Creating a Financial Model
The new generation of innovators and entrepreneurs love a good cause. It’s hip to give back; it’s cool for your product to have a story, a purpose beyond dollars and cents. But you still want your product to turn a profit. You can speak about your product with all the passion in the world, but eventually, one of your investors (or your partner) is going to scream “show me the money”.
Passion is good, but passion steeped in money is way better. Once your market research and analysis has given you the green light to proceed with your idea, it’s time to figure out just how you are going to turn a profit. This means projecting market growth, market share, and future sales and revenues.
There are two ways to create a financial model for your business idea: Top-Down or Bottom-Up. Many entrepreneurs like to use top-down because it tends to yield the most impressive numbers, but in the name of being thorough and leaving no stone unturned, we recommend doing both projections. You want to check out your business from all angles.
Creating a Top-Down Financial Model
Going top-down means you begin to look at the size of the existing market you are entering and how much you expect it to grow over the next few years. Then you figure out how big a share of that market you expect will buy your product or service as well as how you expect your customer base to grow with the market. From there you figure out how much you need to produce and how you should set pricing to make a profit. This is also true in product and services that you resell, you make a commission that may be set or variable.
Since your product is still a business idea, and it doesn’t technically exist yet, no one has purchased your product; top-down projections might just be too good to be true. So far your market research has only showed you that there is a genuine interest in your product, but these enthusiasts have yet to put their money where their mouths are, and your top-down projections may be way too optimistic.
Creating a Bottom-Up Financial Model
To ensure that you aren’t being too optimistic in your projections, it’s good to get a more conservative view by using a bottom-up financial model forecast.
Investors love seeing huge numbers, but a good shark will be able to smell unrealistic projections a mile away. Making a detailed budget for your company where you break down all spending necessary to create your product, market your product, and sell your product is taken into account. This means that instead of looking at the whole market, you only look at the market that is available to you at this moment.
You market research should give you an idea of the size of your market. How many people have responded, how big is your online network of potential customers, and how you realistically expect your customer base to grow. If you have some sales already, those are taken into account.
Using the number of your actual market, as opposed to the whole market will give you smaller, but more realistic projections for revenue.
Optimism is great, and you want to show that you believe in yourself, your team and your business by projecting high, but going too high will only hurt you when you try to impress potential investors.
Next: Finding a source of funding