Investors and Funding18 minute read

Why Your Startup Pitch Needs Sensitivity Analysis


Toptalauthors are vetted experts in their fields and write on topics in which they have demonstrated experience. All of our content is peer reviewed and validated by Toptal experts in the same field.

To impress risk-averse investors, you have to prove that you’re ready for whatever may come.


Toptalauthors are vetted experts in their fields and write on topics in which they have demonstrated experience. All of our content is peer reviewed and validated by Toptal experts in the same field.
Nicholas Piscani
Verified Expert in Finance
7 Years of Experience

Nicholas is a corporate strategy and FP&A expert who works with businesses to optimize their operations and execute high-priority strategic initiatives. He has helped entrepreneurs raise more than $600 million through financial modeling and pitch deck development.

Previous Role

Director of Strategic FP&A

PREVIOUSLY AT

VerizonVictra
Share

It takes more than an all-star team, a product with a competitive advantage, and a sizable potential market to guarantee fundraising success for your startup. With thousands of proposals flooding investors’ inboxes each year, and venture capital facing an uncertain future, it’s crucial that you distinguish your startup by showing your deep, realistic understanding of the impact even small changes can have on performance. The key is to include sensitivity analysis in your pitch.

As an FP&A specialist who has supported multiple successful eight- and nine-figure fundraising efforts through financial modeling and pitch deck development, I’ve learned firsthand the nuances that separate founders who get funding from those who leave the table empty-handed. To present a convincing case, founders must show that they’re effectively balancing risk and responsibility by demonstrating that they have thoroughly evaluated the consequences of every decision.

While it’s understandable that founders want to project optimism when they’re pitching investors, ignoring challenges can damage the trust they need to build with potential funders. Venture capital firms are quickly turned off by implausibly positive financial forecast assumptions, such as overly generous market share predictions or unrealistic unit economics. What they want to see are model assumptions that have been tested and validated.

That’s especially important when capital is scarce. In 2023, raising money has been particularly tough for startups, with global funding diving to $76 billion in the first quarter, a 53% decrease from the $162 billion recorded in the same quarter of 2022, according to Crunchbase. What’s more, in the same period, every funding stage experienced a steep decline of around 44% to 54%. These figures suggest that venture capital firms are growing more risk-averse. The best response to this trend is to exhibit strong fundamentals and provide persuasive evidence of viability through sensitivity analysis.

What Is Sensitivity Analysis?

Sensitivity analysis, also called what-if analysis, measures the effects of changing inputs in a mathematical model. In a financial model, sensitivity analysis can reveal the inputs with the greatest impact on a business, and help managers develop KPIs and strategies to monitor and address changes in those areas of the business. For instance, if variables such as market size, unit cost, price, or sales volume were to change, how might that affect financial performance—and which one has the biggest impact?

In my experience, founders can sometimes confuse sensitivity analysis and scenario analysis. While both practices evaluate the impact of changes on business models, they’re not the same.

Sensitivity analysis typically focuses on the one or two most important variables in a business model—that is, the ones that will generally cause the largest degree of change, depending on the industry and how the model is built. For example, you might want to sensitize sales price per square foot in a real estate development model, customer churn rates in a subscription-based model, or product mix in a manufacturing model.

Scenario analysis, on the other hand, is used to measure how businesses perform with variations in macro factors that influence the whole organization or an entire business unit. Scenario analysis would be appropriate for evaluating the probable impact of a recession or changing industry regulations—two situations that have a significant effect on a company’s performance even if some key variables and assumptions remain the same.

Sensitivity analysis is one of the most helpful ways a founder can calm investors’ nerves, because it provides them with a view of the margin of safety associated with their investments. If an investor is using a minimum internal rate of return (IRR) as one of their investment qualification metrics, for example, sensitivity analysis can easily demonstrate how significantly the forecasted performance would need to change before the investment fell below the minimum IRR.

From an investor’s perspective, knowing that an investment can still achieve the minimum IRR over the life of the investment despite a 10% drop in sales volume, for instance, gives additional credibility to the founder, the model, and the management team. In this case, even if a prospective investor disagrees with some of the growth prospects and assumes sales will be only 95% of the forecast, they can know that the investment is still a viable one.

Now let’s take a deeper look at the many things sensitivity analysis can help you do to impress potential investors—and benefit your company.

Understand How Small Changes in Assumptions Drive Big Changes in Value

When you’re building projections over long periods, say five to 10 years, small changes in the financial model’s underlying assumptions can cause large changes in the growth of cash flows and valuation. In the first table we can see how significantly small changes in assumed unit sales growth and revenue per sale can impact profitability and cash flows for a retail company.

In Table 1, the present value (PV) of future cash flows, including the terminal value, is just under $130 million.

Table 1: Cash Flow Model Before Sales and Revenue Reduction
Revenue Assumptions
Y1
Y2
Y3
...
Y10
Unit Sales Growth
10%
10%
9%
...
6%
Revenue Per Sale
$973
$1,010
$1,047
...
$1,283
Operating and Cash Flow Projections





Revenue
$165,018
$187,561
$211,870
...
$427,834
Operating Income (EBIT)
$11,731
$14,912
$17,789
...
$43,545
Less taxes, excluding interest
-$3,519
-$4,474
-$5,337
...
-$13,064
Net Operating Profit After Tax
$8,212
$10,439
$12,453
...
$30,482
CapEx and Net Working Capital
-$4,316
-$3,517
-$3,882
...
-$2,705
Free Cash Flow
$3,895
$6,922
$8,570
...
$27,777
Present Value of Free Cash Flow
$3,387
$5,234
$5,635
...
$6,866
Discount Rate
15%
15%
15%
...
15%
Terminal Value of Cash Flows




$273,653
Total Free Cash Flow
$3,895
$6,922
$8,570
...
$301,430
PV Future Cash Flows




$62,171
PV Terminal Value




$67,643
PV Total Future Cash Flows




$129,814
Dollar amounts in thousands, except Revenue per Sale


Table 2 illustrates the same forecast, with unit sales growth reduced by 2% and revenue per sale reduced by 1% starting in the first year. The present value of total future cash flows, including the terminal value, drops to just under $94 million, a 27.7% decrease compared with Table 1.

Table 2: Cash Flow Model After Sales and Revenue Reduction
Revenue Assumptions
Y1
Y2
Y3
...
Y10
Unit Sales Growth
8%
8%
7%
...
5%
Revenue Per Sale
$964
$991
$1,018
...
$1,187
Operating and Cash Flow Projections





Revenue
$165,018
$187,561
$211,870
...
$427,834
Operating Income (EBIT)
$11,731
$14,912
$17,789
...
$43,545
Less taxes, excluding interest
-$3,519
-$4,474
-$5,337
...
-$13,064
Net Operating Profit After Tax
$7,691
$9,180
$10,366
...
$19,610
CapEx and Net Working Capital
-$4,023
-$3,070
-$3,249
...
-$886
Free Cash Flow
$3,667
$6,109
$7,117
...
$18,724
Present Value of Free Cash Flow
$3,189
$4,620
$4,679
...
$4,628
Discount Rate
15%
15%
15%
...
15%
Terminal Value of Cash Flows




$187,893
Total Free Cash Flow
$3,667
$6,109
$7,117
...
$206,617
PV Future Cash Flows




$47,388
PV Terminal Value




$46,444
PV Total Future Cash Flows




$93,832
Dollar amounts in thousands, except Revenue per Sale


Again, that’s a 27.7% decrease in cash flows caused by a 2% drop in unit sales growth and a 1% drop in revenue per sale. And unit sales are not the only variable that can change. What if marketing expenses are higher? What if return rates are greater than expected? What happens if net working capital (NWC) doesn’t improve as forecasted?

Successful companies cannot just assume things will go their way: They need to know precisely what they’ll do if costs rise or sales fall unexpectedly. This is why startup companies need to assure investors they’ve stress-tested their models and developed risk management strategies for rainy days.

Identify What Is Most Significant

Sensitivity analysis enables organizations with well-constructed business and financial models to pinpoint and communicate pivotal assumptions. I can’t overemphasize what profound implications this can have for you as a startup founder—not only from a strategic perspective, but also from a fundraising perspective. Not every startup founder can confidently tell investors that they know which assumptions will have the most significant impact on cash flow, and be able to quantify the change in cash flow for every percentage point change in the relevant assumption. When you walk into a pitch meeting with this information in hand, you reassure investors that you’ve thought thoroughly and concretely about the future of the business—and their equity.

Let’s look at this in practice using our earlier retail company example. Starting with the assumptions in Table 1, the model forecasts 10% unit sales growth in Year 1. But how sensitive are cash flows to that assumption versus other assumptions? The following sensitivity analysis tables show how sensitive the present value of future cash flows is to changes in three assumptions that could have significant impacts: unit sales growth, wages paid per unit sold, and annual rent escalations.

Table 3: PV of Cash Flow Sensitivity to Unit Sales Growth
Unit Sales Growth
PV of Cash Flow
% Change vs Model
11%
$140,366
8%
10%
$129,814
0%
9%
$119,854
-8%
Table 4: PV of Cash Flow Sensitivity to Wages Paid per Unit Sold
Wages Per Unit Sold
PV of Cash Flow
% Change vs Model
($58.13)
$134,496
4%
($61.19)
$129,814
0%
($64.25)
$125,142
-4%
Table 5: PV of Cash Flow Sensitivity to Annual Rent Escalations
Annual Rent Escalation
PV of Cash Flow
% Change vs Model
2%
$131,409
1.2%
3%
$129,814
0.0%
4%
$128,114
-1.3%


Looking at Tables 3 to 5, it’s clear that unit sales growth is the most significant factor on cash flow, with a 1% change causing a roughly 8% change in the present value of cash flows. With this information, you can zero in on the most important drivers of the business model.

To take this analysis a step further and look at a more complicated situation, you can evaluate the potential impact of two of these factors occurring. In the current economic climate of high inflation, there’s a real risk that landlords will require higher rents as leases expire. Let’s say that you’re concerned about cash flow sensitivity to the compound effect of changes in both unit sales growth and annual rent escalations. Continuing with the retail example, we can construct the following table.

Table 6: PV of Cash Flow Sensitivity to Unit Sales Growth and Rent Escalations
Unit Sales
Growth
Annual Rent Escalation
2%
3%
4%
11%
$141,976
$140,366
$138,651
10%
$131,409
$129,814
$128,114
9%
$121,435
$119,854
$118,170
Dollar amounts in thousands


A look at Table 6 shows that a 1% increase in annual unit sales growth on the value of cash flows has about six times the impact that a 1% increase in annual rent escalations has. Performing similar analyses for all assumptions in the model will reveal how they interact.

Create Data-driven Strategies

Once you have sensitized your assumptions and identified the areas of greatest impact, you’ll have valuable data for developing strategies to monitor and optimize those parts of your business. In the example model, key drivers of unit sales growth would consist of customer acquisition costs (CAC), repeat customer rates, return rates, and cross-sell and upsell rates. Let’s say that, after sensitizing the unit sales growth rates against these individual variables, as we did with the annual rent escalations, you determine that return rates and CAC are the primary factors. Your team can then pinpoint the specific levels of performance that would be required to attain the forecasted unit sales growth targets. These performance levels would become the key performance indicators (KPIs) that are monitored and managed by leadership.

From there, you can identify leading indicators for daily monitoring that will inform management if the KPIs are expected to come in above or below the acceptable target. For example, a leading indicator for return rate may be customer satisfaction levels or a Net Promoter Score.

A comprehensive sensitivity analysis of this kind provides the entire management team with the greatest chance of fully understanding and preparing for the opportunities and threats. Not only does this benefit your business, but it helps you formulate persuasive, data-driven answers to hard investor questions.

Prove to Investors That They Can Trust You

If there’s anything the business community has learned from the 2007-2008 financial crisis and the economic shock caused by the COVID-19 pandemic, it’s to expect the unexpected. Sensitivity analysis is a powerful tool in this environment. The ability to sensitize nearly all variables in a business model provides tremendous analytical flexibility and can illuminate potential opportunities and threats.

Lack of funding and cash flow problems can substantially impede a startup’s growth and ability to take advantage of opportunities. Startup funding has declined significantly since 2021, meaning competition for it is fierce. By integrating sensitivity analysis into your pitch and valuation projections, you can also answer potential investor concerns, validate your assumptions, and exhibit prudent risk management. In an era of heightened investor caution, this kind of foresight and preparedness can set up your pitch—and your company—for success.

Understanding the basics

  • What is the purpose of sensitivity analysis?

    The purpose of sensitivity analysis is to measure the effects of changing the inputs in a mathematical model. In a financial model, sensitivity analysis can reveal the inputs with the greatest impact and help managers develop KPIs and strategies to monitor and address changes to those areas of the business.

  • What is an example of sensitivity analysis?

    A trucking company may want to know how much a change in the average price of gas would have on the firm. It would perform a sensitivity analysis by developing a model to calculate the effect different gas prices would have on other important parts of the business, such as cash flows or profits. Those results would help the company plan for high gas prices and take advantage of low gas prices.

Hire a Toptal expert on this topic.
Hire Now
Nicholas Piscani

Nicholas Piscani

Verified Expert in Finance
7 Years of Experience

Reading, PA, United States

Member since July 29, 2022

About the author

Nicholas is a corporate strategy and FP&A expert who works with businesses to optimize their operations and execute high-priority strategic initiatives. He has helped entrepreneurs raise more than $600 million through financial modeling and pitch deck development.

authors are vetted experts in their fields and write on topics in which they have demonstrated experience. All of our content is peer reviewed and validated by Toptal experts in the same field.

Previous Role

Director of Strategic FP&A

PREVIOUSLY AT

VerizonVictra

World-class articles, delivered weekly.

By entering your email, you are agreeing to our privacy policy.

World-class articles, delivered weekly.

By entering your email, you are agreeing to our privacy policy.

Join the Toptal® community.