Clues to Spot When Appraising Early-Stage Startup Budgets
Startup budgets in an era of disruption can be anachronistic. Yet, there are valuable qualitative insights to be gained from reviewing forecasts.
For investors, the weight of importance placed on financial projections increases with the progression of funding rounds. At the seed and early-stage, some entrepreneurs obsess over budgets because of the warm fuzz of doing a box-checking process. Investor attitudes to such forecasts can vary, some:
- Disregard them completely
- Only focus on top-line metrics
- Use something in them as a polite excuse for passing, which can cause unnecessary strife during the post-mortem
- Get hung-up on inconsequential bottom-line minutiae
Budgets in an era of disruption and intangibles can be anachronistic. Nevertheless, despite the tendency to be well-intentioned guesswork, there are valuable investment nuggets within young startups' figures. When I go through early-stage financials, despite it being a quantitative exercise, my end goals are qualitative. The business will, understandably, follow a different path, but clues in the budget composition point towards success indicators.
The first place I go to assess the sophistication of an execution plan is budgeted marketing spend. I do this, because in the chain of growth drivers, more often than not, marketing is the accelerant. How a budget expresses marketing goes a long way towards demonstrating how well-considered the business plan is.
Most boilerplate budget templates account for marketing cost as a percentage of revenue, which, in my view, is sacrilegious. Marketing drives sales and, thus, must be budgeted for before the event.
Some seed-stage startups may not have a grasp yet on what conversion rates and costs may be, which is understandable. Some guestimation tactics that can overcome this are:
- Using keyword searches for Google Adwords to guess CPC
- Referencing published statistics for the wider industry and applying a newcomer discount
- Measuring traction to date as a ratio against progression-based variables like AlexaRanking, social media followers, Beta users and referral rates, etc.
- Using a cold-calling exercise to prospects to validate conversion rates
- Trying out case studies for virality and conducting post-mortems on their impact
Compelling seed and early-stage investments will have some crude form of to-date traction. Budget quality vastly improves when there is more forensic analysis of factors that earned success and addresses means for leveraging them. Answering the "what" and "why" not only focuses the team internally but will curry favour with investors, by pre-empting their eventual investigations.
Bonus points also apply to budgets that strip out inflated traction, like:
- "Friendly" sign-ups
- Growth from paid users offered an arbitrarily low lifetime price
- Ambiguous classification of active users
- Paid-for social media follows (HypeAuditor is intriguing for seeing when account purchased followers)
Drivers of Revenue
A revenue expansion story comes from:
- Improving retention rates
- Increasing wallet size
- Outbound (paid) acquisition
- Inbound (organic) referral
Elaboration on what drives increases in these levers is what makes budgets interesting. Often explanations of capital deployment will have scant attribution to how spend on product features, staff or expansion will improve top-line areas.
Attaching role-specific KPIs to hiring may seem rudimentary, but helps to illuminate a plan and build a more believable growth narrative. All too often, General & Administrative (G&A) costs will lack deep thought as to how they are driving top-line growth. Expenses increase as the company grows, but lacking justification for why, aside from empire building. A place to start is labelling each line item in the forecast for what it relates to
- Core G&A: Office managers, team coffee, etc. Things that are there to keep the lights on but are "back office", to use banking parlance
- It's also important to split out OPEX G&A from COGS G&A, the latter relates to fulfiling the service delivery
- Sales & Marketing: Attributable to getting revenue through the door
- Research & Development: Attributable to building IP, which needs to tie into features that improve price or cost advantages
Once split out as such, logic abounds as clarity appears about where growth will come from and the necessary cost to achieve it. There can be a tendency to apply simple straight line
=a*(1+x) formulas to increase expenses, but many OPEX items are step-bound: For example, x more cloud servers when users pass a specific milestone.
Salaries, Headcount and Options
A budget that shows generous executive salaries and no provisions for staff stock options can be a good clue towards the long-term intentions of founders and company culture. Likewise, aggressive headcount expansion plans without empirical justification may show a lack of organisational design foresight.
Hiring is never immediate, and the barbell of inevitable of staff churn further disrupts progress. It may not appear aspirational to account for staff half-life in a forecast, but accepting the reality helps plan realistic routes forward.
Underestimation of Complexity
The song and dance of showing incredible expansion and hockey stick growth has, to an extent, corrupted the early-stage budget process. Nuances of strategies, like country-by-country growth, are more profound than just adding a new row into a spreadsheet. Naivety walks on a tightrope of ambition, but a more functional budget is one that states the KPIs and conditions necessary for validating staggered expansion.
The same applies to returns and warranty costs. If we look at the former, even well-established e-commerce operations like ASOS still have margin problems with free returns. Startup budgets often have no consideration of operational complexity and strategies for improving it.
Assumptions and Justifications
Look for the reasoning behind planned price/cost increases, wage growth and so forth. If the figures seem superficial, press further. A well-thought-out budget does not require an embedded 30-year inflation curve. Deeper consideration about the drivers behind variables shows attention to detail and most importantly, a quantitative mindset towards what grows companies.
Some tools to deploy here:
- Price tracking websites (e.g., Price Archive ) show inflation trends for certain types of products. On a bigger picture, such trends will point towards whether a product is becoming a commodity.
- Cost of living calculators (e.g., Numbeo) give indications towards price differentials between nations.
- Labour costs from Government statistics sites (e.g., BLS in the US) will show wage trends for sectors and job types. Glassdoor and LinkedIn also have useful datapoints.
Remember, the goal of a budget is to demonstrate why capital is the gasoline in the engine of growth. I am not condoning a life of parsimony, but if there is an identified catalyst, amplify its effect by mitigating cash burn in other areas:
- PR: Invest in content generation and social media managers instead
- Offices: Save the big spend for later and rely on remote working
- PAs and admin staff: Contract virtual assistants for scale, flexibility and cost advantages
- Travel: Necessary, but often justified in a linear fashion without reasoning as to why travel is occurring
- In-house counsels and accountants: Lean on external resources until it becomes a 9-5 job
- Elaborate staffing hierarchies: For a seed company, three-to-four levels will suffice
A Map, Not a Piece of Homework
Successful budgets are like the coffee-stained road atlas hidden away in a glove compartment. They are long-lasting and always there as a reliable map for plotting the progression of a business.
If you are building a forecast and your heart is telling you that it's just a piece of marketing collateral to raise money, with dubious utility going forward, then save yourself the time and either:
- Think of a different way to express the potential of the venture, if the organisational design component of it is too nascent to conceptualise
- Take a step back and start again. The advantages of this are that even if you fail to raise money, you will at least have a tool to guide future steps.
In terms of recommended template examples for startup budgets, the best publicly-available version I have seen is VC Christoph Janz' SaaS example; credit to him for making it and sharing it!