Ask a VC: how to model a P&L — Part 5/6 — Consistency of the model

Rodrigo SEPÚLVEDA SCHULZ
7 min readJan 26, 2024
Photo by Fleur on Unsplash

Note: the content of this post was taught in a 7-hour class at HEC Paris Business School in May 2024.

So now we have built a full financial model for our business; last time we added the cashflow information that allows us to understand how much to raise & when.

Now it is time to start playing with the variables in the model and check the consistency of it all. I like to say that changing one variable in a model, is like solving a Rubik’s cube: change one side, and many other sides are changed; same for the model: change one assumption, and many more assumptions will have to change (for example choosing to go with a direct sales force or via a distributor will change Sales & Marketing costs, variable costs like Customer Acquisition Cost, etc.).

Let’s start from the top line:

Revenue: most startups describe usually an addressable market of several billion (insert your favorite currency here). Nevertheless in year 5, most startups again only target a revenue between 10 and 20m. And of course, they are revolutionizing this market with their product!

Let’s be average, and target a 5b addressable market (and serviceable, but this is for another post).

20m revenue on a 5b market is…. 20/5000 x 100 = 0.4% marketshare. Whichever way you tweak it, 10b market, 2.5b market, or 30m revenue, you’re still around 1% market share (give or take) at best. You’re not revolutionizing any market; barely a new blip on any market radar.

VCs don’t want you to go for a small market (ie. less than 1b) because even if you get to 40% market share, it’s only a 400m revenue business, and depending on the multiple EV/revenue or EV/EBITDA, you’re still looking at a business that is not going to have a big valuation, comparatively, because your growth potential after that is very limited, unless you redefine your market then…

So the proper way to tweak your model is to either extend the model by 2–3 years (ie. show 7–8 years of projections), or be more aggressive in sales, and show how you are getting to at least 100m revenue! Faster customer adoption, higher prices, more revenue streams, repeat business, anti-churn strategies, network effects, or a much bigger addressable market, with less competition and a great magic sauce! The trick here is that you probably won’t make any money in the first 2 years (R&D period), but then you need to get to 1m revenue ASAP (a common hurdle to show Product-Market Fit), and then apply the T2D3 framework for example (Triple revenue for 2 years, then double for 3 years), which in this case is 1m x 3 x 3 x 2 x 2 x 2 leading to 1m > 3m > 9m > 18m > 36m > 72m… You’re getting close to 100m revenue in the 5th or 6th year of sales. This is what you should be aiming for.

Many of my portfolio companies did just that, getting to 100m revenue in 5 or 6 years, or even crossing the 1b revenue in barely 7–8 years of operations.

Once we have adjusted the ambition and the market to proper growth potential in a correct addressable market, we can analyze the P&L in 2 ways.

The vertical analysis calculates the ratios of all costs vs the revenue above. You could do this per month, but I’m not sure it’s really helpful; I tend to do it by year. You can do this by adding 5 columns between the years' columns and the months' columns. Block the revenue line with a $ in the formula, and drag right and down. Adjust formatting afterward.

Add a vertical analysis section to your model

Of course, you have grouped all the expenses per category either in a separate tab by now, or you have grouped them with the “group” command, only leaving the S/T for each section.

Looking at my model now (notice I have not updated the revenue projections yet), I see for example that the S/T procurement of T-shirts is going from 22.5% of revenue in year 1 to 11% in year 5. That’s a nice improvement with time, called economies of scale.

Looking at the gross margin, it goes from -252% in year 1 (I wouldn’t worry too much about year 1), to 36.1% in year 5. I might want to get to a plateau above 50% gross margin by year 3 or 4 as I still have lots of expenses to take into consideration. It’s an area for optimization for my T-shirt startup to think about, or an area to investigate if I’m talking to a potential investment.

Looking at sales & marketing, I start at 289.5%, and go down on a nice slope, down to 29.8% in year 5; but it’s still 44% in year 4. My rule of thumb is that 20% more or less should be spent here. Why? Because I’d love to get to 20% EBITDA, for a healthy business; with only 50% gross margin and 20% in sales & marketing, that leaves me with only 10% for everything else such as HR, Technology, and G&A. Not much room to play with. I have to think hard here about how to bring the customer acquisition costs down faster.

Technology costs start at 108.9% of revenue, which doesn’t mean much, as I’m not making enough revenue. However, technology is only 2–3% in years 4 and 5. This says I'm not investing enough in technology for a technology startup, and that competition will catch up certainly. I should be looking at spending more on R&D.

HR as a whole, seems to represent a big part of the startup cost, which is fine: maybe negotiate lower salaries at the beginning in exchange for grants of stock, so that I can keep this low.

The same thinking can be applied to G&A. I’m spending a lot in % at the beginning, less at the end. This is because there is not much revenue at the beginning, and I should focus on finding ways to do so.

Often when you do a vertical analysis like this on a plan you receive, the percentages per year stay the same for many lines, showing that the entrepreneur made very little work in his model, and just used a formula to calculate a cost as a % of revenues. It’s a red flag for me.

On another occasion, I had a very big cost under technology, for development outsourcing somewhere in central Europe. I asked about the ownership of the outsourcing company, and it was owned by the brother of the CEO; said differently, the brothers were taking out money from the business from the very beginning, and this information was hidden in plain sight in the financial plan. We passed on that investment.

Using vertical analysis to optimize my financial plan

Bottom line, looking at the EBITDA line, I’m losing money in the first 4 years, and turning positive in year 5. This might sound good, but looking at the other insights above, I certainly need to make money earlier, reduce costs, and try to bring profitability in year 3 or 4. I’ll play with the numbers in part 6/6, taking these insights into account.

There is another powerful analysis that can be done to show how fast we are progressing on each line: the horizontal analysis.

Using horizontal and vertical analyses to check the consistency of the model

Just add 4 columns between the vertical analysis and the months' columns, and do a ratio of growth for each line vs the previous year. Remember percentages are tricky: you need to subtract 1 from each formula (year(n+1)/yearn — 1) to show proper growth. You can refine the formula to take into account a division per zero, and not show anything in that case.

Here you see that growth in all cases is slowing down almost in all lines; this means the business is not benefitting much from economies of scale, no network effects, and that at this rhythm, the business’ growth might stall. Not sure this is a business you want to invest in. There is no rule of thumb here, just insights that help you understand the logic of the business. Alternatively, this is also a good way to project a couple of years more of the business if necessary using the trends uncovered here.

Next time, we’ll play with the numbers, and design sensitivity into the model.

I consult with corporates and startups and help them address issues like this and many more. Don’t hesitate to reach out at www.rodrigosepulveda.com or book a video call with me on intro.co.

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Rodrigo SEPÚLVEDA SCHULZ

Senior Technology Executive with global experience as an Investor, Board Member, 5x Founder, Consultant.