01. Budgets & Expenses

Estimated Time

• Reading: ~13 minutes
• Video: ~72 minutes
• Activities: to be completed prior to next week

Insights

• As the founder, you need to know your key metrics at all times
• Understanding your burn and cash on hand is vital to survival
• Have a plan to manage your burn

Know your company metrics

• There are several reasons that it is important to understand your numbers
1. As a founder knowing the day to day numbers will help make informed decisions from product development to hiring to marketing
2. It will help to prevent you from running out of money
3. You will build credibility with investors
• Founders should be able to do back of envelope math on important metrics for their company at any time
• Back of envelope math simply means you understand your numbers and can quickly estimate where your company stands financially at any given time
• This is not meant as an audit
• This is not a financial model for formal presentations
• This is to give you a rough estimate of your runway, ensure that you have a plan going forward, and understand your business at a high level

"What I’ve learned is that if (the numbers are) ridiculously stupid, there’s something wrong in how (the founder is) thinking about the business... if it’s really wrong, if there are numbers that aren’t even remotely sane, it shows that the founders don’t understand how business works. That’s scary as an investor.” - Jason discussing investment strategies with Jason Lemkin on TWiST E663

• You should not underestimate the importance of building credibility as a founder
• Having a great product that solves a huge problem is obviously great, but often investors are actually placing their bet on the founder and if they believe in them
• One of the surest ways to be aware of your most important metrics and establish credibility is to be involved when building your financial model

Build Your Own Model

• Part of founders getting familiar with their metrics is building their own financial model
• Jason believes the real sweet spot on financial models is three years
• A 1-year plan does not provide enough detail
• A 5-year plan becomes a bit of a fairy tale
• A 3-year plan is a nice blend of reporting on current growth and what you anticipate
• Every meeting can be different
• It is not wrong to project out five years but 60 months in startup time is forever!
• Once you create your model, don’t forget about it
• A founder should be able to open up a blank spreadsheet and recreate their model from memory
• It doesn’t have to be perfect, but you need to know the back of envelope math on the most important metrics to sound credible
• How much have you raised?
• How many employees do you have and at what cost?
• What is your burn?
• What is your revenue?
• How much runway do you have left?
• Essentially be able to do Jason’s “burn rate party trick” that we’ll discuss below
• Jason always recommends that the founders are hands-on in this process
• In other words, don't have your lawyer build it, don’t pass it off to someone on your team, don't outsource it
• If you build it then you'll understand it better which will allow you to talk about it better when raising money
• That way when an investor asks a follow-up question you can speak to it candidly without needing to stumble around looking for numbers in your chart
• There are several resources online to help you get started in building a financial model
• Kruze Accounting has a great series, Startup Financial Models: Numbers that explain your startup’s potential
• Craig Zingerline and Growth University also have a great course on building a financial model
• When you are going through your model with an investor be direct
• Confidently tell investors where to look and walk them through the numbers
• For example, don’t jump right into talking about your monthly recurring revenue with a huge spreadsheet open on the screen
• Literally tell them where to look, “as you can see from cell C4 to C9 our MRR for the last six months is X, and growing at Y% - you can see the percent growth in D4 to D9.”
• You are not "selling" or "pitching" when reviewing a financial model with an investor
• You are reporting the details
• Your numbers are your numbers
• Do not try to make them something they are not
• Do not apologize for what they are
• Remember, that most early-stage investors are excited to see that you have just a few users but trending in the right direction
• They make their investments based on this
• Too often we hear founders “apologizing” for their numbers
• They may say something like “Although we only have seven customers today we recently pivoted and turned on revenue, but hopefully, this will start to grow now that we decided on a model that we think makes more sense.”
• Instead, be confident and direct, “We started charging for our product three weeks ago and already have seven customers.”
• The second statement gives the same information but is straight forward and not apologetic
• Investors will pick up on your confidence which improves your credibility
• The main thing that investors will be thinking while looking at your model is:
• Do the numbers make sense?
• Is it logical how fast this founder anticipates revenue growth?
• Over say five years investors like to see the anticipated growth of your revenue to triple, triple, triple, and then double, double
• If you claim you will 10x your revenue in one year that will stand out as questionable to most investors
• How many users does this company have now, how are they getting more, and how many do they anticipate they’ll have each year?
• Is growth all organic? Is there a marketing plan?
• What is the CAC (customer acquisition cost)?
• Is it scalable?
• Did the founder distinguish between Paid vs Blended CAC
• What does the Churn currently look like?
• How frequently are customers leaving?
• What is the percent of of returning customers?
• As a founder, you want to track this number and try to identify reasons for the churn
• Have an explanation for why members of cohorts are leaving and a plan on how you will improve retention
• Think back to our modules with cohort analysis
• Is this percent based on a high volume of customers or an early/small sample size?
• How will this number change as the company scales?
• Keep in mind, you are always building credibility
• Often the first pass-through of the financial model is to validate that you have a logical plan and for investors to identify any red flags
• Some founders will add a best case and worst case model as supportive material
• So for example, instead of triple-triple-triple in the first three years maybe they create a ‘worst case’ model that shows growth of 1.5x, 2x, 2.5x and the best case model shows a 3x, 5x, 5x
• Then the founder will point to their main model that falls between these two scenarios
• It is all an estimate anyway so sometime creating this ‘range’ can be more confusing than helpful

Investor’s mindset when looking over a model

• The priority for an investor when initially looking at a model is to determine:
• Does this founder have credibility?
• Do I believe this founder?
• Does this model make sense?
• Can this founder deliver on what they are modeling?
• The other thing Jason likes to do is to try and poke holes in the model
• He will find where the numbers don't make sense and ask the founder to drill down
• There are multiple reasons Jason likes to do this
• One, he wants to understand the model and make sure it is accurate
• Was it a typo or a founder trying to mislead?
• Two, does this founder understand their own model well enough to explain why there isn’t actually a hole to poke at
• Is there something that Jason doesn’t understand about the business that the founder can explain through their industry expertise?
• Three, he wants to see if the founder can withstand the poking
• There are going to be a lot more challenging situations in the startup journey than defending your financial model
• Is this founder resilient enough to withstand tough questions and being called out?
• It is a positive signal in the investor’s eyes if the founder can present and defend their plan well

Have specifics ready for investors

• Be prepared to drill down into any part of your plan
• For example, if they ask "what are you going to spend the funding on?"
• The wrong answer is to say "marketing and product"
• This is obvious, they could have answered that!
• Answer the question with specifics:
• Be prepared to say something like:
• "I'm going to hire 2 SDR at $40K with x% commission"
• "I'm going to spend $150K on a sales team pod that consists of
• 1 Account Exec (3-4% commission)
• 2 SDR (1-2%)
• 1 Customer Success (1-2%)"
• “I’ll be able to scale this pod when we hit X number of sales, which we anticipate to do so in Y months. At which point we’ll duplicate this process.”
• Keep in mind, this is not a contract
• The investors want to know if you have a plan that makes sense
• They are not going to come back in six months and say: “you said you were going to hire 2 SDRs and 1 Customer Success but you ended up hiring 1 SDR and 2 Customer Success? What happened? Why did you lie to us?!”
• That won’t happen! In their mind, you delivered on the plan!
• It is rarely about those minute details, rather investors want to know that you have a plan that seems reasonable that you can deliver on
• Now, don’t tell them you’re going to make those hires and instead spend the money on swag, trips, and expensive offices
• That is a different story and they will likely call you a liar then - credibility lost!
• This has been stated several times, but it is so important we’ll say it again - you are in a race for credibility at all times as a founder!
• Your main job when raising money is to show investors that you know your business better than anyone
• You should be prepared to provide details when needed
• Give them confidence that you are the individual that is going to make the business an outlier success

What’s the right burn rate?

• It is not the answer you want, but like many things when creating a startup - it depends!
• There is no simple formula and the appropriate burn rate will depend on growth needs
• Different businesses will have different expenditure profiles
• Physical businesses have very different profiles than software businesses (atoms vs bits)
• It is a good idea to distinguish between variable costs and fixed costs
• Variable costs are costs that increase as your company grows and you sell more
• An example of this could be the number of zoom licenses for your team needs or the storage space required for your application
• As you hire more employees you’ll need more licenses
• As you acquire more customers you’ll need more storage for your app
• Fixed costs are costs that require an upfront investment, but do not increase with each unit sold
• An example of a fixed cost is the rent you pay each month for your office space
• It is normal to plan for 18-24 months of runway
• Keep in mind that you should allow at least 4-6 months buffer to fundraise the next round

How To Manage Your Burn Rate

• As we discussed previously, it is important to be engaged & pro-active

1. Set your growth goals for the next funding round
2. How much free cash do you have to invest?
3. How much will your growth goals cost?
4. When do you aim to raise the next round?
• How much runway will you need?
5. CEO/Founder bookkeeping or reconciliation
• Although this can be a bit controversial as founders already have a lot on their plate
• But outsourcing these tasks can prevent a founder from realizing the leaks in their buckets
• Even if the founder isn’t the one to actually do the bookkeeping they should have time to do a review regularly
6. Use tools to control team spending

• Things can change quickly at a startup, be flexible and adjust

What to Do When It’s Going Wrong

• Take swift and precise action
• Ideally, you have an idea or a plan in place before this becomes a situation

1. Reconcile your bank statements and payroll
2. Triage
• Immediately eliminate "nice to haves"
• Good rule, be able to cross off half the things if you need to
• Also worth reviewing how many of these “nice to haves” are really necessary even if things aren’t going wrong
3. Review "must-haves"
• Agree on a survival plan
• This should be reviewed with the executive team
4. Negotiate with creditors
• As we discussed in early modules, most things are negotiable
• Adjust terms and payments
• If you are proactive & forthright banks can adjust your payments
5. Scrutinize every single dollar spent
• Are your dollars best spent with a certain provider or elsewhere
6. Compare and contrast new lean business vs prior version
• Creativity is best fostered with constraints
• What is the plan once you are back on solid ground?

Trials & Tribulations With Burn Rate - 5 Learnings Over 5 Years

1. Not paying close attention to your burn is deadly
2. Your funding will disappear faster than expected
3. Speak, live, and build a frugal culture
4. Never count on any future investment or investor
• Not all investors can scale with your growth when you need it
5. Assume the funds you have today are your last

Steps to Healthy Financials

• 1. Right Structure
• Incorporating as a C-Corporation is essentially a requirement if you have investors
• Benefits of C-Corporation
• It gives more protection, under the law, to businesses and investors around fraud.
• It is better on taxation
• Investors don’t get taxed until the exit.
• LLC is a pass-through entity
• Owners report business income and losses on their personal tax returns
• This allows early investments to be written down as business expenses
• Bottom Line: If you are raising money, be a C-corporation
• 2. Accounting: Cash vs. Accrual vs. Modified Accrual
• Cash is tracking when the cash comes in and goes out
• Accrual is accounting for when the expense occurred rather than when it was received
• We all but require that companies we work with use accrual-based accounting
• 3. Monthly Financials
• It may seem like common sense, but founders need to track monthly financials
• This is a backward look into your business
• Financials show the heartbeat of the business
• Do a monthly financial checkup from day one
• Regular financials show credibility, investors will like seeing your systems and processes
• Track your revenue, payroll & expense on a monthly basis
• Profit & Loss Statement
• All your expenses and revenues for the month
• It is a good idea to look in both absolute dollar numbers and in percentages
• Balance Sheet
• Assets like accounts receivable, cash, inventory, equipment, etc.
• Liabilities like accounts payable, debt, etc. and shareholder equity
• Cash Flow
• How cash is moving in your business
• 4. Budget / Forecasting
• Budgeting is crucial to knowing your runway
• This is where having a solid financial model for reference is helpful
• 5. Financial team
• Bookkeeping
• Do weekly bookkeeping with monthly reconciliations
• This is a good task to outsource but should be reviewed by the founder and team
• Payroll
• It is common to use a cloud-based payroll system
• Pay employees twice a month
• Pick a provider that can handle HR benefits
• Have someone on the team (CPA, CFO, or other) to help with
• Finding tax savings, navigating tax planning, filling, and staying in compliance
• Budgeting and forecasting to make sure the business has the financial runway it needs.
• This is a key role for board reporting

Jason’s Burn Rate Party Trick

• Any founder should be able to do Jason’s burn rate party trick for their own startup
• Jason highlights this trick in his book Angel on page 149
• Essentially, what he does is ask a few questions around key metrics and is then able to tell a founder what he anticipates their runway is within a few minutes of learning about their business
• Here is how he does it:
• When a founder is talking about their business Jason writes down their key numbers
• He then does what he calls back of envelope math to understand where the company stands
• This is about understanding the business
• He is not trying to be an accountant
• He is not trying to be perfect
• So what are the metrics that Jason writes down for this trick?
• Monthly recurring revenue (MRR) - to identify how much revenue the company is bringing in each month
• How many full-time employees (FTE) do they have?
• What is the current burn?
• What is the pace at which they are working through their capital?
• How much capital have they raised and when was the last round raised?
• An example of the “trick” in action:
• Let's say the founder tells Jason that their MRR is currently $10k
• And they have 5 FTEs working for them
• For an FTE, Jason typically estimates ~$120k (all in) which comes out to about $10k a month
• This is a good estimate because some will make $70k others $150k
• By all in he is taking into account insurance, benefits, etc.
• So he now knows that they are spending $50K (5 FTE at $10k) on headcount and probably around $10k on miscellaneous expenses for a total of $60k spent each month
• This means they burn = ~$50k/month
• $60k in spend (FTE + miscellaneous) minus the $10k (MRR) each month
• And then let's say they raised $1 million around a year ago
• Since on average they burn $50k/month over that 12 months
• This means that they've spent around $600k in the past year
• This means they have ~$400k left from the original $1m they raised
• If they continue burning at $50k/month then they have about 8 months of runway left
• Jason will then ask the founder, "Is that correct?" and watch their jaw drop!
• The reason this trick works is that Jason understands the space, uses reasonable numbers, and mentally builds a model
• Every founder should not only be able to do this more accurately, but they should make it a general practice to do so
• Tracking this over time will help you identify trends in your spending and revenue
• It will also help you make informed decisions on hiring
• What we often see is with founders who don't do this “unexpectedly” run out of money
• As a founder, you should know your runway and the key metrics that determine it
• It should never be a surprise how much money you have left as a founder

Additional Resources

• Startup Checklist: Optimizing Operations
• Startup Basics with Jason: Managing your cash and building a model to communicate it
• The Burn Multiple - by David Sacks
• What “Financials” Means for Early Stage Startup
• Why Startups shouldn’t use YC’s Post-Money SAFE
• Book: The Minimalist Entrepreneur: How Great Founders Do More with Less by Sahil Lavingia
• Founder.University 2-day intensive presentation: Showing Signal Before Traction

Activities