Build a proper financial model

In my career, I’ve build hundreds of financial models and reviewed thousands more for everything from VC funding to M&A to LBOs.

Lately, I’ve been receiving half backed financial models.

I’m not talking about seed companies where the focus is the product and getting the first customer. I’m talking about companies with a product and paying customers.

I’m not asking for a complete 3 statement financial model that bankers put together.  I’m asking for a model with the key performance metrics highlighted and understanding of the levers that drive your business.

Vanity metrics are nice, but they don’t tell the whole/proper story.

The most important part of the financial model is the revenue build.

I’d like to see your assumptions and understand how you got to the revenue numbers you presented. Don’t just plug 20% growth for the following period.

I want to see that you’ve thought through the number of customers, their spend, their time as a customer, and cost to acquire.  This will lead to your KPIs metrics like LTV, churn, and break-even.  Then compare those to industry numbers and be able to explain why yours are different.

It’s not about being accurate, it’s about thinking it through. Remember back in high school, you had to show your work on those algebra exams to get full credit? Same here.

Every industry and situation is unique, but a well thought out model is important to move an investment along quickly.

Financial Modeling Competency Test

I recently concluded a search for an investment banking analyst/associate as my replacement (another post).  I laid out the specifics, mainly work experience and education, and got flooded with qualified, under-qualified, and over-qualified applicants.  There was no way to determine who to take to the next step.

I needed a screen for minimal competency, but I couldn’t find anything for excel and more specifically financial modeling.

In the tech world, there are many programming/technical assessments.  See Facebook’s PuzzlesPalantir and TopCoder (recommended by Google). They all have different methods of testing competence.  One can also review Github and StackExchange (fka StackOverflow) profiles.  Besides testing skill, this also shows the applicant interest in the company and industry.  No one wants hire an unenthusiastic robot.

Because I couldn’t find a suitable solution, I created my own. Download. I created financial statements for fictitious bicycle shop and asked the potential hires to forecast the business based on certain assumptions I provided.  I chose a simple retail store because it is very tangible without a lot of moving parts.

Depending on the level of the hire, you can add complexity to the model and tasks.

Simple

  • 5 years of growth at 10% per annum
  • Gross profit margin improves due to higher volume of sales
  • Pay back bank debt over next 4 years

Complex

  • Addition of second store financed by a combination of debt and equity
  • LBO for competitor

I then spot/sanity check the numbers and formulas.
Do revenue/gross profit/EBITDA numbers/calculations make sense?
How do the secondary models function? (e.g. PPE and debt)
I also look for attention to details – formatting, colors, linkage etc.

Results:
For a 3 day post on Doostang and some personal networks (Fri – Mon), I received over 200 resumes.  About 25% were given the financial model; about 50% of those submitted their work.  This led to a much more manageable set of candidates to review.  The remaining pool was very strong – they had the necessary skills, showed interested in the job because of the extra time commitment vs. just sending in a resume, and cut thru the resume BS.

Lesson Learned:
There are a lot of people interested in breaking into investment banking and private equity.  This had led to the development of “vocational” financial training programs such as WallStreetPrep and TTS.  As more applicants enroll in these programs, the baseline for financial modeling will be raised, which is great.

However, this will make it more difficult to screen via technical skills.  A while back, I could assume that if you knew how to model, you understood accounting and finance.  Now if you took a program, you would know how to model, but do you really understand accounting and finance?  An understanding that is usually gained thru deal experience and the related building of the models and decks.