I found a very good blog this weekend, Parallax: Calculating Technology's Future (definition of parallax). Mostly the blog covers trends in software and Web 2.0 at the technical level and I had to refer to Wikipedia.com for explanations ocassionally. In a post on financial models the writer makes the point that when he reviews a new business plan he frequently goes first to the financial model because it provides an easier way to understand the business model. The distinctions between business models, financial models and business plans are in a previous post of mine.
Financial models serve five purposes:
- to demonstrate the size of the market opportunity
- to explain the business model
- to show the path to profitability
- to quantify the investment requirement
- to facilitate valuation of the business
From the hundreds and hundreds of financial models I have reviewed over the years I would say that most people build their models to answer question 3 or 5. The second most frequent purpose is to quantify the investment requirement (4). Of course, sophisticated early stage investors and venture capital firms are principally interested in the answers to questions 1 and 2--how big is the market and what is the business model. The business model provides the answer to the all important question--how will you grow the business.
When you build financial models the first question you should ask is "what question does the recipient of the model want answered". The answer may change but almost all investors want to understand the business model. Also, remember that the business model in the financial plan gives you a simple way to demonstrate again your knowledge of the industry (another important point for VCs.) Present the assumptions for the business model in a clear, logical, detailed way and you will answer a lot of the questions the recipient has and you may just accelerate the pace of your capital raise. A VC once told me that a financial model we submitted saved him two weeks of due diligence time. Never hurts to be helpful and answer the questions the recipient wants to know.
I found the blog Parallax through a post by Brad Feld.