It’s taken long hours, hard work, determination and capital to get to this point. But you can’t afford to sit back and relax just yet as you’ll need lots of energy, investment and support to grow your startup.
Anyone who is thinking of investing in your startup or who is considering coming to work for you will want proof that the company is likely going to be successful. Even though you’re sure it will be, your promises won’t hold much weight if they’re not backed up by evidence.
Scenario modelling is frequently used by startups to predict what may happen in different scenarios. These predictions can be what is needed to persuade investors or potential employees that your startup is the right one to back or join.
Let’s see what scenario modelling is, the value it provides, techniques you can use and tips to ensure the information you get from the model is accurate.
Scenario modelling forms part of financial modelling - using mathematical models to form a picture of the future.
Specifically, scenario modelling is the process of examining different scenarios to create a range of potential outcomes and explore the difference between these. In finance, scenario modelling is often used to determine the value of a business, in both favourable and unfavourable events that could impact the startup.
For example, say you’re a youngish startup and you’ve caught the attention of a potential big investor who is interested in buying equity. You’ve kept a level head and have studied the figures and done your due diligence. All seems fine, but you’re also thinking of the future and wondering what may happen if another investor comes along. Or, if the country goes into a recession, you want to know what the potential outcome could be for your startup.
Using scenario modelling, you can get answers to these different variables.
Likewise, your plan may involve exiting the startup and either retiring or starting a new business. Exit modelling can be used to help you plan your exit strategy and identify potential positions that are the most advantageous for your exit.
When business managers perform scenario modelling and exit modelling, they look at future scenarios of the business, the industry and the economy. These scenarios include assumptions on things like the cost of production, salaries, interest rates, inflation, the change in customer base etc.
Assumptions form an important part of scenario modelling but basing these assumptions on guess work is risky. Investors are considering putting their money into your startup, so they will want to see that you can back up your figures and assumptions with evidence.
Admitting that you came to these assumptions blindly won’t fill investors with confidence. Instead, do your research; undertake market research, look at historic sales, track the inflation rates in the countries where your suppliers and distributors are, look at web traffic to your site, and much more. Create a centralised folder (to contain this information) that all founders can access and add-to.
As a sole-founder, you’re in control of how assumptions are made. If there’s a few of you, each one should be involved in the sense check of the assumptions being made.
There are different approaches to scenario modelling, each with their own merits and disadvantages. It would take us forever to discuss each one. Something that is of more importance is getting the data that feeds into the model. For example, how do you know the size of your market? What is your sales projection for the next 12 months?
It’s possible to answer these types of questions using the top-down and the bottom-up approach:
The top-down approach starts by looking at the worldwide market for your business. Next, you estimate how much of this market buys the product or service your business offers, considering existing competition. The answer to this is your sales target.
Following this, you can estimate the cost of producing and delivering your product and service, plus what expenses will be incurred for sales & marketing, R&D, admin etc. At some reasonable point in time, these costs and expenses should be less than your revenue i.e. you start making a profit.
The benefits of the top-down approach for startups include there are fewer data issues so more accurate models can be created. As up to date point of sale data isn’t required it’s easier and quicker for projections to be made. It also shows whether the market is increasing or decreasing - startup founders can see if they’ll ever make a profit.
There is a tendency for startup founders to be overly optimistic with the top-down approach and estimate a bigger market share than what is available.
The bottom-up approach is the opposite to the top-down approach in that you start by looking at the company from the inside and then build outward. Projections are made from resources and information that are available in a specific point of time and include things like company revenues, costs, expenses and investments.
Projections made using the bottom-up approach are said to be more accurate as you’re using actual data in the model. These projections can be used to show you where to allocate your resources for maximum return.
Even though the projections tend to be more accurate, they can mask the optimism that investors seek when investing in a startup. So, it may be a put-off for them.
While it’s not practical to model every scenario, some insight into what could potentially happen in different situations is better than none. Scenario modelling is useful for investors to gauge expected returns and risks from investments. Likewise, startups can use scenario modelling to assess the suitability of potential investors. It also enables companies to be proactive and plan for an event that may result in losses. For instance, lots of startups have been using scenario modelling in the run up to Brexit.
A cap (capitalisation) table is a spreadsheet or table that shows the overall equity ownership for a startup. It also breaks this down into group ownership e.g. investors, employee pool, angel investors. The cap table is seen as the most important document in a startup.
The information contained in the cap table is fed into scenario models. Other key financial decisions are made based on the data the cap table holds. For example, you’ve gone through a funding round and based on the information held in your cap table, several investors have put forward enticing term sheets (a non-binding agreement that details the T&C’s under which the investment can be made). Which one do you go for? What impact will this investment have on your equity and that of your other investors? With the use of scenario modelling, you can pour over the predictions to help you to make a decision.
Considering its importance, you can understand why the cap table must be accurate and up to date. Manually maintaining a cap table in an accelerating startup isn’t easy. Ledgy offers several services to centralise cap table management. This ensures all the important information is securely held in one place and available to those who need it 24/7.
With Ledgy, managing ESOP’s, modelling finance rounds and keeping employees and investors informed is simple and quick. Find out more about - https://ledgy.com/
There’s little you can do to stop future events, but by regularly analysing your assumptions and running them through a scenario model, you can develop plans that are ready to be deployed whenever needed.
Yet, the outcomes that are produced from scenario modelling are only as good as the strategy you’ve developed for running the models. Here are some best practices to help you get the most from scenario modelling:
Scenario modelling isn’t something that should be done once a year and then forgotten about. The economy, markets, your startups cashflow and employees joining and leaving the company are constantly shifting factors. Scenario modelling needs to be a regular activity. Whether that’s once a week, once a month, or quarterly is up to you.
An undoing of scenario modelling is assumption bias by the person(s) carrying out the model. This can happen when the scenario model analyser is drawn to data that they already know. Like, looking at information from markets they’re familiar with.
To prevent assumption bias overtaking your scenario models, it’s best practice to source data from far-reaching, reliable sources such as historical sales, what’s in your pipeline, hiring needs for the business etc. Also, look at inter-connected industries and markets to see what is happening and how businesses are responding.
Startup founders are typically optimistic - they need lots of energy, determination and self-belief to grow a business from nothing. This optimism can shield them from realising that things don’t always go the way they want.
When running scenario models, plan for the best and the worst. For instance, the best case could show your sales projections, potential share price or hiring intentions for the next 12 months - if everything goes the way you want it to. Likewise, the worst case will give you an insight into the position of the business if things fail. Such as if you lose your biggest client or an important employee leaves the company.
Knowing what the worst case is can help the business to bounce back from any issues it may face externally and internally.
It’s a stark reality but 90% of startups won’t be around in 10-15 years. To help place your startup in the 10% of businesses that will still be around in a decade, think about using sensitivity analysis alongside scenario modelling.
Sensitivity analysis is another financial modelling tool that looks at how the change in one or more independent variable impacts other independent variables.
While it’s not commonly used by startups, sensitivity analysis could provide that extra piece of information that cements the success of your business.
For those who are in the know, it is possible to run scenario modelling using spreadsheets. However, as you change assumptions or add more data, it can be easy to lose control of the sheet. An easier way to manage and to maintain accurate modelling is to use a tool that can perform modelling in seconds.
Scenario modelling is a function that’s built into Ledgy. An added benefit is the transfer of data is seamless if you’re also using Ledgy to manage your cap table.
Discover more at - https://ledgy.com
Predicting the success of your startup is possible with scenario modelling, but achieving it takes self-belief, hard work and resilience. This can be exhausting, so let Pitchdrive take some of the strain so you have the energy to focus on motivating your team and keeping investors happy.
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