What are the common mistakes that startups make in a financial model, and why must you avoid them at all costs? As you might already know, financial modeling plays a major role in startups. It is considered an indispensable tool for startups and founders. An entrepreneur might create a financial model for garnering investor interest or strategic planning, like calculating runway and deciding budgets. Nevertheless, financial modeling usually involves a spreadsheet, where complexity and confusion can increase without the proper precautions. Now, you may want to dive into a spreadsheet right away. But it would be best if you went ahead with a concrete plan. That way, you could avoid a lot of mishaps. In this post, we present to you some of the most unfortunate mistakes that startups make in their financial models. Learning about these mistakes will help you to avoid them at all costs.
1. Hardcoding projections and assumptions
Hardcoding values in a financial model is one of the most common mistakes made by entrepreneurs. It definitely shows a lack of experience. Plus, it implies that you lack a fundamental understanding of the model’s purpose.
You have to keep this rule in mind: only revenue and costs should be inputted manually. The rest of the model should then be modified as per these inputs. Suppose that the additional values are hardcoded. If that’s the case, then you are essentially increasing the complexity of the model. Some changes might not even be reflected if these additional values are not changed manually again with respect to the new inputs. This makes it more challenging to go back and make adjustments to the inputs. Plus, you risk hiding certain assumptions. More than anything, hardcoding values showcases a lack of discipline. This could lead investors to doubt your potential and be skeptical of the reliability and transparency of your business.
So, how can you minimize such issues? What you can do is double-check to make sure that only two values are hardcoded: revenue and cost (also known as expenses). Keep in mind that the majority of your model should come from interlinked cells and formulas that update dynamically given different inputs.
2. Forgetting who your audience is
Most startup financial models used for fundraising are usually internal planning tools. However, there is no need to highlight that fact. When a third party goes through the model, they should be able to figure out how to extract the model’s gist.
Make sure to showcase your assumptions clearly and logically. It is important to use formulas to “show your work.” Some entrepreneurs make the mistake of using hard-wired numbers. Remember to avoid this mistake so that the reader can understand the calculations.
What if headcount tables don’t specify the function or title of the resource? Trust us: this could be such a letdown to the reader as a very prominent typo.
Keep in mind that most investors and all VCs have usually had formal financial training. They can instantly spot a formula error. Certainly, you don’t want to make a presentation with typos for investors to see. That’s why you should ensure that you audit your financial model before you send it out. It would be best if you could get someone else to double-check it or work on it for you.
A good tip you can try out is sending your model to a colleague or fellow founder and getting their feedback to find the three deliberate errors. This can help you find any issues that you may have missed.
3. Missing details that investors want to hear
Not considering what the investors want to hear is a huge mistake made by entrepreneurs. Surprisingly, a lot of entrepreneurs make this mistake. They present financial models to investors without demonstrating the growth potential an investor requires. Of course, investors know everything won’t turn out exactly as initially planned. However, they do expect to see statistics that generate potential target returns.
Likewise, investors are concerned about the money. So, your financial model should especially demonstrate how their funding will be deployed. They would want to know over what time period the funding will be deployed and what the startup business will have achieved due to that investment. You also have to show them how much additional money will be needed before your startup will reach break-even and the amount of money a mature business can generate.
4. Not having a plan for the future
You cannot deny that a solid plan is a key to the success of any business. Projections are based on actual assumptions, not a finger in the wind. These guide the business as it grows while also ensuring that smart practices are incorporated based on actual assumptions, not a finger in the wind. These guide the business as it grows while also ensuring that smart practices are incorporated. Note that smart moves should be present from day one. Forming good habits from the beginning helps you to be better right out of the gate. Making a mess in the early days will only make you mop it up for the years to come.
Make sure to keep the books clean from the beginning, and trust us—you’ll see the benefits in the long run. Being GAAP-compliant as much as possible will help you over time. You also cannot undermine the compensation decisions you make today. Suppose you’re doling out stock or options. Then invest in a 409A valuation once a year and anytime a major event occurs (like a major financing deal). Doing so will keep you out of trouble with the IRS and ensure that you accurately account for stock compensation.
Focus on long-term efficiencies
The takeaway here is that it is important to focus on long-term efficiencies rather than just focusing on the short term. Of course, an exit strategy might sound unrealistic. Still, it should always be present when you make decisions. When the time comes to go public or to make the company look attractive to an acquirer, the amount of work involved is huge—it can be even heavier and make any deal shaky if you make several mistakes along the way. So make sure to set your financial processes in place to scale. Remember that this is for long-term benefits.
5. Ignoring compliance
Ignorance is never an excuse that regulators let slide. Keep in mind that the risks are way too great to be in denial. Instead, you have to get it done. Auditor and government interference can make things downright unbearable if you don’t. And growth could stall as senior leaders get pulled away from their daily tasks to handle pressing inquiries. Apart from the high stress involved, audits are disruptive to the business. Troublesome findings can end up with interest charges and penalties. If that happens, there’s also a risk of losing the ability to continue the business.
Of course, private companies have a relatively lighter compliance load than public companies. Yet, the list is still long, between labor laws, tax returns, secretary of state filings, federal and state regulations, etc. Work with compliance experts who can help your company stay up-to-date. That way, you can fully focus on growing the business.
6. Formatting inconsistency
Suppose you absolutely need to include additional hardcoded values. If that’s the case, make sure to group the fields together in the same tab. Title those as “inputs” and apply different formatting to them.
Usually, the “inputs” and “assumptions” tabs need to be first in the spreadsheet. That’s because it determines the outcomes of all subsequent projections. If you incorporate good organization, you’ll be able to minimize the complexity of your model. That makes it more accessible to different viewers. The reason this is important is that the models can be shared, presented, and printed.
We assure you that organization and formatting are not technical issues that require a lot of skills or expertise. Essentially, they require a bit more time and discipline. Plus, make sure to think from the viewers’ point of view when you work on it. Make some efforts in your financial model if you would like to reduce any possible friction among parties involved.
7. Syntax Errors
Some mistakes may be the simplest things. It could be something as simple as confusing two formulas, which can produce unexpected errors. For example, you may confuse COUNT() with COUNTIF(). This would lead to counting all numeric values in a specific range instead of only the values that match particular criteria. However, this mistake would usually be rectified immediately while the model is being prepared, as the number of parameters required is different for the two functions. The spreadsheet software will complain right away, and the mistake will not be prolonged.
Here are some other common syntax errors made by entrepreneurs :
- Mixing up positive and negative digits in a cash flow statement.
- Misplacing or forgetting brackets. =A1+B1*360 does not equal =(A1+B1)*360.
A solution we can suggest is to use checks throughout the spreadsheet. That way, you can verify the calculations. Make sure to have all checks in a single tab to stay organized. Also, keep in mind that the balance sheet always needs to balance. That way, the sum of all assets should equal the total of all liabilities and equity.
8. Long formulas
Another mistake that startups make in their financial models is the use of long formulas. It would be best to avoid long formulas if you could. That way, you can minimize the complexity of your financial model and spend less time double-checking calculations. Make sure not to fall for another pretty common mistake by using nested if conditions. We know that it is necessary at times. Yet, remember that nested IFs tend to generate errors when used improperly, and also reduces the readability of your financial model.
Always keep your model simple. One thing you can try is to narrow the problem down as much as possible. You can do this by adding several columns to work on a formula that will either return multiple or a single value. It is better to do this only when the constituent collection of terms inside a certain formula have real meanings in the subject of interest.
9. Daisy Chains
A daisy chain is when data is taken from several sources even when they were available from a single input tab. Essentially, there are a series of links that are not directly connected to the original source. This is a mistake you should avoid. It certainly forces the reader to go through the spreadsheet multiple times just to figure out the logic. Plus, it also adds to the size of the file.
10. Naming Convention of Files
Like formatting, the naming convention you use to save files can be the difference between taking too much time in file explorer and showcasing the organization skills to the investors.
You must double-check to minimize the possibility of human error. Of course, this does require some discipline. You might name a model “Model 5” and eventually forget its purpose entirely. To avoid this mishap, make sure to be rather specific with naming your files. Although it may seem like additional work for a simple detail, it is totally worth it. All the extra time spent specifying your files reduces the chance of presenting an embarrassingly incorrect version in the future.
11. Incorrect sums
Another mistake that startups make in their financial model is also related to calculations. People tend to come up with incorrect sums by “double counting” values. Let us explain this with an example. A column might include the values of various assets with subtotals in the same column. So if you were to calculate the sum of the values, =SUM(C1:C7), the subtotals would be involved and double the sum.
So how can you prevent this mishap from happening? Well, you can use the SUBTOTAL function to add together each value that is not already subtotaled. =SUBTOTAL(C1:C7) would give you the correct sum.
There you have it! You had the chance to learn about the mistakes that startups make in their financial models. Of course, creating a financial model is essential. It’s pretty easy to make mistakes. Even the simplest mistakes can break your business. Accuracy, transparency, and reliability are necessary for a financial model. Make sure not to make the mistakes we spoke about, including calculation errors.