of the core of the model, right? To summarize here again, we modeled how many customers, how they were gonna churn. We multiplied that by dollars by using a pricing figure. We thought about how that plays out with the calculations and we get to ending MRR, this is probably one of the most important lines in the model. And then we layered on the impact of COGS. By that I mean we subtract COGS, we get to gross profit, which can be used to compute gross margin. And then we subtract out the real operating cost of the business to get to our gross burn. We factor in the positive benefit of revenue when we get to net burn. Net burn impacts our cash, which tells us how the cash balance changes month to month to month. And we see that going down over time, which is very natural.

So that's the model. There's two elements that we can explode a little bit further. So salary and administrative other, we've kind of left those pretty short for now. One way to think about this is that the salary is really composed of a number of people. And you may, these are all sample numbers. I wouldn't read too much into anything in here, especially these kind of core values. But the idea is that you're gonna want to estimate, let's say a marketing associate salary, $75,000. You may add a payroll multiplier to account for payroll, taxes, benefits, et cetera. 20%, 30%, different folks use different amounts. And what that gets you then is a monthly rate, which is the salary times 1.3, the multiplier divided by 12. So now the way that this model is laid out and it helps visually is to show you who we expect to be on the team in January. And then over time you'll see, you know, the team is is pretty stable. And then we add someone here, we add an account executive in July. The reason this is useful to lay it out this way is it allows us at a glance to see how the team is building over time. You know, there's a head count figure at the bottom, but it allows us to visually take a quick glance, look at the salaries over time. Of course, this doesn't include raises, it also doesn't include sort of different benefits or anything like that. But it gives you a quick sense and this in total, I don't know if we have a total row here. I think it just gets totaled up here. This is the total of all of the salaries. And so that's how that builds up. And it allows both you and someone new looking at your model to quickly understand how are you hiring, where do you think you need people. For, again, a pre-seed or seed stage company, there might be one or two people or four people. But even laying this out over time will help folks to understand where you're growing the team and how much it'll cost. Also allows you to edit. I mean in this particular instance, if you wanted to have this account executive start later, you just delete those. And so that is a simple interactive way to think about the salary. Finally, the other item, the other main component of operating expenses, we're calling administrative, but we can take assumptions at what different expenses cost. Now each of these could be much more detailed, but when you think about legal, you might have a plug in here for the average monthly cost of working with a lawyer on random documents, invention assignment agreements, NDAs, things like that. On marketing, in a future stage, this would be a whole tab in the model. You would think about how much are you spending on advertisements or conferences, what's the conversion, the cost of a lead, et cetera. But for now we've put in a plug, which is appropriate at the seed or pre-seed stage, how much you might spend on filing intellectual property. Again, a plug, because what actually happens is it's bursty, it's $20,000 when you file a patent, for example. But we're spreading this out to keep it simple. Maybe some rent, supplies, business insurance, like DNO or general liability insurance, a plug for consultants. And in this case we're saying we don't think we need the consultant all here, but again, another placeholder and then travel and bookkeeping. So when you flesh all this out, what you end up with is what we think is a powerful tool to understand the health of your business, to understand what kind of customer growth you need and what kind of salary, headcount growth. You need to achieve that and how much you can afford in order to maintain a certain amount of revenue with this very simple model.

So I hope this is helpful. This has been the Ubiquity University module on building your first financial model. And my name's Sunil. I'm at sunil at ubiquity.vc. Please feel free to reach out if you'd like to set up a meeting to pitch. We're at pitch.ubiquity.vc. Thank you.

17 minutes
Series: Day One
Startup Stage:
Pre-seed, Seed, Series A
Upload Date: