There are two main methods to build a startup financial model: top down and bottom up.
In a top-down approach, we start with the big picture and then work backwards; we define the milestones that we need to achieve in order to reach the target. For instance, if we have a mobile nutrition startup, we begin by saying that the market in 2017 is worth $27 billion and from starting at zero, by year 2, we will capture 7% of it. In this way, we just defined the revenue and then we calculated the costs associated with this target and so on.
On the other hand, in a bottom-up approach, we start with basic assumptions (e.g., sales people needed and the cost thereof, attractiveness of our business, traffic) in order to build the financial model. Subsequently, we can create scenarios in order to check how the assumptions have to change (e.g., how many more salespeople we need) in order to achieve our goals.
Which Approach Should We Take?
A top-down approach, particularly in the case of a startup, can be rather opaque and based upon subjective, overly-optimistic predictions or even desires. This can put more value on a bottom-up approach towards leading to a better understanding of the model. On the other hand, the top-down approach can ignore today’s situation and provide useful inputs regarding milestones to be achieved. Thus, for financial modeling purposes, the bottom-up approach can give a more structured, realistic perspective, which can be complemented from a strategic perspective with some top-down analysis.