Financial Modeling: What Is It And Why Is It So Darned Important?

Ah, the financial side of your business. If this is the stuff that makes your eyes glaze over (and yet you’re an entrepreneur)…you’re the person I wrote this post for.

I know a lot of us aren’t big fans of doing the financials, and I understand why you feel that way–after all, it’s certainly more fun to build a product than it is to work on the freakin’ numbers.

By the time you’ve read this post, you’ll be able to do a financial model yourself (without hiring a crazy-expensive CFO!), and you’ll know the following:

• How many sales you need every month to pay all your bills.
• How to price your products so you don’t lose money on each sale.
• When to hire your next employee (or when to quit your job)–based on the sales goals you set.
• When you’re going to run out of cash (or, alternatively, how much cash you’ll be able to pay yourself every month without going broke.)
• How much capital you need to raise (if any!)
• How to quickly assess your business every month to ensure you’re meeting the goals you set for yourself–and how to know quickly if you’re in trouble, before it’s too late.

In summary, this is the blog post I wish I had 11 years ago when I was getting started in business. Let me state this unequivocally: Building a financial model has been paramount to the success of my business. However long it takes you to build a model (and it won’t take you too long if you follow the path I’ve outlined below), it’ll be worth it. It may even save your business from going bankrupt–or enable you to quit your job or hire your next employee more quickly.

Now let’s take a look at what a financial model is and how to set one up for your business…

The Basics of Financial Modeling

The first thing you’ll want to do is to set a financial goal. How much money do you want to make with your business? (This is the fun part!)

To set your financial goal, you’ll want to have a grasp on what your personal expenditures are. You’ll also want to know exactly how much you currently bring in from your job, contracting, freelancing, etc.–whatever you’re doing right now to make money.

This is where you need to be honest with yourself. If your current salary leaves you just barely scraping by, that’s a starting point for income for your business–but realize that you’re going to need to make at least 30% more than you do now because of additional taxes and insurance.

Pull together all your expenses and examine them. Are there places where you could start cutting back now, in preparation for going full-time on your business? Cancel any subscriptions that aren’t benefiting you. Focus on paying down debt. Forego larger purchases whenever possible and focus on building up a nest egg.

Once you know what your expenses are, including taxes and any additional costs from going out on your own, you’ll know how much money you need to pull in with your business.

Getting Past Your First Failure Point

By doing this, you’ll get past your first failure point: Failing to make ends meet for your business. You’d be amazed–I’ve spoken in front of many audiences full of people who wanted to start businesses, and less than 5% of them take into account exactly how much money they need to make before starting their businesses. This is a big part of why so many businesses fail.

Be honest with yourself about how much money you need to make, and you’ll know how much to charge your clients. For instance, let’s say you need $8,000/month to make ends meet. (Don’t be surprised if you end up with a larger number than you expect–that’s part of why you’re doing this.) If you’re consulting, then, you need to be billing a minimum of $100/hour for 20 hours a week…just to make ends meet!

If that’s a lot more than you expected, you now understand why this process is so valuable.

A Financial Plan for Your Business

Now, let’s take a look at how your business operates. Ask yourself:

• Am I billing my customers one-time, monthly, or a combination thereof?
• How many customers, at what rate(s), can I expect to gain per month?
• How many customers, at what rate(s), can I expect to lose per month? (This is called churn rate.)

For instance, in my business (a software-as-a-service company), we used to sell plans as low as $9/month. You may think you’re doing potential customers a service by offering lower-priced plans–or you may think that since you’re just getting started, it’s better to have someone paying than no one paying.

I’d encourage you to re-think both those assumptions. In our case, the $9/month customers were churning so heavily that, after factoring in server costs and support costs, we actually weren’t making any money on them. As soon as we realized this, we dropped that plan level, and now our lowest plan is a much more profitable $49/month.

It’s time to get honest again: How many customers at $9/month does it take you to make enough money to make ends meet? 500? 1,000? Then factor in that the average lifetime of most of those customers is going to be 3-6 months, at most, and that supporting 1,000 customers may require you to hire another person just to handle support tickets.

Is that the business you want to build? I can tell you, I’ve built that business twice, in two different industries (web hosting and SEO tools) and in both cases, it was not a great business to be in.

How to Make More Money with Your Business

Let’s take a look at another tack: A consulting/software hybrid. You build a piece of software, and also do consulting with your customers. Let’s say you charge $1,000 per month per customer, and that includes some consulting on your end (you’ll need to work out the finer details, and make sure both you and your customers are clear on what your consulting does and does not include.) Now you only need 8 customers to make your monthly expenses, and with just 8 customers, you can deliver top-of-the-line service and still have time to work on and improve your software.

What about driving the value proposition sky-high, and charging each of your customers $5,000 per month? Now you’re going to have to work smart and figure out how what you’re doing will save them from hiring a full-time employee, but these sorts of business opportunities are out there. Figure it out (without having to work full-time) for just 2 customers, and you’ve more than cleared your monthly expenses. Plus, if you really are saving them from hiring a full-time employee, they’re bound to stick around a lot longer than someone paying you $9/month for something that’s not delivering that much value.

This is the basic layout for building a business that involves mostly you. Now let’s take that to the next level: Building a business for more than just yourself. If you’re paying contractors or employees, or you have (or want!) investors, you’re going to need to build a financial model.

A More Detailed Financial Model

On the advice of an investor, I recently built a formal financial model for Whoosh Traffic. Where a simple financial model, such as the one I detailed above, often just means you take home whatever’s left at the end of the month after expenses, a more detailed financial model will show you how much money you need to raise, how many sales you need to make, and when you need to hire people to grow your business.

Our investor showed us a beautiful, detailed financial model he’d built for a couple startups he is advising. It had clearly taken him hours to build it. After doing some research, I realized I didn’t want to spend hours building my own financial model. Fortunately, I discovered Wade Myers.

Wade has co-founded, invested in, and been a director of over 25 companies. He’s also been on the other side as an investment banker and venture capital firm partner. (A busy guy!)

He built a beautiful financial model as a spreadsheet where I could just fill in the details about my business and it would automatically calculate cash flow, growth rate, and more. He was selling it online at a reasonable price–$40. I jumped on it and paid for it right away. (Here’s the link.)

When I asked Wade why he’d taken the time to develop a financial model template, he said: “I developed the financial model template to avoid the mistakes I made in my earlier startups. I wanted to address what I think is the single biggest weakness of most business plans: a detailed financial model that helps entrepreneurs and investors gain full visibility into all of the assumptions, cash requirements, scalability, profitability, and ramp up of the business.”

Knowing how many hours it would take me to build one (and since I’m not a finance major, I probably wouldn’t do a great job anyway!) I instead put the time into filling out Wade’s financial model.

I’ve posted an overview here of how I used Wade’s financial model for my business:

First, you add in what you’re selling, and how much you’re selling it for. As you edit the cells, your revenue over time changes, so you can quickly see what benefit having higher-priced plans will do, or how many plans you need to sell each month (factoring in churn) to achieve your target growth rate.

Then, add in who you plan to hire, and when. You’ll be able to quickly see what hiring a new full-time employee does to your cash position, and you’ll know as you fill in more details when you’ll be able to hire someone.

I found out some surprising facts:

• Assuming we can hit our sales targets, we only need to raise about half the money I originally thought we did.
• Our sales targets are a lot less complicated than I was making them out to be in my head: We only need to sell 17 new accounts a month, for instance, to grow with little additional capital. This feels “doable” to me, and even more importantly, it’s concrete: We know exactly how many accounts we need to sell and how much to charge to hit our numbers.
• Hiring one software developer for every 200 customers, vs. 1 for every 100 customers, makes a huge difference in your profitability over time!

You’ll discover your own surprises as you go over your financial model, as well.

Getting Your Own Copy of the Financial Model

By the way, I paid $40 for this (and frankly, it’s worth 10 times that.) I asked Wade if he could give you a special deal, though, as you’re one of my valued readers. He agreed–so when you purchase his financial model, use coupon code ERICABIZ for $5 off! That’s a true bargain, and this is a must-have if you plan on building a high-growth company, or you want to quickly see how changing prices affects your bottom line.

His financial model has templates for software-as-a-service businesses, consulting companies, and product sales companies. It even takes into account if you sell your products through a marketplace (like Apple’s app store.) It’s a must-have for your business.

Take a look at Wade’s financial model today for your business. By the way, our investors loved this, too, so this is definitely a must-have if you’re raising funding, or planning to. As a bonus, forward your receipt to financialmodel@erica.biz by June 30, and I’ll send you (at no additional charge) an even more detailed, step-by-step video and transcript on how I built my financial model using Wade’s spreadsheet! That’s only if you order by June 30, so head on over right now and invest in Wade’s financial model.

I hope I’ve given you a lot to think about as you build a growing, profitable business!

By the way: My upcoming “Art of Email” course (launching this month!) will have a whole bonus series on finding and contacting investors, so if you want more details on that, make sure to enter your email address in the box below and join over 1,000 others who have signed up to find out more! (Remember, my “Art of Email” list is different from my primary email list, so definitely add your email address in the box below if you want priority access and some awesome free stuff, as well.)