14 Four Steps to Building the Perfect Financial Model by @tdavidson | December 14, 2010

Of course, no financial model is perfect. In fact, every financial model you build will be wrong.

But creating a financial model is less about being right or wrong, and more about going through the process of detailing how a business “works”. The result, a set of financial statements, key operational metrics, and a set of key drivers and assumptions, creates a map for you to explore how your tactical product, marketing, organizational and strategic decisions impact your company’s profitability. It will help you determine your key milestones, capital needs and types of potential investors.

Here’s the key: your model will be wrong. Instead of focusing on the bottom-line income statement and the hockey-stick growth you’re projecting in year 3 of your venture, focus on your process, assumptions and key drivers and build a detailed month-by-month model that you can modify and update over time.

How?

1. Focus on expenses
You’ve probably already spent a lot of time thinking about your product, users, marketing plan and exit plan. Therefore, start your financial model by estimating your expenses. Because people are the foundation of successful startups, start with your hiring plan. Project the types of positions you’ll need to hire, when you’ll need to hire, and how much you’ll have to pay them (salary, benefits and equity). Estimate office expenses, rent, insurance, legal, accounting, taxes, equipment, and travel and entertainment costs. Create space in your model for your marketing, hosting, sales support and delivery costs to fill in later.

2. Outline how the product or service is built, marketed, sold and delivered
Create your revenue plan with a very concrete, tactical, bottoms-up look at the entire chain of events necessary to take your product or service from a plan to the customer. How long will it take to develop your product and build the organization? Think about your sales staff, website and marketing plan and how your budget for each channel translates to impressions, click-throughs, visitors, trials and sales.

Your model will vary depending on the type of business and business model. Are you B2B or B2C? Are you pursuing a freemium model? Do you have different levels of service at different price points? Are sales one-time or subscription-based? How long will the average customer keep using your product? Consider pricing, discounts, sales, coupons and free trials, when customers pay, and how long it will take to collect invoices.

Then, consider your partners, commissions, affiliate fees, monthly and per-transaction costs. What kind of hosting and customer support do you need to support your estimated level of sales?

Then, combine your expenses and revenue estimates to create your first profit and loss statement.

3. Analyze your assumptions, addressable market and benchmark your projections
Start digging into what your model means. How big is the addressable market for your product or service, and is it growing or declining? Who are your major competitors and what portion of the market do they currently have? What percentage of the market are you estimating you’ll be capturing within 3 months, 6 months and a year? Is it reasonable?

Analyze key metrics and drivers. Which assumptions have the most impact on your projections? Will a small change