How to Build a Financial Model at a Seed Stage Company
When let’s be honest, it feels like you’re making up numbers
Building your first financial plan is daunting. To start, you probably don’t have any accounting or finance experience. You have no idea how to forecast your revenue ramp. You feel like you’re just making up numbers. You want to convey to investors that you’re the next great company with a model that reflects that ambition, but you also don’t want to come across as naive. And most importantly, you don’t want to run your company into the ground because you burned too fast or burned too slow.
In this post, I’ll lay out an approach to building a credible, yet ambitious financial plan that you can use not just for fundraising but to also manage your b2b software business from your Seed round to Series A.
To get there, we’ll step through how to 1) size the investment needed to get your product to market, 2) set a thirty-month cash burn cap, then 3) build an ambitious growth plan within that burn cap.
The foundations of this approach
At the heart of this approach are two core beliefs:
First, that finding Product-Market Fit (PMF) is incredibly difficult but the milestones are generally consistent.
- Validate the concept with potential customers, ideally sign up a few pilots
- Build a minimally viable product (MVP)
- Get a handful of guinea pigs customers into production and successful with the product
- Build a repeatable go-to-market motion as you drive to $1M in ARR
The second belief is that it sucks to run out of money. Typical advice is to raise for eighteen months of runway. Fundraising for the A could take six months. Leaving you just twelve months to get compelling traction like $1M in ARR. That leaves you little room for a pivot if you need it. With thirty months, you plan for six months of fundraising and twenty-four months to hit your target milestones. If things go perfectly, congrats! You accelerate your burn. But if things go sideways, you have an extra year to find your way and save the company.
Ok, let’s get to it. Feel free to use this spreadsheet as a template financial plan.
Step 1. Funding to a Minimally Viable Product (MVP)
Before you can hire a bunch of marketers and salespeople you need to prove that your product works, that there’s demand, and that you can make customers successful. Jump the gun and you could be blowing scarce capital and customers out the window.
So the first thing you need is a team to build the product and continuously iterate on it until the market bites. That team is usually a handful of engineers, a UX person, and someone acting as a product manager to manage specs and roadmap. There’s also one person solely focused on finding early customers and collecting product feedback. That’s typically the CEO, but on rare occasions, it might be someone else. Altogether it’s a small team of five to ten people. Maybe there’s rent, cloud computing costs, and a few other resources you need. It rarely includes sales, marketing, or admin staff.
Take a crack at that minimum headcount. Figure out what reasonable market compensation is for each role. If you're in the US you’ll want to add 20-30% of salary for things like payroll tax and benefits.
Assume no revenue growth during this first phase
Maybe you have early revenues, maybe you don’t. Either way, be conservative and plan for no revenue growth through this initial phase-- you don’t want to overhire on the expectations of early growth.
Step 2. Calculate your burn cap
A cash burn cap is the upper bound on your monthly burn rate. It’s a commitment that you’ll keep your burn rate below that number for the life of the seed round. A burn cap keeps you lean when being lean matters most.
The easiest way to calculate your burn cap is to take the amount you plan to raise in your seed round plus any money you already have in the bank and then divide it by 30 months.
Example: Acme Corp plans to raise $2.5M and currently has 500k in the bank? ($2,500,000 + $500,000)/30 months = $100,000/mo burn cap.
Sanity check this against your current plan. From the work you did in the section above, you estimated your monthly expenses. Is this number higher or lower than your burn cap? If it’s higher, then consider cutting your expenses or raising more money. If it’s lower, then you may be able to lower the amount that you’re planning to raise. Or if the difference is small, perhaps you keep that extra burn cap as a buffer for all the unexpected expenses that inevitably come up over the course of 30 months.
Once you get to a number that makes sense, compare the total fundraise to other similar companies recently? Is your number much higher? Cut headcount and rethink product scope. Too low? Check your math and your assumptions.
For more info on Burn Caps, Brad Gillespie @ IA Ventures has a wonderful post.
Step 3: Build a compelling growth plan
From here, you can start to layer in your ambitions. Most seed investors expect to see portfolio companies ready for a Series A in 18 months. That usually means at least $1M in recurring revenue. If you think you can get there, then model that. At this point, you’re going to feel like you’re making up numbers. And to some degree you are but these numbers should be validated by the customer conversations you’ve had so far.
Modeling Revenue Growth
Set a date you expect to start the revenue ramp-- usually between one to three months after you expect to get to a true MVP. If you have pilot customers, how many do you predict will convert at that point? For how much?
Once you set the date you expect to be “in-market,” make an assumption for how many new customers you’ll be adding every month. You may find it easier to think through customer counts as the input to growth, instead of revenue. The count is more tangible and tends to better correlate to the investments you’ll need to make to fuel that growth.
It’s tempting to just straight-line month-to-month growth. One customer the first month, two the next, three after that. But the reality is that the first months of sales are going to be weird and lumpy. So model it slow at first and then start to ramp.
Average Deal Size
Next, set an average deal size. To keep things simple, use your avg ARR as the ARR for all customers in this model except for any pilots you’ve already set a different expectation with.
B2B products that require salespeople usually need to have larger deal sizes to make the business model work. Self-service B2B products can get away with much smaller deal sizes. Either way, really think through how you’re going to credibly acquire and support enough customer volume to make your model work.
Land and expand
“Land and expand” means revenue increases as the customer adopts more of the product. Churn is people dropping off or reducing usage/revenue of your product for any reason.
If this is a critical part of your business model, you need to model some degree of expansion and churn.
All the best subscription businesses typically see much more account expansion than they see revenue churn. Since you don’t really know any of these numbers yet, shortcut the math and just say “Net Expansion will be X%”.
Model expenses to fuel growth
This exciting growth plan is going to need fuel. You’re going to need a few additional people and maybe spend some on marketing campaigns.
Earn to Burn
Before you start to add people and expenses, look at your burn rate for each month. Make sure it doesn’t go over the burn cap you established in Step 2. This means you’re adding people slowly, as revenue is growing.
Start with salespeople
If you need salespeople, start with two. Trust me.
If you hire one and they don’t work out then you’re hosed. Was it them or your product-market fit? Hire two, you lower the odds of a false negative. Further, there’s typically a limit to the amount of quota a rep can carry, especially this early in-market. $500k ARR booked/rep/year is a reasonable target for your first year in the market. Eventually, it’ll need to be 4-5x their salary+commission. In this stage, be skeptical of any rep carrying more than a $1M ARR quota.
Get a demand generation marketer to feed the pipeline for sales
With sales capacity, you need to keep them fed with leads. This is what a demand gen marketer does. They build and run demand generation campaigns. This role is a luxury at this stage, but if you can afford it, a good demand gen marketer is worth it. The right demand gen marketer might go by different titles depending on your GTM motion: content marketers, growth marketers, account-based marketers, etc.
Congratulations on your new financial plan!
You did it! You built a financial plan for a company that needs time to find product-market fit. You set a burn cap while still conveying your ambitious growth plan to get you to a Series A.
Before you finalize it, run it by experienced friends or friendly investors, just to make sure you didn’t miss something.
Once you’re comfortable with it, you can use it for fundraising. More importantly, keep it up to date as you’re running the company so that you can keep to your plan and also have a model to run the “what if” scenarios you’ll need now or in the future.
Best of luck!