Posts from Finance

It's monday and it's time to move on from the MBA Mondays series on Employee Equity. We did nine posts on employee equity and hopefully we moved the needle a bit on understanding that complicated topic.

I'd like to switch topics now and talk about acquisition finance. The other day Chris Dixon said this in a comment here at AVC:

the two biggest tech companies alone (apple and google) are approaching $100B in cash that they will likely use for acquisition to support their incredibly profitable businesses

The point Chris was making with that comment is there is a lot of buying power out there in the big tech companies that can be spent to buy tech startups. And he is right about that. Google has $34bn in cash. Apple has $50bn in cash and short term investments. Microsoft has $44bn in cash and short term investments. eBay and Amazon each have more than $5bn. The numbers add up to a lot of buying power out there.

But just because they have the cash doesn't mean they will use it. There are a number of factors that acquirers consider before pulling the trigger on an acquisition. They look at whether the acquisition will improve or hurt earnings going forward. They look at how they will have to book the acquisition on their balance sheet. They look at how dilutive the acquisition will be to shareholders (even if it is a cash acquisition, they may need to issue employee equity for retention). And most of all, they attempt to determine how the acquisition will be recieved by their shareholders and what impact it will have on their stock price.

I am calling this entire topic acquisition finance. I am not an expert on this topic but I've got a working knowledge of it and I am going to share that working knowledge with all of you over the coming weeks.

This is the final post in a long MBA Mondays series on projections, budgets, and forecasts. Today we will talk about what happens when reality starts to differ from what you've budgeted – you re-forecast.

Let's go back to the framework I laid out at the start of this series. Projections are long-term high level efforts to establish the scope of the opportunity. Budgets are an effort to establish an operating framework for the coming year. And forecasts are done intra-year to establish what is likely to happen. As someone said in the comments, it's "long term, short term, and real-time."

Forecasts are typically done mid-year but they can and should be done whenever the actual performance differs significantly from what was budgeted. Forecasts are not an attempt to throw out the budget. The company should continue to measure itself and report against the budget. The forecast should exist beside the budget and show what management thinks is likely to happen.

Forecasts are important for a variety of reasons but first and foremost you want to know where your cash balances will actually be. And you'll want to know where you will be on your revenue growth trajectory. If you are planning on doing a financing, forecasts are important because they will give you an indication of what the metrics investors will be using when they offer you terms for a financing.

The process of doing a forecast is not very hard. You simply take the model you used for budgeting and put new numbers in for revenues and costs. The way most forecasts go down is the revenues are taken down to reflect slower sales growth. Then management looks at the costs in the budget. In some cases, costs are not adjusted because management feels that they need to continue to invest in the business. But in many cases, costs are adjusted down somewhat to reflect a desire to conserve cash. Either way, you'll have a new set of numbers for the months ahead.

You combine these new sets of numbers for the coming months with the actual results for the months that have already happened and you have your forecast.

Once you do a forecast, it is a good idea to keep updating it as the year develops. If you do a forecast at mid-year and by the fall that forecast is off, do another forecast. The forecast is not another budget you have to try to meet. It is an attempt to estimate actual results. So keep adjusting the forecast in an attempt to nail it.

As you get into the fall, you will start budgeting for the next year. Use the learning that came from the forecasting exercise to make next year's budget better. Think of budgets and forecasts as agile financial management. The budget is the annual release and the forecasts are the iterations based on feedback.

So that's it. We are now done with projections, budgeting, and forecasting. Next week we'll tackle a new topic.

Last week we talked about budgeting in a growing company. I defined that as a company between 50 and 100 employees. Today we are going to wrap up the budgeting series by talking about what happens to the process when you get to be a "big company." The context for the whole of this MBA Mondays series of posts is the world of entrepreneurial startups so "big company" means 150 employees or more to me. The biggest companies that I actively work with are between 150 employees and 1000 employees. Once they get bigger than that, they are beyond my ability to comprehend them and help them.

The process of budgeting in a large company doesn't differ that much from a growing company. If you haven't read that post, please go back and read it.

The budgeting process is still led by the financial leader of the company (VP Finance or CFO but by this stage you are likely to have a CFO) and the CEO. But the team that runs the budgeting process now includes the entire senior team. That is because each senior team member has control over a meaningful team and piece of the business. So you have to get them all involved in the budgeting process.

It's also increasingly likely that your revenues are coming from a number of lines of business so you will want to do a more detailed revenue forecast with attention to each segment of revenue. Your sales leader will still be responsible for the revenue forecast, but he or she will need help from the finance leader and often from other senior team members to put the revenue forecast together.

You will continue to use KPIs as a bridge between the revenue budget and the cost budget, but the creation of the KPIs and the forecast of them is now driven by the entire senior team. As I said in last week's post, this is the most important part of the budgeting process so make sure to give the senior team ample time to get the KPIs right.

Cost budgeting in a large company is a much more exhaustive process. The cost budget has a lot more detail and input into it. It is an iterative process where each senior team member brings a cost budget from his or her team and the finance leader integrates it all together and then negotiates with the senior team members to get the numbers where they need to be. This is where entrepreneurial budgeting starts to feel like big company budgeting.

One thing that many companies start doing at this stage is benchmarking their budget numbers versus others in their industry sector. This is mostly done with public company numbers since getting detailed financials on privately held companies is difficult. It is helpful to look at what your competitors or similar companies are spending as a percent of revenues on the various parts of the business. And it is helpful to look at how profitable their businesses are versus yours.

As you can see, the primary difference between the budgeting process in a growing company and a large company is the amount of involvement, interaction, and iteration among the senior team. This all takes time. So start the budgeting process by labor day, if not a bit sooner. It will take three months to do this right. You'll want your budget ready for a board review in mid to late November so there is time to do one more iteration before year end if that is necessary.

The budgeting process is really critical in a large company. It forces the company to make highly informed decisions about investments and resource allocation and it creates company wide discipline around hitting goals. I have never seen a company of 150 employees or more operate functionally without a strong budget process.

I'd like to again thank Matt Blumberg and Jack Sinclair of our portfolio company Return Path for their help with these budgeting posts. I have watched them go through all of the various stages over the years and their planning and budgeting has been stellar. Their insights were invaluable to me in putting the "how to" parts of these posts together.

Next week we'll talk about what happens when the reality starts diverging from the budget – forecasting.

I failed to post a MBA Mondays post last monday. Sorry about that. I had something else on my mind when I woke up, wrote about that, and didn't realize that it was monday and I was supposed to do an MBA Mondays post until late in the afternoon.

So we are now picking up from where we left off two weeks ago. Which is in the middle of a four to six post series on projections, budgeting, and forecasting. We covered budgeting in a small company two weeks ago. We are now going to talk about what happens to the budgeting process once revenues start coming in, headcount gets to between 50 and 100 employees, and you are now a full fledged high growth business.

Once you have real revenues, 50+ employees, and a real business, you should have a full time finance person on your team. It could be a CFO or it could be a VP Finance. There are tradeoffs between the two. If you think you are going to be an independent company for a long time that will go public or do a large number of private financings and M&A transactions, then you will want a CFO. If you plan to keep the business simple and head for the exits within a few years, a VP Finance should be fine. I should do a post on the difference between a CFO and a VP Finance and I will, but this is not the time for it.

So your budgeting process should start with your lead finance person. He or she should run the process with you as their partner. Your budgeting team should also include the leader of your sales or revenue operation and your head of engineering or tech ops if you have one. The way I like to think of these two people is the person who "owns" revenues and the person who "owns" capex. This group is sufficient to run a budgeting process in a 50 to 100 employee company.

There are three inputs to the budgeting process in a company of this size; a detailed revenue plan/model, a comprehensive cost model including headcount, and a set of key performance indicators (KPIs). 

Start with the revenue plan/model and do it bottoms up (meaning identify where the revenue is going to come from and how much of it you are going to be able to pull in during the year). The sales leader will give you a plan that he or she thinks they can hit. Dial it back. As much as I love sales leaders, they are optimists. Very few of them can properly estimate revenue in a high growth relatively early stage company. I believe they generally do a good job of identifying where the revenue will come from but a poor job of estimating how much of it will come in during your time frame. Things always take longer. So dial the sales leader's numbers back.

Then once you have a set of revenue numbers, lay out all the KPIs that it will take to hit them. What is needed from the product team? What is needed from the engineering team? What is needed from the bus dev team? What is needed from marketing, customer service, HR, etc? The KPIs are the glue between the top line model and the cost model. Spend a lot of time on this part of the process.

Going from KPIs to a comprehensive cost model is not that hard, especially for a seasoned finance person. The key is being comprehensive. If you are growing headcount aggressively, will your current space be sufficient? If not, you'll need numbers for more space. Things like legal and recruiting costs really start to pile up at this stage. They may not be very large in your historical financials. Plan for them and budge them.

And make sure to budget for capex costs. Some companies rent their capex via leases or managed hosting. If you do this, your capex will show up in your operating costs. Some companies acquire their capex with cash. If you do this, your capex will show up on your balance sheet. Either way, capex can eat up a lot of cash. So budget for it correctly and make sure your engineering or tech ops leader is held accountable to the capex budget.

In my last post on this topic, I said that budgeting time is October and November so that the board can approve it in December. That is generally true for a 10 person company but not for a 50 to 100 person company. I like to see budgeting start in September for a company of this size and I like to see the Board look at the budget in November. That way if there is a disconnect between management and the Board, another revision to the process can occur before the year starts on Jan 1st.

The budget is not just for the Board. It is first and foremost for the team. So make sure to share the budget with the team and make sure they are all bought into it. If they are uneasy about it, listen to them and don't force a plan on the team that they do not think they can hit.

A company at this stage will have a senior team and they should be accountable to the budget. They may even have incentive comp associated with the budget goals. I like to see the entire senior team participate in the budget presentation to the Board. I like all of them to talk to their parts of the budget. That shows they understand it, they have bought into it, and they are behind it.

To be brutally honest, very few budgets are met in companies of this size. These businesses are still very much in flux and things change a lot during a year. But I still believe in the value of doing budgets. The process is incredibly helpful in establishing what can be done and what can't be done. It focuses the mind and the company. And if you realize half way through the year that you are not going to meet your budget, you can and should do a forecast. We'll talk about that in a few weeks.

Next up is budgeting in a 150+ person company. We'll do that next Monday assuming I don't have another brain fade.

Today and for the next two weeks, we are going to talk about budgeting on MBA Mondays. Since the budgeting process works differently in companies of various sizes, we are going to focus on three company sizes; 10 people, 75 people, and 150 people. Today we will talk about the 10 person company scenario.

As I said in a previous post, I have been working with Matt Blumberg and Jack Sinclair, CEO and COO/CFO of our portfolio company Return Path on these budgeting posts. I have been involved with Return Path for ten years now and I've watched Matt and Jack run excellent budgeting processes and so we are getting the benefit of their work and learning in these posts.

Last week we talked about projections. It is important to run a projections process before you turn to budgeting. Think of budgeting as a refinement of the projections process where the goal is to predict what is going to happen in a particular calendar year.

I believe that budgeting should be done on a yearly basis. If you want to start budgeting and you are in the middle of the year, that is fine. Just budget for the rest of the year and then do your first full year budget in the late fall.

The late fall is budgeting time. October and November are the best months to do it. If you have a board, you should be able to present your budget for the next year to the full board in December so they can approve it before the year starts. If you don't have a board, then you should be able to lock into a budget with your team in December.

The budgeting process starts with a financial model. If you have done projections, then you should have a financial model already built. If haven't done projections, then go back to the projections post, follow the directions, and do some projections. Then come back and read this post.

The first step in budgeting is to review the key business metrics and lock them down based on what is realistic for the next year. Be very realistic. A good budget is a conservative budget. In a ten person company, the budgeting process can be done by a couple of the senior managers, typically the CEO and the most financially savvy of the other team members. These two people can run the process all by themselves without any input from the rest of the team. That will change quickly as the company grows, but in a very small company you do not need to involve the entire team in budgeting.

If the company is pre-revenue as many 10 person companies are, then the focus will be on hiring and people costs. And the budgeting process will largely be about spending and how many people the company can hire and how much money the company can spend and how long its cash will last before needing another round of funding.

If the company has revenues, they will not likely be large yet at 10 people, so the revenue forecast will be a bit tricky. In the first few years of revenue generation, the revenue model changes a lot and the drivers of it change too. I would encourage everyone to be conservative about revenue budgeting early in a company's life. Most budgets are missed because revenue does not come in as planned.

Make sure to include a cash line item in your budget. Most budgets are done as profit and loss statements which is how they should be done. But you should back into a cash projection based on the profit and loss numbers and include that line item in your budget. If this is new material to you, go back to my posts on profit and loss, balance sheet, and cash flow to see how these three statements work together.

Once the budget has been locked down and approved by the board and/or by the senior team, you should share the budget with your entire company. Some executives don't like to share the entire line by line budget with the team and I can understand that. Some executives don't like to show a cash line that runs out with the team and I also understand that. But you should at least show the key business metrics and some of the most important line items in the budget with the entire company. This will be their roadmap for the next year and it is important that they understand it if they are going to be expected to help you deliver it. 

All that said, I favor being as transparent as you can possibly be with your company. It is hard to hide information from the company. The important information leaks out eventually and if and when it does, you won't be there to provide context. So the more information you provide, the better off you will be.

Once you have a budget, you need to measure yourself against it. Each month report the actual numbers versus the budget and track how you are doing against each key business metric and line item in the budget. At some point during the year, you may want to do a reforecast. We will talk about that exercise in a few weeks.

Next week we will talk about how this process changes as you grow to 75 people. It a very different process at that point.

MBA Mondays is starting a new topic this week. It's a big one and I think we'll end up doing at least four and maybe even five posts on this topic in the coming weeks.

I said the following in one of my first MBA Mondays posts:

companies are worth the "present value" of "future cash flows"

The point being that the past doesn't matter too much when it comes to valuing companies. It's all about what is going to happen in the future. And that requires projecting the future.

There is another big reason why projections matter. They are used for goal and expectation setting. Generally speaking goal setting is used to manage the team and expectation setting is used to manage the board, investors, and other important stakeholders.

And finally, projections matter because they tell you what your financing needs are. It is critical to know when you will need additional financing so you can start planning and executing the process well in advance of running out of cash (I like 6 months).

There are three important kinds of projections. I'll outline each of them.

1) Projections – These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. They are aspirational and are often done with a "what could be" perspective.

2) Budgets – These are a set of numbers, both financial and operational, that the management team prepares each year, usually in the fall, that outline what the company plans to achieve in the coming year. They are presented and approved by the board and the management team's compensation is often driven by them.

3) Forecasts – These are iterations of the budget that are done intra-year by the management team to indicate what is likely to occur. They reflect the fact that the actual performance is going to vary from budget (in both positive and negative ways) and it is important to know where the numbers will actually end up.

Over the coming weeks, I will go through the processes companies use to project, budget, and forecast. Because I do not do this work myself, I've enlisted one of our portfolio companies to help me with these posts. 

I've been working with Return Path for ten years now. Matt Blumberg, CEO, and Jack Sinclair, CFO and sometimes COO, have done over ten sets of projections, budgets, and forecasts for me and other investors, board members, and team members. In the process they have evolved from a raw startup to a well oiled machine. With their help, I will talk about the how three "model companies" go about projecting, budgeting, and forecasting. These companies will be 10 person, 75 person, and 150 person. These are the typical sizes of companies that I work with and are probably also the sizes of companies that most of the readers of this blog are dealing with.

I'll end this post with a picture that Matt sent me last week. This is ten years worth of board books that include Return Path's projections, budgets, and forecasts. The goal of MBA Mondays in the coming weeks will be to get all of you to a place where you can create something similar.