There are two approaches when it comes to financial modeling. The first is a top's down approach and the second is a bottom's up approach. The easy route, and less helpful one, is the top's down approach. Unfortunately however, most founders I work with use this method when making their models. Let's compare the top's down and bottom's up approach to financial modeling and why I prefer the latter for all startups.
A Top's Down Approach - Dealing in the Absurd Hypothetical
A top's down approach begins with the market as a whole. First you determine the market size for your business and start to work backwards. You estimate how much of the market your business can potentially capture and then layer in strengths and weaknesses to adjust that penetration rate up or down to land on your sales numbers. You then fill in the rest of model off that top line number with estimates of margin percentages, staff, etc. On the surface the approach makes sense and it is a fairly quick and easy way to get to initial sales projections. However, this method is highly problematic and leads to some of the crazier models I have seen. Let's take a look at some of the drawbacks.
The first major problem with top's down approach is that people don't properly size their market. I wrote an earlier blog post on this (go check that out!) but people tend to include the entire global market for their product or service, when they can't possibly reach that market. If you only sell your product in the US, then taking a percentage of the global market isn't helpful. The second major problem with top's down has to do with sizing. Top's down models hinge on the assumption of penetration rate. This can be hugely problematic when dealing with large market sizes, for something like health care. There are trillions of dollars in health care so even just a change of .1% to your market penetration is equal to $1 Billion. Companies think they are being conservative when they show a market penetration of .1% but in reality that number should be .00001%. Actually getting to a true market penetration percentage is EXTREMELY DIFFICULT and most people don't have the time or resources to do it properly. The last, and by far biggest problem, with the top's down approach is that it misses the HOW. Top's down models don't show how market penetration is ever achieved. If you just got .1% of the market things would be great, but you aren't showing investors how you could possibly get there. The market penetration assumption is inherently flawed because it assumes market penetration simply happens and not how it happens. A top's down financial model is one of the quickest ways to get laughed out of a pitch meeting.
The Bottom's Up Approach - Controlling the Controllable
A bottom's up, starts with the product or service you have and then works up. Projections are made with what is needed to get your product to market, such as sales people, leads, and conversion percentages. Bottom's up approaches are superior to top's down approaches because they are baked in what you actually have. Forget what ridiculous market penetration you have, how many sales people do you have, how many leads can the generate, and what percentage of those leads turn into demos, pilots, customers, etc. The bottom's up approach shows HOW your business is actually run on a day-to-day, month-to-month, year-to-year basis. It shows how you are actually going to get to the sales projections you have in your model. The other major benefit to the bottom's up approach is that it allows you to track and adjust assumptions. For example, if your financial model is assuming 200 leads per month and your team is only generating 120, then you can easily adjust that figure down and see what your new financial projections look like with the lower leads. Bottom's up models are more flexible than top's down ones and give founders real time feedback on how their business is doing.
Summary
A bottom's up approach to financial modeling is superior to a top's down approach in every single way. The bottom's up approach is far more realistic and flexible. They offer real time feedback and show HOW financial projections are actually achieved. If you need help making a bottom's up financial model, please reach out to us at InfleXion Point Advisors. We are happy to help!
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