As part of the POWERED Accelerator’s residential mentoring programme, we invited highly accomplished corporate financial executive Vinod Keni to elaborate on a few essentials of financial modelling based on his extensive experience in the finance sector, both in the US and India.
Most entrepreneurs have the necessary technical know-how to run a business, engaging with varied aspects of the industry they’re in. Although they may specialise in a certain field, it goes without saying that an entrepreneur is involved in every part of their company and business. To enable them to hone their skills under certain integral sectors of a business, we invited industry experts from various fields as part of our residential mentoring programme. The following is a snippet of what goes down as part of our mentoring sessions.
Financial Models in a Nutshell
Vinod aimed to explore the big question that no one can seem to answer. Financial models is a highly complex topic containing various sectors and sub sectors, thereby making it hard to delve into the intricacies of the subject. Vinod went on to simplify some of the topics that come under financial models that he felt startups should address.
Providing a general overview of what a financial model could contain, he goes on to state that, as a business owner, a financial model entails one’s customer base, product pricing, product cost, profit and value estimates, etc. It usually takes more than one iteration and won’t be possible to generate overnight. As an entrepreneur, the driving force to generate a good financial model would be to keep the main focus on profit, while negating overly-optimistic assumptions that naturally tend to arise.
Assessing your Addressable Market
One key aspect of a financial model would be to understand one’s addressable market. Vinod goes on to state a hypothetical situation in which, say the target market is 1 crore. Realistically, one could expect only 100 or 150 thousand consumers to be interested in their product which is the addressable market, this is amidst other competitors in the market. Further dividing the addressable market, considering various other factors as well, what’s left is only a certain percentage, for purposes of this example let’s say that number equals 15,000, which ends up being the potential customer base. Here the underlying question then becomes, how does one achieve that rise from 0 to 15,000?
He says that an entrepreneur’s assumptions on the total addressable market must always be tested, reports from various industry bigwigs combined with the entrepreneur’s assumptions would enable them to understand their market base. A great example would be that of Microsoft, wherein they got a base product out, which they kept refining with updates and grabbed their customer’s interest. This brings us to the understanding that while building and refining your financial model, the most important stakeholder tends to be the customer. The success of a business is largely, if not solely based on the customer’s choices and propositions. Hence, an entrepreneur needs to keep availing feedback from the customer as these factors keep changing constantly. Furthermore, value addition noticed by the customer takes time because the customer may not see the value in the product unless they actually use it for a certain amount of time, gaining practical experience. Few customers may see value and the rest may not, this is the reason it is not possible to capture the entire addressable market.
The Cost of Doing Business
Vinod thinks that the key to getting one’s numbers correct is to be realistic, to know that the predictions made in the first year are bound to be wrong and overtime a financial model can be perfected to a certain degree.
The term being self-explanatory, the first thing one needs to assess while generating their financial model is the source from which they are going to procure funds to invest in their business. Understanding the investment size and the different kinds of finance sources there are would enable an entrepreneur to substantiate the way they approach these sources. One must also consider the financial cost of business, this would entail the interest involved if the investment is from a borrowed source. One such factor is equity money – the interest that is charged as part of raising capital. Non-Traditional sources usually charge 18% – 24% whereas FinTech SMEs would charge from 16% – 32%. These costs eat into profit margins and make a product unviable.
Apart from financial cost, another factor to consider is the product cost that your business entails. Vinod thinks that it is always beneficial to talk to one’s suppliers, that way the entrepreneur has a better position to refine their product when they have more information. He goes on to state that, as far as the energy sector goes, a lot of hardware goes into the making of products and more often than not, that hardware is specialised. This adds to the input cost which further escalates the product cost. The lack of economies of scale would further put a strain on the entrepreneur and the way to resolve this would be to figure out the optimum quantity of production that would balance out with the cost of production. Another factor that plays a significant role in the product cost is the cost of selling. Sales costs give an entrepreneur insight on whether they can settle for a deal that offers lower margins or walk away.
On a concluding note, Vinod mentioned that the scenario is vastly different while presenting to investors. Investors need a reason to reject the proposal and hence will do heavy research on the numbers. He went on to mention that at Artha Venture Capital Fund, they discount most entrepreneurs’ financial models by 50%. As consolation to the rather harsh-sounding reality check, he advised the entrepreneurs that while building and pitching their financial model, confidence is the key. They need to be able to justify their sales view and be able to back statements. Investors focus on a 3-to-5-year exit horizon as that is the period in which they expect returns.