Financial Models for Pre-revenue Investors

I spent years deconstructing other people’s financial models for M&A departments. It helped me have something substantial to support my cynicism of ideas that would likely fail, and an excuse to like the ideas I liked. And that’s about how everyone uses them to make a case. In the end that’s all a math exercise — the bottom line revenue shows the truth — all the assumptions and models in the world can’t change that. A business case is actually either made by real financial performance, or it’s just a model.

Far more often then not, models are wrong — they are based on assumptions. It’s just as reasonable to assume that some assumptions are conservatively wrong and that the business may met or exceeded revenue expectations — not necessarily that the model was correct. From a purely statistical point of view, all pre-revenue investing can be reduced to a full on crap-shoot — there just is no real way to know. That’s why when markets trend down, investors want to see “revenue traction,” or basically real numbers, to understand the real business based on as much data as possible.

I love this post at Steve Blank’s blog and wish I though of it: No Accounting For Startups His hypothesis is that you need set expectation with VC’s about the model so you can make adjustments as you start to build a business. This is very sound advice for an entrepreneur working with VC’s. In my mind it validates the reasons to NOT use VC’s, or more specifically Angels. To manage VC’s, companies are required to spend a lot of time on building models, creating phantom variables, to adjust assumptions, and manage financial expectations. The other option is to stay lean, and run hard at revenue and adjust the moving parts in real time when you KNOW what business model works! (But if you need a revenue model; I can build you a beauty.)

Steve suggests that when the model is disproved, that the startup “pivot” to a new model. The problem is that pivoting instantly implies that some assumptions were wrong up to that point. When the supporting set of assumptions start to fail, it could create a total implosion of the entire model. Even without a full implosion, when key assumptions fail and management was depending on the model as a guide, they are forced to go into rescue mode. It tends to get super ugly figuring out what to jettison.

Arguably, this is why the Angel model fails, and VC’s are hard to manage. My new millennium approach is to start with MULTIPLE SCENARIOS, instead of having one “be-all, end-all” model and attempting to “pivot.” To have many approaches to the business argues for the kind of fluidity that requires the single control of a strong CEO. To make that work the CEO has to keep the majority equity, majority control and enough sense to take the risks and know the options. Interjecting pools of investors with voting rights on the board undercuts that true ability to pivot; the one where the leader has to suck it up and take it on their shoulders. Otherwise the conversation about what do when the model fails, is a toothless CEO in a room full of finance guys. The same finance guys who believed bad assumptions in the first place and look a little foolish.

The best way to start a business is to focus on the business, keep majority control as long as possible, at least to being cash flow positive, and most important not get distracted into managing investors.