The Real Value of a Cashflow Model
The Real Value of a Cashflow Model
Nov 20, 2024
Nov 20, 2024
I’ll take the other side of this.
First off, I appreciate Michael Ho’s take on financial projections, especially his emphasis on assumptions being the critical components.
But it did get me thinking that we need a reframe of the true value of projections (what I would call cashflow models, same thing) because they're not just for investors.
A cashflow model's primary value is helping founders make better decisions. You just so happen to show them to investors when they're interested.
Having done so many of these now, I can tell you the common quotes I hear from founders I’ve worked with:
“We can calm down and make good decisions now.”
“Like the foundations of a building.”
“I feel so much better.”
And before I go on, note that I use the term cashflow model instead of financial model. That’s because a financial model is a hangover from the corporate world, something you need to blow the dust off before you watch it clunk back to life. It’s too accountantey and complex for startups. I have yet to encounter a reason that an early stage founder would want to forecast a balance sheet.
The difference is that a cashflow model is slick. It’s cash in and cash out over time, and the primary output is runway. I don’t care what business you’re in, everyone needs to understand cash.
It’s helpful also to understand what a model is in the first place.
A model is nothing more than a mathematical representation of some underlying set of business processes. In the case of startups, the underlying processes are your business realities and strategies and everything else you are pitching and believing and dreaming and intuiting about the future.
These real-life things are the fuel of a model, and what a model does is takes all this information, usually everything that would be appropriately contained in a data room, and turns it into a spreadsheet, organized, timebound, and quantified, that you can then use to understand the financial impacts of your decisions.
That’s the key point—no matter what, a founder must have a conception of the financial impacts of their decisions. And that is what a cashflow model does.
The art of a model is in how clearly you can capture the underlying processes and how efficiently you can represent them in the model. That is, not too complex, not too simple. We want balanced and actionable.
Point of clarification: I’m not saying that the cashflow model makes decisions for you, because it doesn’t—it always follows and probes what’s happening in reality—but deciding between alternatives one way or another without having an understanding of what could plausibly happen financially is not good enough when you’re dealing in business and asking investors for potentially millions of dollars.
I want to double down on this. I see many passionate founders who are experts in their domain, their expertise, their product, their convictions, but they dislike business. This is a big problem because what really makes a founder dangerous is when they have both sides of the equation: product + business. That’s the equation for real authority and founders who raise successfully.
A few points about what a model can and cannot do:
A model can tell you what the next 24 months of cash burn look like. Expense modeling is easy and necessary and at the very minimum a founder must understand their cash outflows—team, materials the team uses, capital spending—for the next 24 months. It’s useful to know your burn because then you can think of any new expense in terms of what it will do to your runway, and the framing is pretty easy for a yes or no decision: If I sacrifice two months of burn to hire a new employee, do I get where I need to go at a minimum two months quicker?
To the extent you know, founders can add in cash inflows through dilutive financing, non-dilutive financing, pilot income, and initial sales, if any. It’s okay to exclude a more robust sales and cost of sales model if you’re really not yet sure what you’re ultimately going to build and who’s going to buy it. Skip to 21:44 in this YouTube video I made to see what questions you need to answer to get started with a sales model.
To expand on this point above. You at a minimum must always have the equivalent of a 2-year operating budget that shows your use of cash, other sources of cash, and your dilutive fundraising needed to cover the balance. This is how you make sure you don’t inadvertently run out of money and have to make bad deals to top-up. If you want to go deeper into a 5-year cashflow model, this is optional at the earliest stages. The main difference for the 5-year model is the inclusion of sales projections and the associated costs to earn those sales. That’s where almost all the complexity is and where all the biggest assumptions show up.
A model cannot tell you what will happen in year 5. Probably you don’t even know what you will be selling in year 5. So the point is that models are more accurate in the beginning, and they lose their accuracy as they go deeper into the future. But that’s not a reason not to try. Because in trying, you are showing yourself, your team, and your investors, that you have really thought through the entirely of how your business might just grow and that you can be trusted that much more.
A model cannot tell you what will happen with accuracy down to the dollar, but it can tell you what is plausible. That is, what is +/- 50% from your baseline. That might seem like an uncertain confident level, but it’s really not that bad. This is still actionable information when you compare two scenarios.
Speaking of which, a model can make alternatives more clear when contrasted side-by-side. I’ve done lots of analysis by duplicating a model of mine, the base case, and then adjusting the new version for what would happen under a different set of underlying realities. Then we can see at a glance how the two alternatives compare. This presumes that you have a strong base case.
A model can make benchmarking available to you. Every business is different, yes, but there are archetypes that generally describe how a business grows. And if we look at mature businesses that are in the same industry or have a similar business model as the company creating a model, we can see what our own mature-state might look like. Then you can start to compare more widely too. Say, if your sales projections in year 5 are already in excess of a company that has raised 10x the amount of capital as you plan to and has taken 12 years to get there, temper your expectations.
A model can break when the underlying reality breaks. But usually it doesn’t break too badly unless a full rework of the business is done—in that case you need a new model. But if there’s just smaller changes over time, collect them in a notes tab and make them all at once on a scheduled basis, once every 3 months is a good place to start.
A model cannot tell you your strategy, and you cannot reverse engineer strategy with it. So don’t try. What it can do is force you to think critically about every part of your business and, once set up, it gives you a place to feed into all the new information you encounter to see what happens.
It’s a curious thing about modeling how contentious it is and about this game we all play with it. Investors don’t believe the hockey stick growth, but then they criticize when it’s not there. Founders don’t believe it either, but they feel compelled to put it in. I don’t know why this is. But I do know it’s incredibly inefficient when a founder feels compelled to have two models—an internal one that they believe and an external one which everyone thinks is absurd.
But these arguments are really beside the point anyways. The real point is this: having a cashflow model and understanding it shows that you're a founder who gets business. It shows you're a founder with authority who understands how money flows, and how your business decisions impact your financial situation. And, when done right, it's one of your most powerful decision-making tools.
If you want to figure out how to get a cashflow model done right you can check out this video I linked already. It’s long, but that’s the point. If you’re a founder or a member of a founding team, set aside some time one day and learn this stuff. I guarantee it’ll serve you well and likely in ways you never considered.
I’ll take the other side of this.
First off, I appreciate Michael Ho’s take on financial projections, especially his emphasis on assumptions being the critical components.
But it did get me thinking that we need a reframe of the true value of projections (what I would call cashflow models, same thing) because they're not just for investors.
A cashflow model's primary value is helping founders make better decisions. You just so happen to show them to investors when they're interested.
Having done so many of these now, I can tell you the common quotes I hear from founders I’ve worked with:
“We can calm down and make good decisions now.”
“Like the foundations of a building.”
“I feel so much better.”
And before I go on, note that I use the term cashflow model instead of financial model. That’s because a financial model is a hangover from the corporate world, something you need to blow the dust off before you watch it clunk back to life. It’s too accountantey and complex for startups. I have yet to encounter a reason that an early stage founder would want to forecast a balance sheet.
The difference is that a cashflow model is slick. It’s cash in and cash out over time, and the primary output is runway. I don’t care what business you’re in, everyone needs to understand cash.
It’s helpful also to understand what a model is in the first place.
A model is nothing more than a mathematical representation of some underlying set of business processes. In the case of startups, the underlying processes are your business realities and strategies and everything else you are pitching and believing and dreaming and intuiting about the future.
These real-life things are the fuel of a model, and what a model does is takes all this information, usually everything that would be appropriately contained in a data room, and turns it into a spreadsheet, organized, timebound, and quantified, that you can then use to understand the financial impacts of your decisions.
That’s the key point—no matter what, a founder must have a conception of the financial impacts of their decisions. And that is what a cashflow model does.
The art of a model is in how clearly you can capture the underlying processes and how efficiently you can represent them in the model. That is, not too complex, not too simple. We want balanced and actionable.
Point of clarification: I’m not saying that the cashflow model makes decisions for you, because it doesn’t—it always follows and probes what’s happening in reality—but deciding between alternatives one way or another without having an understanding of what could plausibly happen financially is not good enough when you’re dealing in business and asking investors for potentially millions of dollars.
I want to double down on this. I see many passionate founders who are experts in their domain, their expertise, their product, their convictions, but they dislike business. This is a big problem because what really makes a founder dangerous is when they have both sides of the equation: product + business. That’s the equation for real authority and founders who raise successfully.
A few points about what a model can and cannot do:
A model can tell you what the next 24 months of cash burn look like. Expense modeling is easy and necessary and at the very minimum a founder must understand their cash outflows—team, materials the team uses, capital spending—for the next 24 months. It’s useful to know your burn because then you can think of any new expense in terms of what it will do to your runway, and the framing is pretty easy for a yes or no decision: If I sacrifice two months of burn to hire a new employee, do I get where I need to go at a minimum two months quicker?
To the extent you know, founders can add in cash inflows through dilutive financing, non-dilutive financing, pilot income, and initial sales, if any. It’s okay to exclude a more robust sales and cost of sales model if you’re really not yet sure what you’re ultimately going to build and who’s going to buy it. Skip to 21:44 in this YouTube video I made to see what questions you need to answer to get started with a sales model.
To expand on this point above. You at a minimum must always have the equivalent of a 2-year operating budget that shows your use of cash, other sources of cash, and your dilutive fundraising needed to cover the balance. This is how you make sure you don’t inadvertently run out of money and have to make bad deals to top-up. If you want to go deeper into a 5-year cashflow model, this is optional at the earliest stages. The main difference for the 5-year model is the inclusion of sales projections and the associated costs to earn those sales. That’s where almost all the complexity is and where all the biggest assumptions show up.
A model cannot tell you what will happen in year 5. Probably you don’t even know what you will be selling in year 5. So the point is that models are more accurate in the beginning, and they lose their accuracy as they go deeper into the future. But that’s not a reason not to try. Because in trying, you are showing yourself, your team, and your investors, that you have really thought through the entirely of how your business might just grow and that you can be trusted that much more.
A model cannot tell you what will happen with accuracy down to the dollar, but it can tell you what is plausible. That is, what is +/- 50% from your baseline. That might seem like an uncertain confident level, but it’s really not that bad. This is still actionable information when you compare two scenarios.
Speaking of which, a model can make alternatives more clear when contrasted side-by-side. I’ve done lots of analysis by duplicating a model of mine, the base case, and then adjusting the new version for what would happen under a different set of underlying realities. Then we can see at a glance how the two alternatives compare. This presumes that you have a strong base case.
A model can make benchmarking available to you. Every business is different, yes, but there are archetypes that generally describe how a business grows. And if we look at mature businesses that are in the same industry or have a similar business model as the company creating a model, we can see what our own mature-state might look like. Then you can start to compare more widely too. Say, if your sales projections in year 5 are already in excess of a company that has raised 10x the amount of capital as you plan to and has taken 12 years to get there, temper your expectations.
A model can break when the underlying reality breaks. But usually it doesn’t break too badly unless a full rework of the business is done—in that case you need a new model. But if there’s just smaller changes over time, collect them in a notes tab and make them all at once on a scheduled basis, once every 3 months is a good place to start.
A model cannot tell you your strategy, and you cannot reverse engineer strategy with it. So don’t try. What it can do is force you to think critically about every part of your business and, once set up, it gives you a place to feed into all the new information you encounter to see what happens.
It’s a curious thing about modeling how contentious it is and about this game we all play with it. Investors don’t believe the hockey stick growth, but then they criticize when it’s not there. Founders don’t believe it either, but they feel compelled to put it in. I don’t know why this is. But I do know it’s incredibly inefficient when a founder feels compelled to have two models—an internal one that they believe and an external one which everyone thinks is absurd.
But these arguments are really beside the point anyways. The real point is this: having a cashflow model and understanding it shows that you're a founder who gets business. It shows you're a founder with authority who understands how money flows, and how your business decisions impact your financial situation. And, when done right, it's one of your most powerful decision-making tools.
If you want to figure out how to get a cashflow model done right you can check out this video I linked already. It’s long, but that’s the point. If you’re a founder or a member of a founding team, set aside some time one day and learn this stuff. I guarantee it’ll serve you well and likely in ways you never considered.