How to Impress VCs with your Startup Model (Part 1): Tactical Tips for Financial Modeling

By: Claire Biernacki, BBG Ventures Investor

This is the first of two posts on building startup financial models for VC investors.

Here’s what we look for in a model at BBGV

At BBGV, there is a lot we take into account when considering whether to invest in a company — from the market size to the competitive landscape to the team. One key element is reviewing a company’s financial projections. When a member of our investment team is excited about a founder’s vision after an initial meeting, a “next step” is often to review the company’s financial model. Reviewing the model helps us understand the market size, how quickly the company can scale, and the assumptions around levers for growth, profitability, and financing needs — all of which are critical factors when weighing an early stage investment. We know the projections often won’t (or ever!) play out exactly as modeled but it helps us understand how the founder is thinking about the business. In our diligence, we build a case outlining what we’d have to believe for the company to become a multi-billion dollar business, pulling from critical assumptions about the business, market and team. The model is a crucial tool in building this case as it provides insight into the core financial levers for success.

Financial models come in all shapes and sizes, and require varying levels of detail, inputs, and outputs depending on company size, stage, and industry. I’ve reviewed hundreds of models for investment opportunities in our pipeline since I joined BBG Ventures in January 2020. Recently, a founder mentioned that I was the only investor who asked questions about the model — and she thanked me for digging in, saying that it helped her think strategically beyond the first 12 months. Her comment stayed with me, and inspired me to outline what we look for in a model, and best practices for sharing a model with investors. My intent with this post is to provide transparency into how we analyze opportunities at BBGV, but I hope it will be valuable to any founder raising a seed or pre-seed round.

A quick note on when to start thinking about your financial model: While founders often hold off on preparing their model until they’re about to fundraise, it can be a helpful tool before then, at the earliest stages of the company. Financial forecasting provides an opportunity to step back from the day to day and lay out the assumptions and framework for the future growth of the business. Below, I’ll also discuss how BBGV uses the model post-investment to help founders set goals for their next round.

But building the model is only half of it. You’ll also need to be able to share and communicate in a way that inspires trust and brings investors along on your journey. In a follow-on to this article, I’ll cover best practices for sharing your model and communication tips to impress investors.

How we use the financial model to analyze an investment at BBGV

While we don’t expect the model to be an accurate prediction of the future (raise your hand if you’ve ever seen a startup model actually play out…), we review it to confirm a few key things:

1. Large Market Opportunity and the Company’s Ability to Achieve $100M+ in Revenue

One of the first steps in our diligence process is to do a bottoms-up market sizing — using the assumptions in the model around pricing and revenue streams — to understand potential revenue at scale and exit outcomes. We prefer a bottoms-up market sizing instead of using a top-down approach because it incorporates assumptions specific to the business versus analyzing the industry as a whole. A bottoms-up market sizing multiplies the target population by the price point of the company’s product to identify annual revenue potential. We want to confirm that a company can achieve meaningful revenue by capturing a small percentage of that bottoms-up market size — usually less than 5% depending on the market. Investors typically look for $100M+ in revenue but this will vary depending on industry exit multiples, as VCs ultimately want to see a path to a $1BN+ exit outcome — or increasingly $10BN! (For example, a high-growth company with $100M in revenue at a ~10x exit multiple would be valued at $1BN.)

Below is an example of a bottoms-up analysis that I created when we were weighing an investment in a mental health company.

Note that both the addressable market and the company’s share of market exceeded the targets noted above. We looked at the number of millennial women in the U.S and adjusted that number based on the company’s initial target demographic: millennial women who make >$100K; and the percentage of those women who have tried therapy but had not found a therapist they liked, which resulted in a target market of ~1.4M women. We then applied a weighted average of the company’s revenues to get to a market for this specific population of ~$9bn. Even if the company captured only 5% of this market, they could achieve meaningful revenue.

One caveat to bottoms-up market sizing is that if a company is creating an entirely new market, the market size can be difficult to calculate. Uber is an example of this — the company started out as a black car competitor, but the market opportunity ultimately ended up being much greater than a bottoms-up analysis of the black car market would have projected (more on how Uber’s market size was underestimated in this article by Bill Gurley). Ultimately, some of the best investments come from startups that are creating new markets. While the future market opportunity may be unknown, the model should show that the founder has the ambitions to reach meaningful scale either way. Sometimes we see founders stick with a top-down analysis or a list of market sizes pulled from industry reports, which rarely tells the full picture. Creating a bottoms-up market sizing on a separate tab within the model can help to demonstrate the true size of the market if there are concerns that it could be underestimated by investors. Check out this detailed post by Pear VC for more on how to create a bottoms-up market sizing.

2. Realistic and Thoughtful Assumptions

The assumptions in the model help investors understand the levers that will drive growth and profitability. Although there are growth metrics that VCs target (as mentioned above), we also want to see that your assumptions to reach those milestones are realistic.

For pre-launch companies, creating assumptions may be intimidating since there is usually limited data about company performance. We encourage entrepreneurs to speak with potential users, build a waitlist or do a beta test with a subset of potential users to generate feedback from early testing, which can be incorporated into assumptions. Industry and competitor research can also help inform the projections. For companies that are already in-market, founders should incorporate historical data.

Once an entrepreneur has the right inputs, they can review the outputs to see if the growth rates are in line with the targets. (The businesses that are the best fit for VC are those that can see a clear path towards $100M+ in revenue and a multi-billion dollar valuation, as noted above.) As a sanity check on the outputs, founders can compare the annual revenue levels to the size of the market from their pitch deck to confirm the company isn’t capturing market share at an unrealistic rate (i.e. too quickly or too slowly). Ideally, the output of the assumptions in the 3–5+ year time frame will align with the story that founders tell investors about the vision and growth expectations for the company, and demonstrate how the product roadmap is expected to evolve (more on storytelling and how to align a company’s story with revenue in this Holloway Guide article).

Quick Tip: I’ve seen some models where the company gets to less than 1/10th of the $100M revenue target I mentioned earlier. In this situation, I provide founders with feedback and help them to craft an achievable but higher-growth case that is more in line with VC targets. On the flip side, while a model should not be too conservative, the assumptions should reflect a plan that founders believe they can execute on — a case that is too aggressive could raise red flags.

3. Strong Unit Economics and Plan to Achieve Profitability

Investors are increasingly focused on profitability vs. growth at all costs. Like everything else in the model, the timeline to profitability may be hard to project but we like to see that the company’s unit economics are strong enough to reach profitability if desired. Ideally margin improvement is reflected in the later years of the model, with the earlier years focused on scaling. Strong unit economics are increasingly important to venture investors: Foundry Group’s Brad Feld goes as far as to rank gross profit margin over revenue when comparing and valuing companies at the later stage. However, many VC-backed companies raise large amounts of funding and even exit without reaching profitability (80% of companies that went public in 2018 were unprofitable). At BBGV, we want to see that founders are focused on both growth and the path to strong unit economics, even if the timeline to profitability is years away.

4. Founder Understands the Pace of Growth Needed to Raise Venture Capital Funding

The model needs to show strong momentum in order for a startup to raise funding. Below are a few great resources that provide guidance on metrics to track — most investors look for strong monthly and annual revenue growth as well as high margins but specific targets vary by industry.

• For companies that are post-launch, strong revenue growth is critical to a successful round. Triple, triple, double YoY growth is targeted for most SaaS businesses and MoM growth of 20%+ is usually considered strong across industries.
• A16z provides an overview of 16 startup metrics to track for all companies as well as specific metrics for SaaS businesses to track and marketplace metrics.
• For consumer products businesses, investors look for signs of traction — depending on the company and its timeline, traction may be demonstrated by actual revenue or by other signs of demand for the product including a waitlist or a strong community. By the Series A, companies should target $500K+ in MRR. This post by the team at Ro provides context on other metrics that are important to track for consumer products startups.
• LTV/CAC targets are typically 3x+ but it may be too early for this metric to be meaningful at the pre-seed / seed stage.

5. Runway Until Next Round and Ability to use Capital Efficiently

Investors usually expect the fundraise to provide at least 12 months of runway without revenue, preferably 18 months. Running out of cash is one of the top reasons startups fail so investors want the model to reflect that founders will prioritize cash management. Investors may use the model to run downside scenarios, and will want to see that a company has sufficient runway even if it misses targets.

6. Founder Understands How the Team will Scale and Critical Hires

A strong team is critical to our investment thesis — we discuss plans to expand the team with founders as part of the diligence process. The model helps us to understand other non-immediate hires and how the team will scale over time. Revenue expectations, the size of the fundraise and other cash items inform how much founders spend on their team but team salaries are often the largest expense category in the early years. For founders that have questions on appropriate compensation levels for new hires, we use a tool called Option Impact to help benchmark salaries and equity compensation by filters including stage, role, industry and geography.

7. Ability to Raise Series A and Additional Funding Rounds

When considering an investment, we want to have conviction that the company can raise their next round successfully. During the diligence process, we consider Series A KPIs in order to stress-test whether the current round of funding is sufficient to achieve the metrics they need to show for their next round. (Check out NFX’s “proof points” to consider for the Series A for a few that are relevant.) During the diligence process, I’m always impressed when a founder has already identified KPIs that are critical for the success of the business and has started tracking them through a dashboard. Having a KPI dashboard shows that an entrepreneur is actively thinking about the key levers for growth. At BBGV, we hold a twelve to eighteen month post-investment program consisting of meetings twice per month to provide high-touch support across hiring, press, marketing, partnerships and other critical areas. As a part of the process, we work with our portfolio companies to determine the three most critical factors or KPIs for the company to raise their next round of funding. We use the model as a tool to inform these metrics.

If you’re a female founder building in health & wellness, climate, or future of work & education and have questions on anything I mentioned (or disagree with any of these points!), I would love to connect. Feel free to reach out on Twitter — @ClaireBiernacks.

Look out for Part II which will go into the specifics of appropriately communicating the model to investors.