Assumptions are the financial model building blocks and within the control of founders : #
Where do you find assumptions to build your financial model as an early-stage (pre-seed) startup? With no revenues and probably no prior experience with the business, it can be challenging to put together a financial model. For an early-stage founder, especially one starting with limited resources, simplicity is very important. A financial model at this stage should be high level and typically comprises of a simple income statement, a few metrics and perhaps a cashflow summary.
This financial model suffices for most purposes – internal decision making, a pre-seed round pitch deck or funding application. There are just two sets of assumptions that are required for this financial model – revenues and costs. Later funding rounds and more advanced use cases will require more detailed financial models and other considerations such as cashflow and balance sheet assumptions.
Let’s take a quick look at where to find assumptions for all these components and how these are typically combined to obtain a full model.
- Revenue: if you are building a financial model then most likely you have a business plan. Your revenue assumptions should come from this business plan. For a business with one source of income, in it’s simplest form, Revenue = Price X Volume. For a business with multiple business segments, this assumption is simply repeated and summed up to obtain the overall revenue. For more complex business models such as Subscriptions (SaaS) and marketplaces or platforms, there are more detailed, granular assumptions involved which we will cover separately.
- Price: the question you are answering here is what price will you charge your customers in exchange for your product or service. The ideal pricing strikes a fine balance between internal and external considerations such as: competitor pricing, value you are providing, level of innovation and how much revenue you need to maintain a sustainable, profitable business in the long term.
- Customer surveys and competitor analyses are two sources of pricing assumptions. Surveys directly ask prospective customers what they are willing to pay. Their responses as always should be taken with a pinch of salt but is always a good place to start. A review of competitor websites or physical stores will reveal what they currently charge for similar services or products.
- Volume: pricing and volumes are interwoven and always considered together. A pricing that works for a business at a high volume does not necessarily make economic sense at a lower sales volumes. Similar to pricing, projected daily, monthly and annual volumes should come from research, customer surveys or a detailed insight into the industry you are operating in.
- Stated differently, your volume assumptions are somewhere in between two considerations:
- At a given price, what is the number of customers that are likely to sign up for your services or buy your product? and
- At a given price, what is a reasonable number of customers that is required for a target revenue outcome?
- Cost: the second major component of an income statement are the various costs that every business bears in producing and distributing their products and services. Costs are usually classified as operating or non-operating costs.
- Operating Costs: these are the day-to-day costs incurred in the normal course of business. These are further broken into Cost of Goods Sold (COGS) and Selling, General & Administrative (SG&A or Admin) Costs.
- COGS: this is probably the most important and in simple terms consists of all costs required to bring a product or service to the market. For product companies, COGS primarily comprises raw materials and direct staff costs while for tech companies, COGS comprises hosting and related technology costs as well as any direct employee costs such as customer success.
- For founders who have a product, it is relatively easy to add up what the production costs are for the previous period and estimate for the projections. For founders building projections while still at pre-product / pre-MVP, there are two approaches to the COGS assumptions
- Percentage of revenue: this is the simplest and most basic cost assumption method and most times suffices for early-stage entrepreneurs. Simply, it is assuming COGS as a percentage of revenue. This works when it is possible to compare with competitors or benchmark to similar public companies.
- Unit economics: this is more detailed – and definitely the right approach as the business grows. It requires an understanding of all costs that feed into this COGS line and how much is associated with each unit.
- SG&A: this comprises all other operating costs not directly related to producing your goods or services. Office rental costs, technology costs and other admin costs come under this bucket. For most startups and small businesses, marketing expenses are by far the highest component of admin costs. The two approaches discussed under COGS apply here as well and so let’s apply them specifically to marketing costs
- Method 1: although marketing expenses often precede actual revenue generation, this approach of taking a percentage of revenue is still feasible if income is projected for the first year. In that case, it is not uncommon for marketing expenses to be many times the revenue (2x, 3x) since the denominator is small by definition
- Method 2: the detailed unit economics approach requires understanding all the different elements that feed into your customer acquisition costs (CAC).
- Staff costs are relatively simple as it is straightforward to understand the marketing staff that are required to deliver the projected growth
- Unit costs of marketing campaigns and PR can be derived by running experiments. For instance, a one-week Google Ads or Twitter campaign will provide data such as cost per acquisition and cost per click which can be extrapolated to obtain total marketing expense for a projected customer growth.