Typically, industry estimates are taken as starting point and narrowed down into targets that are fit for your company. In essence the top down method helps you to define a forecast based on the market share you would like to capture within a reasonable timeframe. SOM is therefore equal to your sales target as it represents the value of the market share you aim to capture.
The bottom up approach is less dependent on external factors but leverages internal company specific data such as sales data or your company’s internal capacity. This means a projection is made based on the main value drivers of your business. The company could define the costs per click using LinkedIn’s advertising tool, estimate the number of website visitors it will attract as a result, the conversion from website visitor to a lead, and the conversion from lead to customer. Based on these metrics the company will have a good idea of potential sales, of course constrained by the budget available for online advertising.
The pitfall of the bottom up method though is that it might fail to show the optimism needed to convince others of the potential of your company. If you are a start-up founder and you are looking to raise funding, the bottom up approach might not do the trick. Investors usually expect start-ups to grow fast and gain significant market share rapidly. It is difficult to create a forecast with a steep growth curve if every sale must be rationalized and if its point of departure is the maximal capacity of your company. Moreover, the whole reason why external financing is needed, is often to expand capacity and grow faster than a company would do organically. Therefore, when you build your start-up’s forecast it could be advisable to combine both the bottom up and top down methods, especially when you plan to achieve a strong growth curve by means of external funding.
No matter what approach you use to build your start-up’s financial model, it is crucial you are able of substantiating your numbers with assumptions. As a start-up, historic data is often not available, so you need to be able to present the ‘proof’ behind your numbers. This will also help you when you start discussing with investors, as they are typically interested in knowing the reasoning behind your numbers. Every sector, company, business owner and investor are different, but a good financial model usually contains at least the three outputs. Every sector, company, business owner and investor are different. From that perspective it is thus fair to say every financial model has its own characteristics.
Since any financial professional is able of interpreting financial statements having a forecast of them in place is typically a requirement in practically any fundraising process. The profit and loss statement are basically an overview of all the income and costs your company has generated over a specific period and shows you whether you are profitable or not. The balance sheet is an overview of everything a company owns and owes at a specific point in time. Liabilities show the obligations of a company and how it has financed itself using debt, whereas assets show how these funds are used within the company. The difference between the value of assets and liabilities consists of equity, which is the paid-in capital by investors that finance the assets not covered by debt. Shareholders' equity represents the net value of a company.
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