What Is Financial Modeling & How Can It Help with Fundraising?

What Is Financial Modeling & How Can It Help with Fundraising?

There is no standardized way to fundraise in the life sciences industry, although some paths are well-traveled. With multiple funding sources available, it’s all about what you and your potential investors want to see in a company and what you expect from one another.

For example, suppose you’re only working with a proof of concept (POC), prototype, or minimum viable product (MVP). In that case, you may want to look for different resources than if you already have hard data and initial revenues to show to investors.

Early-round investors looking to invest in a company at the seed stage are often willing to invest in companies that have an idea and not much else. Maybe there’s some promising new molecular entity or preclinical data showing potential for commercialization. An idea or promising NME can sometimes be enough for a biotech investor. Discovery phases tend to scare early-stage investors less.

In contrast, some investors participate in later fundraising rounds, such as Series A and higher, because they are more risk-averse and need more data on a company before investing. At this stage, they will usually require a track record of performance, revenues, or profitability to consider investing to aid in their decision-making process.

However, it can be difficult for early-stage biotech that isn’t generating profit to meet these requirements. In this case, they’ll want to see your future financial forecasts to understand better how you will make money in the future despite being unprofitable right now.

This is where financial modeling, a tool most often used by investment bankers, equity research analysts, and private equity firms, becomes critical to successful later-stage startup fundraising rounds. Financial models can be an important reason professional investors decide to invest in a startup because of their usefulness in evaluating a company’s future value, sales, and ability to grow.

But financial models aren’t solely used by investors for business valuation and raising capital. They can also be used internally to anticipate the future, make necessary changes, and analyze new business opportunities.

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How Can Financial Models Help Companies in the Life Sciences?

Financial models are used in the life sciences—every industry, practically—to forecast a business’s financial performance into the future. They serve as a roadmap for your company and its journey. And while you focus on how much cash is in the bank and your cash runway, investors will be thinking about your company beyond those numbers.

Investors in the life sciences and biotechnology think differently than other investors, so not all the same metrics that apply to a tech company will apply to a biotech. However, they may still want to know if you can scale revenue, customer acquisition costs (CACs), and customer lifetime value (LTV). Metrics like these will come into focus when you are raising capital from investors through a Series A, B, or C round.

While you might be able to raise a seed round with a well-defined yet simplified internal financial model, you’ll likely want to prepare an accurate financial model of your business as you move upmarket and seek out capital from more risk-averse investors.

This is where investing or not will become a financial calculation on the investors’ part, rather than something that feels like “following your gut.” In this sense, your financial model can be a huge determinant of whether or not they invest.

What Should a Financial Model Include?

Financial models can range from simple to complex. The complexity will depend on the quality and quantity of your data points and the amount of time you have to build and maintain it. (This is why you’ll see many first-time founders take a shot at financial modeling, only to bring in a professional to help.)

To keep things simple here, let’s consider the most common components a simple financial model will include:

  • Balance sheet
  • Income statement
  • Cash flow statement

This type of model is referred to as a three-statement model and works to connect all three financial statements in a way that sets assumptions that can drive changes across the entire model using historical data. One report alone will not paint a complete picture of a company. Having all three statements linked correctly can show what the company looks like and how it’s doing.

There are other types of financial models and information that can be included, which are all used for different reasons.

A discounted cash flow (DCF) model builds on the three statement model by modeling the value of a company based on its net present value (NPV) of future cash flows. A merger model (M&A) can be used to evaluate the ins and outs of a merger and acquisition. Initial public offering (IPO) models build IPO models that value a business before going public. Leveraged buyout models evaluate the potential return a business will get for acquiring another.

The one you end up using and the information you include will depend on who is making the model and what your goal for the model is.

How Is a Financial Model Built & Who Builds It?

Financial models are typically built in spreadsheet software like Excel or Google Sheets. The modeling is often handled by a well-trained professional/consultant certified in financial modeling and valuation/financial analysis; however, there are numerous online video tutorials and free templates available that you can use to build a model on your own and learn more about corporate finance.

If you decided to build a financial model on your own, having it validated is important. Model validation is an essential part of model risk management. Mistakes can be expensive, and errors are easy to miss. There are numerous third-party sources you can rely on to validate your financial model.

A Quick & Simple Example of Financial Modeling

It can be easier to understand a tool when you have an example of how it works. Let’s use a hypothetical one.

You’ve recently founded a startup that currently includes you and two co-founders. On the back of an envelope, you can write down that you plan on paying yourselves $100,000 each and now have $500,000 in the bank.

That means you’ll spend $300,000 on salaries with $200,000 left over. $50,000 goes to initial research, while another $50,000 is spent on corporate overhead. This leaves you with a $100,000 buffer—your emergency funds.

You can then itemize that budget in an excel spreadsheet and take it to an investor or two participating in your seed round. You’ll be able to explain the business in and out, as well as the first year of budgeting, and they’ll be able to walk you through the financial side of the equation.

However, somewhere between Series A and B rounds, you begin selling performance instead. As you move upmarket and start looking for more serious investments, it becomes about the numbers more than your idea and what you will build.

Your company’s growth rate will serve as a proxy for how significant the total market opportunity is, how fast investors think you can grow, what multiples they might get on the company, and how much capital your company will need in the future.

Many venture capital (VC), angel, or seed stage investors will be thinking, “I want to build my ownership position, help the company have enough cash to build something valuable, and attract investors who will fuel the company as things progress.”

However, if your model isn’t thoughtful and professional, your market opportunity might look too small, or your revenue run rate might seem insufficient. Or, maybe you’re burning too much cash. As a founder, it’ll be up to you and the professional accounts you work with to show them through the model how the company will succeed and grow.

That means you need to put the work in right away and create the basis for a collaborative conversation that builds trust and gets investors interested in the company in the first place.

Should You Rely on Financial Modeling?

A good financial model can represent how you think about your business. Using the financial model and numbers, you’re telling your startup’s story and its potential.

But what if you don’t have any historical data, or you’re not looking for outside investors? Is creating a financial model still a good idea? budget still a good idea?

Of course! Creating one and keeping track of your financial activity is still highly recommended. Without a simplified or comprehensive financial model, you might not have the outputs to create a well-defined budget. Without a financial model or budget, you will have much more difficulty knowing your business’s financial health, activities, and projections.

This article is informative and does not represent financial advice. Speaking with a financial modeling professional or financial analyst is considered best practice before creating a budget plan on your own.