Using Financial Modeling to Vet Ideas
We have recently been working with several of our Studio companies that have completed customer discovery and are moving from idea stage to launching the business. At that point, you have learned enough in customer discovery to start building an early financial model to help you project cash flow, growth, funding needs, etc. While there are many great tools out there to leverage a budgeting framework, I want to focus on three key areas where modeling helps at the idea stage to get you comfortable with launching the business.
Does it Make Sense?
After doing some good customer discovery, you can start to get a much better initial grasp of target market, price point, product scope, operating costs, etc. You can then do some quick modeling to say: “Does this even make sense?” For example, if I can charge $1,000/month per client but it costs me $1,500/month in variable costs, this is not profitable. Or even if I sell the $1,000/month to my entire target market, is it big enough to matter? What you are looking for here is the quick gut check that even in the best scenario, do the economics make sense? Assuming they make sense, you can also start testing what the economics could look like as the business would start to scale as well as how much operating leverage that brings.
Sensitivity to Key Assumptions
Once you start doing modeling, there are some assumptions you will feel great about and others in which you have less confidence. What you can do in modeling is test which assumptions most significantly impact the model. This allows you to go deeper and pressure test those critical assumptions and not spend time worrying about assumptions that, even if they are off 50%, do not change the answer. Then focus on testing those crucial assumptions to improve your confidence. Lastly, you can model several scenarios to see “what you would have to believe” about the key assumptions to make the model work.
Cash Flow Forecasting/Funding
Another key value of financial modeling is allowing you to model by week/month/year what your cash flow needs will be. You can start to predict when you will run out of cash, what happens if revenue delays, what amount of funding may be necessary to scale the business, etc. It’s always critical to know when you will run out of cash and what changes to the business you can make to manage that situation.
Financial modeling has many benefits for an established company, but even at the idea stage modeling different scenarios can be helpful to direct your path forward.