CHAPTER TWENTY-TWO
FORECASTING AND BUDGETING
Like all elements of startup planning, the only thing you know about a budget or forecast when you finish it is that it's wrong. You just don't know how wrong it is or in what way it's wrong.
This is a difficult reality but it isn't a problem. Startups aren't about reading the crystal ball; they're about your ability to react. That doesn't mean you shouldn't make predictions, you just need to be willing to recalibrate them constantly based on new data. There are two things that you can predict: revenue will take longer realize than you expect and expenses will be higher than expected. Budget accordingly.
RIGOROUS FINANCIAL MODELING
Every CEO—startup or otherwise—should be able to roughly model their business and understand its main financial drivers. These might change over time. To be more precise, these will change over time, probably quite drastically. That isn't an excuse to avoid making predictions about your cash flow and your expenses. It's the reason why you have to continually adjust those predictions based on new realities.
Financial modeling is not only a task to be strictly delegated to your CFO. That person may own your financial model but you need to be extremely comfortable working your way around it, changing variables, understanding how little changes you make in those variables ripple through from concept to cash.
“That new client is going to be huge” isn't a satisfactory prediction of cash flow and “We're going to run a bit over this quarter” isn't a budget prediction. If you want to be a CEO, you must understand the basic mechanics of balance sheet, cash flow, and P&L statements. These aren't distractions from the essential work of changing the world and disrupting the marketplace. They're the only ways that you can honestly—and rigorously—judge how close you are to actually achieving those goals. If you can't do the model yourself, you're going to have a very hard time understanding the levers when they're presented to you and you're going to have a hard time making critical business decisions as a result. If you want to abdicate all of those responsibilities, you should consider being Chief Product Officer or Chairman. You can still wear your founder badge with pride.
Forecasting and Budgeting in a Downturn
When Lehman Brothers failed in 2008, we were nervous. Everyone in the world was nervous. We have a recurring revenue model at Return Path, which makes revenue much more predictable than it is in areas like media and manufacturing, so were lucky. Nonetheless, we immediately forecast much higher customer churn, price reductions and slower customer adoption. The one thing we failed to forecast was longer collection cycles: every company we worked with started hoarding cash in late 2008 and we effectively found ourselves financing Fortune 500 companies so they could pad their cash balances for Wall Street. That proved to be a nightmare on our balance sheet—but the rest of our planning certainly helped.
Things change rapidly in an economic downturn. Make sure you reforecast monthly rather than quarterly, especially cash and cash flows. Develop your core revenue streams and make sure they're really your revenue—not just skimming tertiary revenue out of the ecosystem (like only making money on remnant online advertising inventory or affiliate fees). A downturn will really lay bare a revenue model that's unsustainable.
OF COURSE YOU'RE WRONG—BUT WRONG HOW?
If your internal financial models are as broadly stated as your pitch deck, you won't have good answers to these questions. If you went through the process of rigorously modeling every potential revenue stream or expense, you can check your predictions against reality. This allows you to do a few things:
- Better understand the drivers of your business. Keep things vague (“we need to accelerate customer growth”) and you're understanding of your business will stay vague. Force yourself to work through a balance sheet and P&L statement and you will start discovering the precise drivers that move the needle in your business.
- Measure success or failure against a baseline. Even if your baseline predictions are wrong, they give you a less arbitrary way to measure performance than deciding after the fact whether you're happy with a given quarter's results.
- Recalibrate your models based on outcomes. Every model should be an improvement over the last one. What did you get wrong this time? How can you avoid the same blind spot or mistake the next time?
Startup business plans—and startup cash flow predictions and startup budgets—are essentially formalized guesses. There's nothing wrong with that. Formalize your guesses enough times and they will start turning into meaningful predictions. Skip the process and your decision making will never improve.
Former Quickoffice CEO Alan Masarek on Aligning Resources with Strategy
Alan Masarek is one of the most disciplined business operators I know. (Google must have thought so too: they recently acquired his company Quickoffice.) To open this section, I have asked him to talk about the nexus of resources and strategy.
The job of a startup CEO is generally tougher than that of running a more established company. Startup CEOs face a veritable Rubik's Cube of challenges, trying to run companies with constrained resources while operating in developing markets. This fundamental challenge is the essence of what this section attempts to define. Simply stated, how can startup CEOs align their constrained cash and human resources alongside business strategies that will inevitably change as their targeted markets evolve?
I believe most CEOs intellectually understand that their targeted market segments will change frequently. However, the failure of many of these same CEOs is to not synchronize their resources with this in mind. To achieve a successful outcome, CEOs must keep this continual change in mind.
The first thing to remember is that most startups fail simply because they run out of money. Cash for a startup is like oxygen for you and me. Without it, your business dies! While this is a widely understood fact, all too frequently we see startups pursuing overly broad business objectives without sufficient cash to stay in business long enough to achieve those objectives. In essence, their business strategies are not aligned with their funding realities and these companies fail without achieving the progress necessary to secure additional funding to keep going. In fact, they might have only accomplished 50 percent of what they needed to do to raise additional funding. Had they pursued a strategy that was half as broad, they might have accomplished 100 percent of their goal and been able to secure the funding required to continue.
Another common pitfall for startups relates to the timing and magnitude of spending. For example, it is common for startups to spend an inordinate share of their precious cash on marketing before their product or business model has proven viable. In the worst case, companies only serve to hurt themselves by attracting customers via aggressive marketing efforts but then disappointing them with products that are incomplete and unpolished. It's even more difficult and expensive to attract customers after a negative experience than it is to capture a new customer with a superior product or business model.
In my experience as co-founder and CEO of Quickoffice, Inc., we encountered these “business and resource” alignment challenges many times. In our early years, mobile was dominated by rudimentary mobile phones and PDAs, and our business struggled. Later, our business thrived with the explosive growth in high-end smartphones and tablets like the iPad. At each step along the way, we labored to align our resources with our market opportunity and financial resources. It was hard and we made mistakes aplenty but using a baseball metaphor, we managed to “hit with a high batting average.” We were able to successfully navigate them by following many of the themes that Matt outlines below and our efforts were rewarded when we sold Quickoffice to Google in 2012.
The alignment of your business strategy with your resources is really tough and you will rarely know you have done it well or not so well, until after the fact. I believe your goal is to achieve that “high batting average” so your business will stay healthy enough to continue forward successfully. That's the lesson I hope you take away from this section.
Alan Masarek, Former CEO, Quickoffice
BUDGETING IN A CONTEXT OF UNCERTAINTY
A lack of certainty around revenue forecasts and budgetary needs should have one certain outcome: managing expenses on the assumption of worst-case scenario—or something close to it.
After a few quarters of laying out your predictions and checking them against reality, you will probably notice two consistent themes, as I mentioned at the beginning of the chapter:
- Revenue always takes longer to realize than you expect.
- Expenses are always higher than you expect.
Again, Brad and Jason made this point very well in Venture Deals: “Since your revenue forecast will be wrong, your cash flow forecast will be wrong. However, if you are an effective manager, you will know how to budget for this by focusing on lagging your increase in cash spend behind your expected growth in revenue ” (emphasis mine).
Assume that your revenue will be lower than expected and you won't burn through your cash reserves ahead of schedule. Budget against the most optimistic scenario—and you will go broke.
FORECAST, EARLY AND OFTEN
I don't want the previous section to suggest that I'm unaware of how painful this process is. Even in industries without the radical uncertainty of startups, forecasting is a pain. To alleviate this pain somewhat when we were earlier in our revenue cycle, we adopted a 12-month rolling forecast model at Return Path, with quarterly reforecasts. Sometimes, there are simply too many moving parts in a business to provide enough visibility to produce an accurate 12-month budget. Four things in particular can make this extremely difficult:
- Investment and return. You make investment decisions every day and you can get pretty good over the years at predicting return on investment. Predicting the timing of that return can be very difficult. Products ship late; customer seasonality can factor in; marketing campaigns can take longer to pay back than you expect.
- Competition. By definition, you have even less of an idea what competitors will do—or for that matter, when new competitors will arrive on the scene. Any competitive activity can impact pricing and lengthen sales cycles in ways that are hard to predict.
- M&A. Any acquisition you make throws the entire budget into chaos, both on the revenue side and the cost side.
- Revenue gaps. No revenue model has perfect predictability. Media businesses are notoriously lumpy, cyclical and economy driven. For any business that has a recurring revenue model, missing your numbers in a given month or quarter makes it nearly impossible to get back on track for the rest of the year, since next quarter's number depend on making this quarter's numbers. This is what Fred Wilson calls the “New York Jets syndrome:” once you lose seven games, you know you're not getting into the playoffs.
Forecasting early and often is a great solution to this problem and it's a particularly effective tool to keep the team motivated. There's no shame in doing this: even large public companies consistently set new guidance to Wall Street at the end of every quarter for the following quarter and remainder of the year. Because it's a bit of a pain, I'd recommend that CEOs and CFOs follow a few practices we have learned over the years:
- Make sure you have an incredibly flexible spreadsheet model that supports the process. You can't reinvent the model four times per year. It has to be able to handle multiple scenarios with easy-to-use toggles and it has to be able to accept “actuals” as well as forecasts.
- Manage expectations properly with the board and with the team. As long as everyone knows what the process is, you can avoid a lot of confusion. The critical thing here is that neither constituency should feel like the system is being gamed or that numbers are being sandbagged.
- Compare to originals. Our model produces “waterfall” comparison charts showing how a given quarter's forecast changed over the quarters leading up to it and then how the forecasts compared to actuals. This is important mostly to produce learnings about how to forecast better in the future.
- Plan to work your way out of the process over time. Do quarterly budgets for a year or two, move to semiannual budgets for a couple of years and then try moving to full-year budgets.
This process has become much more important as the typical life-span of a startup has grown from two to three years to exit, to a decade or more. As Fred Wilson has pointed out, the preponderance of Internet companies either get acquired early on in their life (e.g., for less than $50 million) or once they have achieved escape velocity—at which point IPOs are also common. He says that the space in between, “the valley,” is where a lot of solid VC-backed companies sit and where good solid returns are made. I'd add that the valley is exactly where it's critical to forecast early and often; that's where businesses are working their hardest to grow from proof of concept to escape velocity, often with limited visibility 12 months out on their budget.
Management Moment
Follow the Facts
Successful teams know how to get outside of themselves. They have no personal agenda in mind—only the best interests of the company. They make every effort to see issues on which they disagree from the opposing point of view. They understand the difference between fact and opinion. There are so many memorable quotes on this topic, I'm not sure where to start, so I'll list them all in the hope that one sticks with you:
- Winston Churchill: “Facts are stubborn things.”
- Various: “The plural of ‘anecdote’ is not ‘data.’”
- Anonymous: “If we're going to base our decision on facts, let's hash them out. If we're going to base our decision on opinion, let's use mine.”
If everyone on a team not only understands what is and what is not a fact and all team members are naturally curious to understand and root out all the relevant facts of an issue, that's when the magic happens.