How to create a financial model for the enterprise: 5 basic steps

How to create a financial model for the enterprise: 5 basic steps

Yevhen Nikolaichuk, TECHIIA’s Chief Financial Officer shares the most important points of the financial model, the search for investment in other jurisdictions, and offshore shortcomings.

"All models are wrong, but some are useful," according to George E. P. Box, who is probably the greatest statistician of the twentieth century. And he is right because some models are so useful that you can't do without them. For example, without a financial model, any business venture is doomed to fail.

The financial model is somewhere between an enterprise development plan and a declaration of intent. The document includes both financial and non-financial indicators. The financial model clearly defines all stages of business development, investment attraction, payback period, profit margin, etc. A properly created financial model is a good start. Stand by this document, and over time, your business is likely to become a successful one.

But everything is not that simple, because everyone around would be millionaires if it was simple. When making a financial model, many people make gross mistakes. According to the statistics, one-third of startups collapse due to the fact that the founders incorrectly calculated the money burden and could not attract additional/necessary funding.

Let's look at what problems a startup may face at the beginning and how they can be avoided at the stage of compiling a financial model.

1. Think of shareholders

Ukraine has a full-grown IT industry. This is a huge market, IT service export in 2020 is estimated at $5.7 billion. Startups appear on it almost every day. Let's imagine that our IT specialists came up with the idea of creating a unique app. Writing code is working on the product itself. But the work of a startup as a company should always begin with the formation of a financial model. Let’s take this startup as an example and see how to properly create a financial model.

Founders need to analyze their idea in monetary and non-monetary indicators:

  • What is the main point of the product, what problem does it solve?
  • Who might be our customers, is it B2B or B2C?
  • How will the app make money and how much?
  • Where to attract investments - in Ukraine or abroad, and at what stage of the company's development should it enter the debt capital market?

By answering these questions, you will understand whether management and shareholders (if they already exist at the time) will perceive the essence of your idea. You will determine how the project will grow, how the team will be recruited and code will be generated, how the finished product will be launched and the customers will be attracted. All this should be presented in the form of a table, with which you can estimate the funding needed for development and launch.

2. Properly estimate your abilities and time

At this stage, the main recommendation is to properly estimate your abilities. Assume that in the beginning, your expenses will exceed your profit.

When building a financial model, do not forget about the "black swans" - some accidental events that will hit the markets and are impossible to predict. What happens if you need more developers to create the code? What if the launch is postponed to later and you still have your operating costs in the form of rent and salaries to employees? Will the company be able to survive this? Just keep in mind that you may incur unforeseen additional costs at any stage.

One of the important parameters of the financial model is the time from the start of the product and its launch. In IT, it usually takes several months: to recruit a team, create a product from scratch, validate, run. And reaching the break-even point can take years.

3. Determine the amount of investment required

Usually, startups are run on the owner's money or money borrowed from friends. They are short-lived, and without funds, the project simply can no longer operate. This problem cannot be solved without borrowed capital. You need to be ready for this and, when creating a financial model, determine the terms and methods of financing: whether you are looking for money in investment banks or among private investors.

Many startups start working as a group of like-minded people, without any legal entity. But by the time you need to attract investment, you must register one. Investors will come only for a legally registered share in the company, which has intellectual property rights and trademarks. And registering a legal entity is an additional cost, you need to pay for consultations, for opening a company, its support.

At the stage of attracting investments, it is necessary to clearly understand how much money is needed and what part of the company the founders are ready to offer in exchange for investments. Remember that the earliest investors always come in at the lowest possible cost. With the strengthening of market positions, understanding that the product meets all the market demands, the price of a startup will grow. The product will become more sufficient, the customer base will grow, new features will be added.

If everything goes according to plan - that is, the forecasts laid down in the financial model come true - then the chances of implementing a long-term planning program are also very high. This greatly affects the valuation of the business. That is why founders try to delay the process of attracting investment as much as possible, because, at the start, you will have to give a bigger share to investors.

4. Focus on the market for which you are creating the product

The next important point is the need to focus on the capital market for which your business creates a product or service. This will determine the jurisdiction in which you need to register the company.

If you are creating an app for the US market, you should focus on the US and look for investors there. In this case, your business will generate additional value in a particular jurisdiction, and attracting funds from local investors will be easier to do.

For example, you are creating an application for cheap ticket search, an apartment search, and rental service, or an application for finding and booking tables in American restaurants. In this case, it is better to immediately build a strategy for the development of a startup for a specific region and communicate with investors from this jurisdiction.

But there is another approach. Its feasibility also depends on the financial model. If the owners can solve the issue of investing in Ukraine, the application can be created here: we have all operating costs, including salary, much lower. In that case, you need only to open a sales office in the US that will be able to operate even without the registration of the legal entity.

5. Do not register the company offshore

In conclusion, a few words about startups whose ambitions are limited by tax optimization. In case, when choosing jurisdiction to register your business, you are not guided by strategic goals, such as entering new markets and finding access to new partners and resources, but how to avoid paying taxes offshore, you will have to forget about the idea of finding investment funds.

Today, international capital is extremely skeptical of such constructions. Times have changed, and now, in order to get, for example, investment from the US, you need to create a company in the US and operate in compliance with the requirements of the US regulators.

Now it is very important to follow business cleanliness, and tax optimization with the help of offshore can have a negative impact on the assessment of your company in the future. That is, you can save $20,000 a month on taxes, but in the future, when the investment is still needed, you will have to spend a much bigger amount on investment appraisal.

This is a worst-case scenario and, unfortunately, there are enough such cases. A well-constructed financial model will help to avoid such a turn of events.

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