How to Build Financial Models for Startups in Service Businesses
Not all financial models require three statements to be useful to founders and investors. The income statement is the only statement that is required in financial models for startups. Balance sheet and cash flow statements, while useful for modeling working capital, physical assets, and capital flows, are often not required.
The primary goal of financial models is to show cash flow. For businesses that do not have a physical product, like software as a service (SaaS), an income statement is sufficient. The income statement provides the necessary information for calculating cash flow for these businesses.
Cash flow for startups in service businesses can be measured by the burn rate, a term for negative cash flow from expenses, and EBITDA (earnings before interest, taxes, depreciation, and amortization), which is an estimate of cash flow from earnings. For SaaS, critical questions to address are budget, milestones, revenue, and costs, all items that do not require a balance sheet or cash flow statement.
In addition to the income statement, Gantt charts are a useful tool for organizing project work and detailing expectations. A Gantt chart is a spreadsheet that shows activities over time. Gantt charts can also include items like monthly budget, or burn rate, and total spend, providing a quick reference for capital required and how long it will last.
Modeling Budgets and Milestones
When building financial models, we want to identify the milestones we aim to achieve and how much it will cost to achieve these milestones, within given time frames.
For SaaS, our Gantt chart might show a product development phase, also known as the beta phase, and a launch phase for the product. In month 1, the first milestone is to put up a website and write the code we need for proof of concept. In month 2, we will continue to improve on our code for the proof of concept, add additional functionality, and so on.
Before we begin selling our product, our focus is the burn rate, defined as how much money we expect to spend each month. We might assume that the beta phase will have a burn rate of $40,000 a month for 6 months, or a total of $240,000 to develop a product that is ready to go to market.
The launch phase of our SaaS product requires spending on sales and marketing, as well as continued funding for product development and testing.
We calculate revenue for the financial model by multiplying units sold by the dollar value per unit. If our SaaS service is delivered by the hour, we can estimate revenue by multiplying the number of hours we expect to sell and the price per hour.
Pricing requires that we understand the market and the value of what we are selling to end users. We gain this understanding through competitive and market analysis, which includes data on competitors, customers, services provided, and price. Perhaps our research shows the current market is $340 an hour for a service provided by skilled professionals.
As a SaaS startup, our value proposition might be to reduce costs by automating the existing services provided by professionals. We will develop a software product, which is just as good and cheaper. Whereas the current human delivered services now cost $340 an hour, we can deliver the same service for $180 an hour, almost 50% less.
Our revenue projection can be derived from market size, which is the total dollar value of the goods or services sold in the market, and our expectations for achieving a given level of market share. If we can deliver the same service for half the cost, we can assume that some customers will be willing to try our product and pay us for it. With an addressable market of $1 billon, we might reasonably build a 5-year model that shows revenue growing to $10 million, or 1% of the total market.
Costs for the income statement of the financial model fall into two main categories, the cost of goods sold, known as COGS, and the cost of operations, often called sales, general and administration, or SG&A. Interest expense and taxes are not part of the calculation for operating income, which is our primary input for calculating EBITDA. Assuming that we expense the cost of product development, and have few physical assets, we can forego including depreciation and amortization in the model.
To model COGS, it is best to determine a unit of value and model our costs against that unit. In the SaaS example, our unit is one hour of service provided, so we need to make assumptions about how much it will cost to deliver one hour of service, like hosting, processing, and storage costs. If we assume that we can sell the service for $180 per hour and our cost to deliver that service is $90 per hour, then our expected gross profit is $90 per hour, indicating a gross margin of 50%.
Our operating expenses are based on what we expect to spend on a monthly or annual basis for costs related to SG&A. These might include costs for engineers, sales, management, and support, as well as legal, accounting, insurance, and other expenses.
Startups that do not have a physical product, can often build financial models with only an income statement, and do not require cash flow and balance sheet statements. Investors want to see financial models with projections for budgets, milestones, time frames, and cash flow. All of which can be shown with a Gantt chart and an income statement.