What Do VCs Look for in a Financial Model?

If you’re a startup or growth-stage company seeking investment from venture capitalists (VCs), then you’ll likely already know that success has everything to do with your financial model.

To a VC, a financial model isn’t just about understanding the numbers on the page. It’s a testament to your business acumen, your way of thinking and how well you understand potential challenges that lie ahead.

Let’s take a closer look at why financial models are so important, as well as how they can be the reason you get funded, or passed over.

Why Financial Models Matter to VCs

To a VC, a strong financial model says: “I know how to manage capital, scale a team, and handle risk.” That’s the difference between a deal and a dead end.

Remember, venture capital is specifically aimed at companies with long-term growth potential. If they can’t see that, they’re not going to open their wallets.

Therefore, the financial modeling methods must answer these questions:

• Is this scalable? Can your business expand rapidly without a huge increase in costs?
• What’s the burn rate? How quickly does your business get through funds, and how soon are you likely to need more?
• What’s the potential return? What will the VC get out of it? Is there a specific path to something like an acquisition or an IPO?

Ultimately, finance models exist to reassure investors that you will use their money wisely and deliver a good return.

Key Elements VCs Expect to See

Each venture capitalist has their own approach to financial modeling, but they all expect a few standard components. These essentials help paint a clear, compelling picture of your business potential:

Revenue Forecasts 

First, the VC will want to see your top-line projections, the clear drivers that bring in revenue such as your pricing model, sales channels and customer growth.

Believe it or not, the size of the numbers isn’t the most important thing. What matters most is how realistic and data-backed they are.

Here are the key revenue drivers to include:

• Revenue projections: These are your estimated revenues broken down by time periods and streams.
• Growth assumptions: The key drivers behind your projections, such as customer acquisition, market size and churn.
• Historical data: Past revenue data, including trends and assumptions.
• Monthly or annual recurring revenue: Used for subscription-based businesses like SaaS.
• Segmented revenue: A breakdown of revenue split by segments like region or customer demographics.
• Scenario analysis: How sensitive or resilient the business is to market changes.
• Exit revenue forecast: What the revenue is likely to be at exit, which is used to estimate VC valuation and returns.

Cost Structure

A well-designed model isn’t just about how much money your business will make. VCs also need to know the projected costs of running and scaling the company.

These costs need to be clearly stated, transparent and align with your growth plan. VCs want to see how your outgoings are likely to affect your burn rate and operational leverage.

What types of costs are we talking about here?

The two main types of business costs are fixed and variable:

• Fixed costs are the expenses that remain the same, regardless of production or sales volume. For instance, staff wages, rental of equipment or premises and insurance.
• Variable costs are expenses that fluctuate in value, such as the cost of inventory, shipping and raw materials.
• Some variable costs are considered “semi-variable” and should be noted as such. These would be items like utilities, where prices fluctuate slightly but within a specific range. Breaking costs down this way allows for more accurate cost predictions.

These costs can be categorized further into direct and indirect costs:

• Direct costs relate to product, service and delivery (labor and materials, for example). VCs use this to determine pricing strategies and gross margins.
• Indirect costs, such as overheads and back office business functions, are used to determine operational efficiency and spot areas that could be optimized.

CAC and COGS

Beyond the basics, VCs pay close attention to two critical cost areas: the customer acquisition cost (CAC) and the cost of goods sold (COGS).

CAC matters to VCs because it provides a clear indication of how quickly you can grow your customer base:

• A low CAC may indicate insufficient marketing efforts and inefficient sales processes.
• A high CAC may signal the need for continuous investment and challenges in scaling.

COGS is equally important because it’s a measure of the direct costs specifically associated with producing goods or services:

• A high COGS indicates inefficiencies and profitability challenges.
• A low COGS demonstrates operational efficiency and pricing power.

VCs are interested in businesses with a low COGS because it means that they are likely to scale while maintaining profitability. 

Unit Economics

Unit economics refer to the profitability analysis of selling a single unit, whether that’s selling a single product or serving a single customer.

This tells the VC exactly how much value you can extract from each customer and whether or not your business can remain profitable at the same time.

The core aspects of this financing model include the CAC as outlined above and a metric called the customer lifetime value (CLV).

Essentially, VCs want at least a 3:1 ratio when looking at customer lifetime value (CLV) vs. CAC. This is considered the “Goldilocks zone” and means that each customer generates three times more revenue than it costs to acquire them.

A ratio of 1:1 suggests that you’re losing money with each customer, while a ratio of 5:1 would demonstrate that you are under-investing in growth.

Additionally, the payback period should not be lengthy. Faster is better, with 12 months or under considered acceptable to a VC.

If the payback period is currently too long, the VC will need to see a structured plan on how you intend to improve.

Cash Flow and Burn Rate

How liquid is your company right now? And how long can it stay that way?

VCs pay attention to cash flow to assess the financial health and sustainability of your business. It’s also crucial for understanding if you have enough liquidity to ride out downturns or unexpected events.

To determine this, the VC looks at detailed cash flow statements to monitor predictability and identify any risks. Excessive spending and delayed payments can weaken your investment appeal.

Equally important is your burn rate. How quickly do you get through your available cash? Do you have sufficient funds to cover operational expenses and still generate a positive cash flow?

There are two types of burn rate that VCs will consider in finance models:

• Gross burn rate: This is the total amount of cash your business spends each month on outgoings, regardless of how much revenue it generates.
• Net burn rate: This is the amount of money lost each month while factoring in revenue.

The answers to these questions and the burn rates will tell a VC how much runway you have. This tells a VC how many months you can operate before needing more capital.

Your financial model must align your burn rate and runway projections with your fundraising goals. If you say that $5 million will last two years, your model must support that claim and demonstrate exactly how.

Headcount Plan

Staff costs represent the largest operational expense. After all, you can’t scale without taking on adequate staff to cope with the growth.

Therefore, VCs want to see a detailed hiring roadmap directly tied to your fundraising milestones.

This includes balancing staff headcounts in line with the existing runway. Don’t overhire and risk draining resources. But don’t underhire and stunt growth either.

As well as viewing your hiring plan, VCs will analyze various staff metrics, comparing them to industry averages and various scenarios to determine how resilient the business is.

Use of Funds

VCs don’t simply hand out money and hope for the best. They want to know exactly what you plan to do with it and what you expect to achieve from the investment.

You will have to provide:

• A detailed breakdown of the use of funds. For instance, 30% on research and development, 10% on prototyping, 20% on hiring, 25% on marketing and 15% on runway extension.
• Clear alignment of spending to business goals and milestones. Each dollar spent should directly support the growth and advancement of your business.

What VCs Don’t Want to See

While VCs expect detailed information, there’s also plenty they don’t want to see.

When creating your financial models, take care to avoid the following:

• Overly optimistic projections: Optimism is fine, but it must be firmly rooted in reality. If you claim to grow revenue from $0 to $100 million in five years, you must justify exactly how. 
• Hard-coded spreadsheets: Avoid models that require a finance degree to update. If changing one variable breaks the entire sheet, you’ve lost flexibility. Choose a specific tool or software meant for the job; there are plenty of options out there.
• Lack of documentation or version control: With so many files changing hands, keeping track of each version is essential. Clearly label files in a logical progression so that VCs always know which one they should be referring to. Also, document changes by including a tab that outlines key assumptions and inputs.
• Oversimplified or incomplete assumptions: Put the work into developing complete and detailed financial models. To do otherwise suggests that you haven’t thought deeply enough about each assumption.

Signs of a “VC-Ready” Financial Model

Now that you know what should and shouldn’t be included in your financial model, what would qualify as a great example of a “VC-ready” version? 

It goes way beyond neat formatting and pretty charts. Here’s how to get your ducks in a row:

• Apply logic—don’t just rely on math: A seasoned VC will quickly spot a templated, cut-and-paste model. A VC-ready model will be tailored to your business’s unique circumstances and market conditions. Every input should stem from a strategic decision or clear reasoning.
• Transparent assumptions: Great financial models demonstrate precisely how they arrived at an assumption. VCs want to understand the why behind the numbers, not just the what. Maintaining transparency throughout the model demonstrates trust and that your projections are based on real data and benchmarks.
• Dynamic and easy to update: Markets change and volatility fluctuates. Therefore, a VC-ready model will reflect dynamic conditions. This means that making a change in one tab should affect the entire model without additional manual input. The VC needs to quickly see how adjusting inputs will impact revenue and cash flow.
• Tells a story: Great models reflect a narrative: where the business is right now, the path it’s taking and the steps it will take to arrive at its destination. Use summary tabs, graphs and milestone flagging to make your company’s unique story come to life.

Final Thoughts

Impressing a VC takes a lot of legwork and effort. But the hard work is worth it when you secure that much-needed capital.

If you’ve read through this guide and are thinking that it sounds like an impossible task, it’s probably time to get some expertise on board.

At Finvisor, we specialize in supporting growing businesses with their financial tasks without the burden (and cost) of taking on full-time staff. Our advisory and fractional CFO services can be hired on a “needs” basis and will guide you through the process of developing high-quality, VC-ready financial models.

We offer highly experienced financial professionals with real-time communication and affordable pricing, because it shouldn’t be difficult or unaffordable to get access to financial support.

Finvisor operates in a wide variety of cutting-edge, high-growth industries, including AI, biotech, edtech, SaaS, and more. If you’re interested in finding out more, we welcome you to get in touch.