There is a lot of misconception in the startup community about what a startup financial model represents and, especially, how accurate it is. When I discuss the importance of financial analysis with entrepreneurs, they push back arguing that there is no validity to the numbers not verified by the market.

They are correct about that. We won’t know if the financials are true until they are fully realized. However, this is true for ANY company, including Amazon, the most valuable company in the world.

Their confusion stems from a much deeper lack of understanding of the overall purpose of a financial model which we discuss further in this article and the corresponding video.

Unfortunately, a financial model is not a crystal ball. If it really were possible to create a financial model that would accurately predict the future, all the uncertainty regarding asset pricing and valuations would be forever gone. It would be a different world. But it is not possible, and because it is not possible, it is also not possible to predict with 100% accuracy how much money your company will make and when.

Of course, this begs a question: “Why do we need a financial model if we know it is not accurate?”

To answer that question, I propose a new paradigm: let’s think of a financial model as a map of your business plan that you can follow IN ORDER TO achieve your goals.

Imagine you are walking in a forest. It’s a warm summer day. The birds are singing, the sun is shining, and life is beautiful until you realize that you are LOST. Would you not want to have a map with you that showed you how you got there and which path to take home? Yes, of course, some of us can follow the stars or turn into Robinson Crusoe, but most of us would want to return to civilization before sundown, relatively unscarred.

Just like a regular map, a financial model maps a strategy your company is executing. It thus serves as a useful management tool that can warn you that if you are expecting to turn left (or make $1M in revenue), but you keep turning right (or losing money), it is time to either change your path (or adjust your strategy) or create an entirely new map (or pivot).

Moreover, a good map accurately reflects the terrain: all the twists and turns, lakes and swamps, mountains and desserts. Similarly, a robust financial model comprehensively maps out your business plan so that it is easy for you to see not only which parts of your strategy are working or not, but also why. This leads to better and more rigorous decision-making.

Not only can a financial model help you successfully grow your company, but it can also help you secure funding faster. Most investors look for entrepreneurs who are not only visionaries, but who also have acuity to swiftly react to market feedback and determine when a change is needed. This latter skill sets apart ventures that succeed from those that fail. A financial model can help you more effectively monitor your company’s financial performance as well as correctly evaluate the financial feasibility of each decision.

To learn how to properly model any software and service startup, take Course # 2 on www.thestartupstation.com.

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