The Angel Toolbox: Financial Modeling

Man holding calculator while looking at financial data

Author: Bernie Batt, SWO Angels member and Analyst

As an active angel group, our members utilize several forms of due diligence in order to weigh opportunities that come before our members. Financial modeling is one of the most important tools in the investor tool box.

The process of financial modeling is essential for many functions of a business. It allows businesses to weigh one option over another. Should we build this product, or another? Should we build a manufacturing facility or purchase manufacturing services from someone else?

Angels utilize financial modeling from a few different angles in the due diligence process. They must understand and question the financial forecast prepared by prospect companies, and leverage modeling skills for determining viability of the business model and valuation.

One of the keys to evaluating an early stage company is understanding their financial forecast, which is a financial model prepared by the company to show the predicted cash flows in the coming 3 to 5 years. In good quality financial forecasts, there are clear assumptions which a reader can trace. These assumptions include revenues driven from a projected use of resources. The assumptions such as how much the cost of customer acquisition, salaries, capital investments, rented space, consumables, etc. are all important data points. Are they going to grow revenue at 100% per year? How can they feasibly do this? Evaluating assumptions requires understanding of the industry. Angels review financial forecasts to understand the business plan and level of sophistication and planning at that stage. The benefit of following the money is to see how the company hopes to move towards their vision. The key to evaluation of a forecast is looking at each data point starting with revenue and working towards direct costs and questioning each assumption for reasonableness.

In our valuation lunch and learn, we looked at the many ways that potential investors can dig down and figure out the value of a company. Some of the valuation methodologies such as net present value (NPV) and multiples utilize forecasting of cash flow, revenue, and earnings before interest, taxes, debt, and amortization (EBITDA) rely heavily on underlying financial models. Utilizing the company’s financial forecast, angel investors can leverage their expertise in order to adjust values and assign probabilities to develop an alternative model that is not biased by founder’s rose-coloured glasses. This model can be used for a discounted cash flow (“DCF”) valuation, can assign multiples, and check the work against a qualitative valuation. Understanding value drivers, and assumptions can help with the negotiation process.

Evaluation of financial models and creating them are important tools that drive the due diligence process, valuable for evaluating strategic alternatives as businesses grow, and are required to make difficult decisions.

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