CHAPTER NINETEEN

MAKING SURE THERE'S ENOUGH MONEY IN THE BANK

Running a business is very different from managing your personal finances. The revenue is less predictable than a salary; multiple people contribute to expenses; and there's a lag time between revenue/expense and cash impact.

Keeping a watchful eye on cash is especially important for two reasons: funding requirements and funding availability don't always go hand-in-hand and most startups regularly have to deal with the fundamental quandary of rapid growth being at odds with profitability.

SCALING YOUR FINANCIAL INSTINCTS

Return Path received its first institutional financing in late 2000 (we did a large “angel” round in late 1999) and our first “real” board meeting was in November of that year. It was a memorable experience all around but there is one piece of advice that I'll never forget hearing. Without the slightest bit of sarcasm or irony, one of our board members insisted that I never let the burn rate get above $1 million per month.

I had started Return Path almost a year before and we didn't come close to an annual burn rate of a million dollars. A million dollars a month?! Of course, I would never spend money so irresponsibly. You've probably guessed by now that I'm the type of person who kept careful tabs on his first checkbook, obtained at age 10 by riding to the bank on a bicycle with a piggy bank in tow. Is someone who takes care about every $100 really going to drop the ball on $100,000? Shockingly, the answer is often “yes.”

Even if you're frugal as hell and build desks out of doors, nobody has the precision instincts about $500,000 versus $750,000 that you would have about $500 versus $750 in your personal life. Some people simply do lose their heads: what's $10,000 when you have a million? (It's $10,000.) The more important point is that nobody has developed instincts about how to handle this kind of money.

All of us have had a few hundred dollars or more in our accounts for quite some time now and have a sense of what it would mean to spend $200 on dinner instead of $30. When was the last time you had to manage multimillion-dollar budgets? And even if you did have some oversight over a major budget (as I did at MovieFone), when was the last time you were the final decision maker about how that money was spent? Unless this is your second go at being a startup CEO, the answer is probably “never.”

Without instincts, financial problems can creep up on you. In fact, there's a famous parable every businessperson knows about exactly this issue.

BOILING THE FROG

It's an old story, most likely apocryphal, but every management consultant in the world has told it a couple hundred times:

If you throw a frog into a pot of boiling water, it will leap right back out. If you put a frog in a pot of water on the stove and then heat it up to boiling, you'll “boil the frog” because it doesn't realize that it's being very slowly cooked until it's too late.

We've boiled frogs at Return Path more than once. In one case, we let a staffing problem sneak up on us in a critical department. We were short one person in accounting and business operations and we decided to control costs by going without the extra person for a month or two. Then, another person in the group unexpectedly left. Then, another person in that group got seriously sick and was out for several weeks. We were now down three people in a critical area, without a proper pipeline of candidates coming in the door for any of the open positions. For a period of time, we weren't getting what we needed out of that group, despite the heroic efforts of the remaining team. It wasn't until the last person had already been out with an illness for a few days that we realized we had a serious problem on our hands.

The second time was a few years ago. We were working on doing a financing to fund our rapid growth and calculated that we had six months of runway left before we'd need more cash. Then, new expenses popped in that we hadn't focused on. We'd already stopped hiring, the biggest lever. Our ops team did a major hardware purchase (the kind that affects cash but doesn't hit the income statement, so we weren't thinking about it). Then we did annual salary increases (which we forgot to specifically add into the budget midyear). Then we had an unusually high Travel and Entertainment month with a few conferences (T&E is budgeted evenly across the year, even though it really has peaks and valleys). Then revenue was a little short of plan. All of a sudden, that six-month runway turned into three months! And the financing process, which was going fine, became rushed and hurried. We got it done and we probably didn't leave a lot on the table, but it was unnecessarily harrowing. And, like the other example, there was never a moment where it was obvious that we had a problem until we did.

How do you stop yourself from getting boiled?

• Recognize when you're in a pot of water. What areas of your company are so mission critical that they're always at risk? Have you done everything you can to eliminate single points of failure? As long as you're losing money, are you comfortable that you know every source of spending?
• Recognize when someone turns on the burner. Do you know the early warning signs for all of these areas? Can you really live without an extra person or two in that department? Is it really okay that you forgot to budget in raises?
• Recognize which frogs you care about. You can't solve all of the problems all of the time. Figuring out which ones need to be solved urgently versus eventually versus never is one of your most important roles as a company's decision maker. Focus first on cash in the bank!

Care and intuition will take you far here but metrics will always take you farther.

TO GROW OR TO PROFIT? THAT IS THE QUESTION

There's an elite club of (former) startups that never have to debate the relative merits of growth versus profitability. Google can set out to scan every book ever written (129,864,880 by their last count) without having to worry about the cost of such a project dragging down the profitability of their search ads business. Steve Jobs allegedly ordered his product teams to build a number of complete, polished prototypes of every new product (a dozen iMacs here, a dozen iPads there) before choosing one—or mashing them up and sending his team back to work. If you're reading this book, I'm going to assume that you don't have that luxury.

Every time you have a budget meeting once you're out of the raw startup phase, you have to strike a balance between growth and profitability. Every time. Even when you're making money. Invest everything into new hires and more product features and you will fuel growth. Cut costs and halt new initiatives and you will put money in the bank. How do you decide which approach to pursue?

First, Perfect the Model

Before you can think about the trade-off between growth and profitability, you have to get your business model right. Not just on your first Lean Canvas, but on your second, and your third. Get out of the startup phase and into the revenue phase. During this phase, you have to focus on neither growth nor profitability, but rather on frugality, on staying alive until you get to the point where you're ready to start scaling your business.

Choosing Growth

Once you have a model that's working, choose growth. Growth in revenue, growth in user base. Sometimes this doesn't make sense—if your business is mostly professional services, for example. As long as you're selling some kind of product or technology with high gross margin and a large and expanding market in front of you, early on, you have to choose growth.

Investors in those kinds of businesses aren't looking for steady annual profits that grow 10 percent a year. They aren't looking for a dividend. They are looking for a 3 to 10 to 50× return on their investment. That kind of return will happen only if you're growing your revenue or user base 30 to 50 percent per year, or even more in the early stages. Rapid growth companies are acquired at high multiples of revenue, or achieve ultra-successful IPOs. Even post-IPO, public market investors seem to be willing to value continued high growth over profits.

That said, you should be investing money in growth (at the expense of profits) only if you are reasonably confident that the investments you make will pay off. That confidence has to grow as your business gets larger—in the early days, of course you don't know if things will work at all. By the time you're in the revenue stage, though, you should be putting money to work in sales or marketing that you're fairly sure will pay back—or put smaller amounts of money to work to test things out first.

Choosing Profits

As your business matures (again, if you are running a high margin/high growth potential software or Internet business in particular), though, the lure of profitability starts to beckon. Why should you be constantly in fundraising mode with 70 to 80 to 90 percent gross margins? Why should you and your investors continually suffer from dilution? Those things might make sense in a world where your valuation is growing so fast that fundraising is easy and dilution is small, but that's not the case for most businesses.

It's also the case that strategic acquirers often value profits over growth—or at least a balance between the two—almost the opposite of the IPO market. Once you get to be $50 million to $100 million in revenue, other companies may start to look at you funny if you haven't actually demonstrated yet that you have the discipline to run a profitable business. It's one thing for strategic buyers to spend several million dollars on a neat piece of technology of team. It's another for them to spend hundreds of millions of dollars on a company that's going to be a drag on their earnings per share. This rule gets thrown out the window, however, if you are growing fast enough (e.g., >40 percent per year) and if most of your loss has a positive long-term ROI directly attributed to increasing customer acquisition.

Sometimes, though, the choice startup CEOs face isn't between growth and profits. It's between growth and halting it in order to stay alive.

If you have a solid product and an effective sales team generating somewhat predictable month-over-month revenue growth, achieving profitability isn't all that hard: just stop hiring. Lots of companies, including Return Path, did so in 2008–2009. The economy was melting down and completely uncertain, so we did our best to maintain top-line revenue and growth while preparing for the worst by cutting and freezing bottom-line expenses as much as possible. The result was that we went from very unprofitable to very profitable within six months. Once the world was in a better macroeconomic place, we felt more comfortable investing more money in our long-term growth once again.

The Third Way

Increasingly, some companies are trying to find a “third way” here in this debate, where they're not chasing growth at all cost but they're also not trying to maximize profits. They are declaring that they want to be in business for the long haul and while they're concerned about their investors' desires for liquidity, they don't want to rush to sell the business or to go public, with all of the accompanying challenges and headaches.

So they're exploring new financial models of long-term, private ownership. They're slowly starting to turn on enough profit so they buy out investors without slowing growth too much. And these include some great companies. It will be interesting to see how these companies pioneer new models in the coming years.

This is admittedly a very complex topic that could be the subject of a whole book. Suffice it to say that the trade-offs between growth and profitability are real and persistent throughout the life of a startup.