Unless you have a trust fund, or are willing to go back and work at McDonald’s again, becoming an equity stakeholder in a startup is probably the best way for most of us to make some money with our skills. To make that leap, however, requires money—and lots of it. Luckily, there’s a whole top-level industry out there focused on helping people get that cash. Venture capital firms give small businesses (the “venture” part) equity stakes in exchange for partial ownership and operational assistance from their new partners; it’s a win-win situation for both parties involved. To break into this world as an investor rather than a business owner means understanding the nuances of financial modeling in order to properly assess risk factors and provide accurate feedback on projected returns.

What Does a Venture Capital Financial Model Look Like?

A venture capital (VC) financial model can take many forms, but the most common format is an Excel spreadsheet. Other tools are available, but the spreadsheet format is the most flexible and adaptable for different kinds of businesses and growth rates. It’s also the most accessible, which makes it great for early-stage ventures when you might not have a huge budget for professional, custom-built software. A venture capital financial model, like any other financial model, has a “balance sheet” and an “income statement” built into it. The balance sheet shows the current debt and equity of the business while the income statement tracks operating expenses and revenue over time.

How to Build a Venture Capital Financial Model

The first step in building a model for your business is to understand the business model itself. This means researching the market you plan to break into, your competitors, your expected revenues and expenses in the short, medium and long-term, and the monetization strategy you plan on using. As you conduct this research, be sure to document key assumptions and build them into your model. Once you have this information, you can build your model either manually or with a financial modeling software such as SmartDraw or Visio. If you choose the manual route, make sure to document assumptions and inputs for each line item. This will help make your model more transparent, allowing investors to easily follow your logic and assumptions.

Key Assumptions in a VC Financial Model

There are three types of key assumptions your investors will be looking for in your model: market, financial and operational. Although there are plenty of other assumptions that affect your business—such as supply chain, hiring, etc.—these are the most critical for a financial model. Market assumptions include things like the size of the market your business is entering, the potential for growth and the amount of competition. Financial assumptions focus on the amount and type of financing you’ll need in order to get your business off the ground and sustain it while bringing in revenues. Operational assumptions are used to help forecast how much money you’ll need to operate your business each month, the time it will take to become profitable, and the amount of time it will take to break even.

The Equity Cash Flow Calculation

The equity cash flow calculation is where you’ll plug in most of the inputs for your financial model. It’s broken down into three sections: the initial equity investment, the equity cash flow and the payback period. The initial equity investment is the amount of money investors put into the business at the start. The equity cash flow is the money you expect to receive from investors over time as they get their returns on their initial investment. The payback period is the estimated amount of time it will take you to pay back the initial investment plus the investors’ returns. Be sure to take into account any interest the investors charge and use an appropriate rate. Venture capital firms usually charge between 10-20%, so plugging in 20% is a safe bet.

The Risk Calculation

The risk calculation is where you’ll plug in the probability of your key assumptions actually coming true. For example, let’s say a VC firm is considering investing $1 million in your business. In addition to the equity cash flow calculation, they’ll also want to know the chance of that investment paying off. To do this, create a pie chart for each key assumption and use these pie slices to indicate the probability of each assumption coming true. Once you’ve finished, add up those percentages to get your total risk. You can then plug the risk percentage into a standard financial model to get a more accurate picture of how the investment will perform.

How to Build a Financial Model for a Startup?

Financial modeling is an essential part of any business model, but it’s even more critical when you’re looking to get funding. Startups often have very little in the way of assets or collateral, making their potential returns very high—but also very risky. Venture capital firms are looking for ways to mitigate this risk and ensure they get their money back. By creating a financial model, you can demonstrate that your idea is sound, has a demand and has a chance at becoming profitable. More importantly, you’ll have the chance to show these things and make adjustments before you pitch to an investor—rather than after. If you decide to build a financial model, keep in mind that larger firms will be looking for a much more detailed model than smaller firms, such as angel investors. Make sure you know the level of detail expected before building the model.

Types of Ventures and When to Use Which Model

There are many types of ventures for which you can create a financial model. These include retail, wholesale, manufacturing, real estate and more. The first thing you’ll have to determine is the nature of your business model. Will it be a start-up, a turnaround or a high-growth company? If you’re looking to raise venture capital, you’ll want to pitch a start-up, which is a new business with high-growth potential. Start-ups are risky and highly uncertain, so you’ll want to make sure you have built a very detailed model before taking it to investors. A turnaround is when you buy an existing business and turn it around by making significant changes. Turnaround businesses are risky but less risky than start-ups because they already have an established product and market. You’ll likely have to present your plan to private equity firms instead of venture capital firms.

Key Variables to Consider when Building a VC Financial Model

There are a number of variables to consider when building a financial model for your business. Some of these will vary depending on the type of venture you’re building, but these variables are critical for all businesses. Variable Description Example Market size The number of people who might buy your product or service World health care spending ($9.5 trillion) Market share The percentage of the market your product or service represents 10% Competition The number of companies selling the same product as you 3 Cost of goods sold (COGS) The amount you pay for your products or materials $1,000 Marketing and advertising costs The amount you spend on advertisements $50,000 Other operating expenses The amount you spend each month on other business costs $1,300 Number of employees The number of people working for you 2 Annual revenue The amount you make per year $10 million

Why is Financial Modeling Important in Venture Capital?

Financial modeling plays a key role in securing funding for almost any type of business, particularly those in the VC realm. It shows potential investors where exactly their money is going, how much they’ll make from it, and when they can expect to get it back. All of this helps make the business less risky for the investor, allowing them to take a potentially profitable risk on a company that might not otherwise have been worth the investment. It also helps you build a better business model and understand exactly how your company will operate, giving you a clearer path to success.

Wrapping Up

Building a financial model is essential in any business, but it’s especially important when you’re looking to secure venture capital funding. A model shows potential investors where their money is going, how much it will make, and when they can expect to get it back. Financial modeling is also important for building a better business model. It allows you to see how your company will operate and gives you a clearer path to success.

Related Course: Financial Modeling Skills Course