Do Startups Need a Financial Model?

Breaking down the viral debate from this week

Hey y’all — this may sound crazy outside of Silicon Valley, but financial models are controversial when you’re fundraising.

So much so that this tweet blew up this week with strong opinions on both sides (I’d highly recommend spending some time reading through both the replies and the quote tweets after you’re done with the newsletter):

Jenny was the Managing Director at Techstars for 7 years and has backed unicorns at the earliest stages.

For her, and many investors (including many outside Silicon Valley), having a financial model indicates a founder is thinking critically about understanding the levers they have to pull to grow their business.

But for others it’s a red flag that the founder either prioritizes things that don’t matter, or doesn’t realize that everything about their plan will change over the life of the company. Both can be dealbreakers.

So — who’s right?

Let’s break down both sides of the argument and find the truth.

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Does Fundraising Require a Financial Model?

Huh? Why Would You Not Want a Financial Model?

When you learn about entrepreneurship in school you’re taught to have a clear, strong business plan and financial model when you start out, and to use that as a way to communicate the path your business will take.

The real world is much messier.

Any plan you had when you started (you know, that time before you actually learned how your ICP will respond to anything) gets changed quickly and many times.

In fact it changes so many times that you realize you could have learned what you now know faster if you hadn’t spent the time making the initial plan.

If you’re reading this newsletter you probably already know that.

Every day or even hour of your time that you devote to your startup needs to be spent getting it off the ground.

The same is true for a financial model.

Your projections will be wildly wrong.

Not only that, but the levers you have at your disposal in the model may not end up being what you think they’ll be — the entire business may change, and you likely don’t know enough yet at the pre-seed stage to be sure.

Investors all know this.

They see tons of startups and have many first-hand datapoints showing that everything can change and often does.

What they don’t know is if YOU know that.

Investors are looking to de-risk the idea of investing in you. Startups are inherently so risky that they look for ways to think of your startup as less risky than others.

One of those ways is to assess your founder mindset — how much do you “get” what being a founder will really be like?

The thinking there is that the more you “get” it the more you’ll be able to anticipate challenges and emotionally steady when things get rocky.

This is a very common place where first-time founders and founders who don’t have a strong network in Silicon Valley fail to build trust with an investor.

That might not be fair, but it’s true.

Two of those signals for how well someone is ready to be a venture-backed founder are:

  1. How well they know how to prioritize their time

  2. Whether they realize everything will change from their “plan” or not

Presenting investors with detailed financial projections at the pre-seed stage fails both of those tests.

Ok… So Why is a Financial Model Useful Again?

If all that is true then why does Jenny, a successful and well respected VC, want to see a financial model from pre-seed founders?

It’s not that she actually cares about your projections, or doesn’t value whether you have the “founder mentality” or not (she likely values that quite a bit too).

She and other VCs who want to see a model use it as a proxy for understanding whether a founder is able to correctly break down the incentives and value levers in a problem space.

She’s assessing a founder’s ability to do that precisely because, if the business needs to change, she wants to trust that this founder will be able to quickly figure out how to break down and evaluate new opportunities and position their product for success in a new market.

The same way you’d be able to more easily trust a civilized human than a wild beast, the thinking here is that a founder who can understand the levers in a business will make better decisions more often.

It’s just a different way of de-risking an investment opportunity and reaching conviction.

Interestingly this mindset is more common in VCs based outside of Silicon Valley.

I commonly hear from friends or members raising in Europe, Australia, and other places around the world that pre-seed investors want to see a full multi-year model and data room.

Whereas in SF it’s more commonly about backing the right team that’s interested in the right market and assuming the rest will figure itself out along the way.

I attribute this to a few things:

  1. Startup culture has penetrated the professional class in SF so deeply that the right founder will be able to learn from others and the collective knowledge of the network as they go much more easily.

  2. There’s a larger amount of capital available for VCs in SF, and more forgiveness by LPs if funds don’t perform as well as expected as long as the fund’s GP(s) are truly embedded in the SF ecosystem.

  3. There is a higher per capita density of great builders in SF, so investors can be pickier.

I left SF a few years ago but this magical flywheel is truly special and can let investors focus on different indicators.

The Truth

The simple takeaway here is that each investor is different. Not only do they value different traits in founders, but they feel confident getting clarity on a deal in different ways.

For some, that’s a financial model, even if both they and the founder know that everything will likely change as the business matures.

My actionable advice for founders here:

Know your investor. Talk to founders they’ve backed before, and read their content online (you can use X advanced search for this pretty easily) to get to know what helps them reach conviction quickly.

Also think about what type of investor you want to work with. If an investor tells you they want you to spend time on a financial model for a pre-seed, do you take that as a red flag that they’ll make similar inconsequential (to you) asks in the future?

Does that matter in your decision about whether to let them onto your cap table?

Maybe, maybe not.

My personal conclusion is that I’m better off trying to understand the information that gets me to conviction as a pre-seed investor in discussions with the founder and reference checks rather than from a financial model and, as a result, as a founder I’d want to partner with likeminded investors.

But for your startup it’s up to you.

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