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Why build a financial model?

Financial models can help entrepreneurs make critical business decisions. But it's more about the process than the result.

Aren’t financial models useless?

Ask any entrepreneur about what they’re building and the problems they are solving, and their eyes light up. But ask any entrepreneur about their financial model, and the energy disappears.

Trust me, I talk to entrepreneurs every day, and I’ve been helping entrepreneurs build financial models for about 15 years, and I’ve seen the reaction umpteen times. But building financial models can still be valuable, if you remember one thing: the model doesn’t matter, the thought process does. Overly complex financial models are a waste of time without a solid understanding of the basic inputs and outputs of your business. That’s why I’ve worked to help entrepreneurs think about finance and build financial models the right way.

A model is a tool, not an answer

In March 2012, I ran a survey to understand what entrepreneurs thought about financial models, and one recurring thought stuck out: that financial models are largely BS.

A financial model is just a fancy equation with a bunch of input variables. If the input variables are mistaken, it doesn’t matter how good the equation is, the whole thing is useless – or even worse than useless, as it breeds false confidence.

The common refrain about financial models, within the context of early-stage entrepreneurs and startups, is that financial models are useless because predicting the future is too hard and the resulting numbers are always wrong. I disagree. Creating a financial model forces an entrepreneur to outline very specifically how a business works: how a company creates their products, how users and customers find and use their products and how those processes create revenues and costs. The result, a set of operational metrics, financial statements and the “equation of the business”, creates a set of views of the business’s potential future. While any one view of a speculative future is inevitably wrong, digging deeper, analyzing the key drivers and testing a range of assumptions can help an entrepreneur build the necessary insights into making crucial product, marketing, organizational and strategy decisions.

So back to the point: true, to a degree. If your inputs are mistaken or a poor approximation of reality, then the results (revenue, net income) will be highly inaccurate. But the results aren’t the important parts to a financial model. Nobody cares about your hockey-stick growth projections, but people do care about how you think you’re going to create that hockey-stick growth. The results don’t matter, but the thought process is critically important. Instead of worrying about building accurate financial projections, spend your energy building a model that helps you tell the story behind your business:

In the end, the most important thing isn’t a really detailed financial model – it’s having a grasp of what the major influencing factors are on your model (hint: sales and growth) and then getting some kind of data that helps you accurately predict these variables.

Remember that first and foremost, a model is a tool to help you understand a business. Creating a financial model forces an entrepreneur to outline very specifically how a business works: how a company creates their products, how users and customers find and use their products and how those processes create revenues and costs. The result, a set of operational metrics, financial statements and the “equation of the business”, creates a set of views of the business’s potential future. While any one view of a speculative future is inevitably wrong, digging deeper, analyzing the key drivers and testing a range of assumptions can help an entrepreneur build the necessary insights into making crucial product, marketing, organizational and strategy decisions.

Financial models help make “strategy” actionable

I care about financial modeling because I believe that financial models are one key way for us to make “strategy” actionable. Financial models can help even the earliest entrepreneurs with business decisions. We can build “minimum viable models” the same way we build “minimum viable products”. Financial model literacy can and should be a part of startup culture but first we have to rethink how financial models are built. Financial models can help entrepreneurs make critical business decisions. But they have to be done right.

I care a lot about building models to the right level of detail - enough detail to make the right decisions, but not too much that it overwhelms us. Enough that we can powerfully model complicated business operations, but not too much to make it impossible for us to understand the flow and integrity of a model. I’ve built a lot of incredibly detailed and complex models in my life, but I spend almost all of my time working to make them less complex: easier to understand, easier to edit, easier to use. You should understand how a model works, especially a template, and it’s my job to help you.

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