Finance fundamentals For VC Backed Startups – Setting Budgets for Probabilities
Not every startup puts emphasis on basic finance fundamentals from the start. A big part of running a successful startup company (including, sales, marketing and product teams,) comes down to managing finances, yet in the early days, it can feel like you not making any progress. Learn how you can go from scrappy and lean to a strategic finance machine.
A new year means a new budget. But no matter what time of year a founder starts a business, they need to create a new budget. A venture capital firm Bessemer Venture Partners (BVP) published an ebook where they say “In the early stages of a company, efficient revenue growth is more important than profitability.”
They lay out 3 ideas for achieving the right kind of growth for a startup business:
Efficient growth is when growth in topline revenue reflects the dollars invested in the business
In a bull market, companies with large existing market opportunities have justified higher burn rates if they also have rapid customer and revenue growth rates. For market creators, businesses must keep burn low as buyers emerge and revenue grows. However, given the current market where capital is no longer “free,” venture investors recommend keeping burn rate as low as possible in order to extend your runway for as long as possible.
Don’t expect to figure out efficient growth on day one, or even year one
Finding the right balance between growth rate and burn rate will evolve over time as leadership emerges, go-to-market strategies become more efficient, and the cost of capital goes down.
The formulas for calculating efficient growth are different for early- and later-stage software startup companies
The VC firm BVP stated that “for growth stage startups earning less than $30 million Annual Recurring Revenue (ARR), efficient growth is defined by net new ARR over net burn (optimal score being >1.5). Longer term, software companies should focus on maximizing their efficiency scores, calculated as ARR growth plus FCF margin of ARR.”
How startups should think about budgets
According to the BVP ebook, there are three key reasons why companies have budgets:
- Motivate teams to achieve at their highest levels;
- Invest resources in the highest priority projects; and
- Protect the company if things go wrong.
When a company sets a budget, they are predicting the future, which is uncertain. And they will never be 100% accurate. So, with that in mind, should CFOs try to be:
- Aggressive, to set high goals, knowing we’ll rarely achieve the budget?
- Conservative, to achieve the budget most of the time?
- Balanced, to achieve the budget about half the time?
Elon Musk, once said, “in order to have a good outcome, we must strive for a great outcome.”
Striving for greatness comes at a cost: disappointment.
Several years ago, The Wall Street Journal reported, “In the past five years … Tesla has fallen short of more than 20 projections made by Mr. Musk, ranging from car-production output to financial targets. … The company missed 10 of his stated goals by an average of nearly a year.”
Still, if you shoot for the moon, you may reach outer space.
“I believe it’s important to set aspirational targets as it drives results,” said Paul Lyandres, a CFO at Procore. He further explained, “teams often underestimate what they are capable of, and stretch targets push us all to reach our full potential.”
Amit Karp, a partner BVP once said,“as a CEO, one of the best ways to gain investors’ trust is by achieving your existing monthly/quarterly/annual targets. Even better is demonstrating that you are not only exceeding your short-term targets (e.g., monthly or quarterly revenue plan) but also increasing mid-term targets (e.g., annual revenue plan). This is the startup’s version of ‘beat and raise.’”
To be prepared for any internal or external scenario, you’ll want to build a cash cushion.
Jenn Grunebaum, a CFO at a cloud security company called DEVO, suggests that you should always budget for a contingency because it gives us flexibility in any market environment. She stated “when you’re in a burn situation and worried about cash balances, you have to be aware and prepare for all expenses, whether they’re one-time or ongoing.”
The key to a successful budget framework is thinking in terms of probabilities
Every startup is different, and the same company is different from one year to the next. There’s no universal formula for how aggressive or conservative to be in budgeting. The key is discussing it at the beginning of the process. The CEO can first lay out the vision for the year, discussing and selecting an aggressive, balanced, or conservative approach, in partnership with the CFO. Then they can discuss this approach with the board of directors. Not every director may agree; they can disagree and commit instead.
A budget has four key components, and each component can have a different probability of achievement
- Wall Street guidance
- Sales quota
There’s no absolute “right” answer for setting budget probabilities, but BVP has some have recommendations.
For revenue – they suggested researching the former CEO of Intel Andy Grove approach: 50/50. As Grove says, “there’s something about a 50/50-win rate which seems to motivate teams to achieve peak performance—the optimal balance of risk and reward. And since every budget allocates important investment resources, a 50/50 approach means we’re investing in what we believe are the expected outcomes, not too high, and not too low.”
For profit – they explain that they want to protect the company and be more conservative. 70% achievement seems like a solid outcome. They suggest adding a line in the expense budget for “contingencies.” that way, if there’s a negative surprise, if we miss the revenue budget, we’re still likely to achieve the profit budget.”
For Wall Street guidance – a key goal is establishing and building credibility with investors. Missing published forecasts can lead to the additional cost and distraction of securities litigation. For this they suggest being a bit more conservative, aiming for a 90% achievement rate.
For sales quotas – from their experience of them investing in hundreds of startups, they stated that the best salespeople are optimists. So if a startup wants to achieve a 50% revenue budget achievement rate, and sales quotas are optimistic, they need to build in a buffer. Suggesting setting sales quotas at a 30% achievement rate.
Growth at an Optimal “not any cost”
When interest rates were zero percent and startup capital was cheap, The startup market rewarded growth at any cost, (cash burn didn’t seem to matter) but what lasts is growth at optimal cost. To do that, you’ll have to be smart with your resource allocation, and a rigorous budgeting framework can help. Here are three insights from one of their operating partners who dubbed it the Goldilocks budget:
- The key to a successful budget framework is thinking in terms of probabilities. To do that, ask yourself how many of the past few years you’ve achieved your budget.
- Set different probabilities of success for different parts of your budget. That way you can be ambitious where you can afford to be, e.g. sales quota, and conservative where you can’t, e.g. profit. Read our recommended probabilities here.
- Don’t be so optimistic with your Q4 revenue budget that you end up missing it. The most important revenue of the year is the revenue run-rate at year-end, which establishes the base for revenue the following year.
Mapping your startup’s runway
The ebook stated that when a VC backed software startup is transitioning from $1 million to $10 million of ARR, you’re evolving from a viable product to a viable company—and a viable company has to stay on top of its cash flow. They suggested doing these 3 things to achieve this:
- Map your runway to clear milestones – To do this, we recommend creating an eight-quarter plan, outlining your intended playbook for hiring, product expansion, geographic expansion, and more–and ensuring you have enough cash to hit your biggest goals.
- Drive strong growth endurance – This metric, which measures the retention of growth rate from one year to the next, typically shows that you should expect next year’s growth rate to be about 70% of the current year.
- Balance growth with profitability – Investors know that startups begin by consuming cash more than generating it, but it’s always a good idea to make the product, G0-To-Market, and other business decisions with ROI in mind.