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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Q3 Performance That Blew My Mind

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Last night I got an email with a Q3 sales update from a company I’m an investor in for a while. They consistently meet or beat their plan and are an extremely well managed business. Their plan for Q3 was aggressive in my book (and they’ve managed their costs to a lower outcome) had an expectation for what they would come in at based on data from as recently as last week. I knew what they thought the upside case was and didn’t believe it so my brain had locked in on a number slightly below or around plan.

I’ve found that the Q3 number is often the hardest to make when you budget on an annual basis – Q1 is easy since you have a lot of visibility, Q2 is harder, but doesn’t have as much growth built in as Q3, then you have a heavier growth quarter with the summer doldrums (Q3) followed by the insanity that is Q4 in the annual cycle. So I usually view Q3 as “hard to beat; challenging to make.”

This company destroyed their number. They beat plan and came in at the upside case. They ran the table on new business. It was awesome to see. And it blew my mind, in a pleasant way, as this is a humble company that doesn’t overstate where it’s going.

As we enter Q4, I systematically look at the performance of every company I’m involved in for two reasons. First, I want to make sure I understand the real trajectory as they exit the year as Q4 is often an outlier, usually to the upside, as a result of end of year purchasing. I also rarely pay much attention anymore to Q4 plans as they are almost always obsolete and instead focus on the cost / burn dynamic in Q4.

It’s harder to calibrate in cases like this when a company far exceeds their Q3 plan. It’s equally hard in the other direction when a company misses their Q3 plan. And it’s really challenging when there is a big step up for Q4′s plan when you start going into the 2013 planning cycle.

I’m curious how y’all approach this, both entrepreneurs when they are thinking about their own planning as well as investors / board members when they are reacting to the early data from Q3 and thinking about Q4 and 2013.

Financial Literacy

Comments (255)

I’m stunned by the lack of financial literacy of so many people in so many contexts. The commentary by politicians, economists, and the media on the European debt crisis and the US debt ceiling dynamics is appalling. The general media and blogosphere commentary on the financials of high growth companies, especially those who have either recently gone public or filed their S-1′s, range from perplexing to just plain incorrect. And more and more entrepreneurs who I’m exposed to who are presenting their companies for financing have a complete lack of understanding of their financials – both current and projected. Of course, some of my fellow board members don’t understand how to read financial statements either, which doesn’t help matters much.

Fred Wilson took on some of this with his awesome MBA Mondays series, including several great posts around financial statements that every entrepreneur should go read right now:

In my experience there are four specific things that people struggle with.

  1. An inability to read the Balance Sheet, P&L, and Cash Flow statements.
  2. A lack of understanding of how the Balance Sheet, P&L, and Cash Flow statements fit together.
  3. A lack of understanding how non-accounting metrics (e.g. bookings) impact the financial statements.
  4. A lack of understanding of GAAP (Generally Accepted Accounting Principles) and how to use the financial statements to help normalize out all the weird things GAAP makes you do.

I used to think it was all a GAAP problem. GAAP is complicated, continuously evolving and changing, and often creates more ambiguity that it resolves. But unless you actually understand how to read a financial statement, GAAP doesn’t even come into play. And by financial statement, I don’t just mean the income statement (or P&L) – I mean the income statement, balance sheet, and cash flow statement, along with understanding how they interact with each other.

If you understand how to read the financial statements, then you can start to solve for the GAAP challenges. You’ll be able to understand things like the implications of deferred revenue on cash flow, stock option expense on net income, and the actual equity dynamics of the balance sheet.

While there are so many things about this that I fantasize about (e.g. “the media would actually learn this stuff” and “accountants would make GAAP simpler and clearer vs. more complex”) the only thing that really matters in my world is that entrepreneurs understand how to think about this stuff. So, in the spirit of Fred’s MBA Mondays series, I’m going to write a series of posts that describe how my brain processes the financial statements of a typical high growth company with a goal of adding on to the great base that Fred has created.

I’m open for suggestions as to whether I should take on one that is newly public (e.g. the S-1 and historical financials are available), or a private company (I’m open to volunteers, although it’ll mean you are publishing your financials – at least at this moment in time.) If you’ve got suggestions or want to volunteer, just leave a comment.

Beware the Hockey Stick in Your Budget

Comments (38)

We are deep in budget season as the last board meeting of the year typically includes the 2010 Budget – or at least the “2010 Draft Budget” or “2010 Budget – Draft”.  This is also known as “the joy of cramming a spreadsheet into a powerpoint presentation.”

The budgets I see generally fit into one of the following five categories.

  1. Pre-Revenue: We are pre-revenue and won’t generate revenue in 2010.
  2. First Year of Revenue: We are pre-revenue but will generate our first revenue in 2010.
  3. Growing Revenue: We are on a revenue growth curve in 2010 but will lose money every month.
  4. Becoming Profitable: We are currently losing money but will become profitable in 2010.
  5. Profitable: We are profitable every month this year.

While I’ve written about this before, it’s worth noting that “profitable” is often used to mean either EBITDA positive, Net Income positive, or Cash Flow positive.  These are three totally different things and you aren’t really in a happy profitable place until all three are true.

Of the five types of budget categories above, three (#2, #3, and #4) typically have the “hockey stick problems.”  Specifically, the revenue curve in the budget model looks like a hockey stick throughout the year with steep revenue growth in Q3 and Q4.

The hockey stick revenue helps justify additional head count and an overall ramp in expenses.  If the revenue plan is correct, this is fine.  But the revenue plan is rarely correct, especially in Q3 and Q4.  As a result, the expense base in the budget is much too high.  One of two things happen – the budget breaks (and gets ignored) or the company continues to operate on the expense budget (or some approximation of it), resulting in a much bigger loss and cash spend than forecasted at the beginning of the year.

There’s another issue – hiring is often front end loaded and the timing is somewhat unpredictable.  It’s also hard to “unhire” a month after you’ve hired someone because you are below budget.  While some people talk about people as a “variable cost”, it’s a tough variable cost to immediately turn to zero shortly after you’ve hired someone.

Each case is a little different, so let me spend some time on how I think about each one.

First Year of Revenue (#2): The problem in this case is that the company will burn through its capital faster than expected.  You can solve for this by forcing the expense budget to look like a pre-revenue budget (e.g. assume no revenue).  When revenue starts to ramp, then you rebudget, even if it’s mid-year.  Basically, discount all revenue to zero until you start generating it.

Growing Revenue (#3): This is the trickiest of the three cases.  You have revenue.  You want to spend more money to grow revenue (this is rational).  You expect revenue will grow nicely (maybe, maybe not).  In this case, I suggest you build the budget and then shift your expense plan forward by one quarter.  This delays the spending ramp by 90 days which enables you to see if you are ramping revenue as expected. I’ve rarely seen this slow down the revenue growth and, when it’s clear that revenue is ramping ahead of plan, you can always layer in some expenses explicitly ahead of plan.

Become Profitable (#4): Similar to #3, you start by lagging your expense ramp by a quarter.  Equally important, you should manage to a net cash number (cash + borrowing capacity – debt) and make sure you never fall below a threshold that is set as part of the budget process.  Once you start generating positive cash flow, you can rebudget, just like case #2.

I find that Pre-Revenue and Profitable companies typically don’t have the hockey stick problem in the budgets.  Pre-Revenue don’t by definition since they have no revenue!  Profitable companies have usually been through the cycle so many times that (a) they understand how to be realistic about revenue growth and (b) they are so happy to be profitable and self-sufficient that they err on the side of under-budgeting revenue and then expanding their expense base as they exceed plan.

Be smart – avoid the hockey stick.  Even when you are playing hockey!  It hurts when it hits you in unexpected places.

Don’t Adjust My EBITDA

Comments (2)

In my first business, we didn’t have a line for EBITDA on our financial statement.  We went straight to Net Income.  We knew our cash flow from our statement of cash flows (and our bank account which we checked regularly since we were self funded.)  We never talked about EBITDA, nor did we ever feel the need to come up with things like “Adjusted EBITDA.” 

Now – I went to business school so I knew what an EBITDA was – I just didn’t care much about it at Feld Technologies because it didn’t matter.  Cash mattered the most.  Cash Flow mattered next.  Net Income mattered a distant third (as long as it was positive every month – it got more important if it was ever negative, but it was still third.)  The list continued.  EBITDA was not on it.  This was 1987 – 1993.

Earlier this week I looked at financials for a company I’m not involved in.  Cash has been vanishing at an uncomfortable rate so I was asked by a friend who is involved in the company to dig into the financials to try to understand what was going on.

The first financial presentation I saw focused only on adjusted EBITDA.  It was sort of defined, but not really very clearly (I didn’t know the dynamics of the elements of the adjustment well enough to have a good understanding at first glance.)  Cash flow was buried in one of the back pages of the financials (and not explained in the presentation.)  EBITDA wasn’t really visible; Net Income wasn’t really visible – it was all revenue and adjusted EBITDA.

Revenue was strong (it’s a good sized company – not huge – but nice growth.)  Adjusted EBITDA is positive.  Balance sheet cash is declining rapidly month over month.  Hmmm.  That doesn’t work.

I punted on the financial presentation (e.g. please don’t send me your explanation – just send me your cash flow statement, balance sheet, and income statement – by month for the last twelve months – as it comes out of your accounting system.)  Easy to do – I had it quickly.

EBITDA is very negative.  However, it’s still not as negative as the cash flow.  This is an equipment intensive business so about 50% of the delta was “adjustments associated with customer acquisition”, 25% of the delta was capital equipment (CapEx) investments, and 25% of the delta was “other things that got rationalized as adjustments to EBITDA.”

Not only was adjusted EBITDA pointless, it completely obfuscated what was going on.  However, the CFO of the company was spending all his time focusing his CEO and investors on adjusted EBITDA to explain how the business – while losing piles of cash – was really doing just fine on an operating basis “if you just didn’t count these couple of things.”

Last week the WSJ Journal has an article titled Profit as We Know It Could Be Lost With New Accounting StandardsThere is a potential massive overhaul in financial reporting coming (the accountants and the AICPA will need something to do in 2008 now that everyone is finally figuring out how to deal with SOX) – you can see some before and after examples here.  They are actually pretty interesting (as interesting as accounting gets – not up there with Lost or 24).  However, the first step is banishing all of the “adjusted stuff” in the financials.  Not helpful.

Book: No Vision, All Drive

Comments (3)

I’ve gotten to know David Cohen and David Brown through our work together at TechStars.  DavidC and I have talked a little about Pinpoint (the company that the David’s co-founded) and I’ve had one meeting at ZOLL Data Systems (the company that DavidB runs that is a subsidiary of the company that acquired Pinpoint.)  But I didn’t really know their story.

DavidB took some time off (left ZOLL but then went back.)  During this time he wrote No Vision, All Drive.  I love self-told, first person, authentic entrepreneurial stories (one of my favorites was The MouseDriver Chronicles.)  DavidB did a great job of telling the Pinpoint story – starting at the very beginning – and sticking to the story rather than veering into the prognostication zone that so many authors of business stories feel compelled to go to.

Pinpoint (and subsequently ZOLL Data Systems) is one of the great sleeper stories in the Boulder software scene.  They grew steadily from founding, survived the bubble gracefully, never raised any capital, and had a very nice exit when ZOLL acquired the company.  DavidB’s tale will be familiar to any startup entrepreneur and is inspiring to anyone that aspires to start a company.  The anecdotes about DavidC were hysterical and help me better understand one of my co-conspirator at TechStars.

I’m on a “read each Kurt Vonnegut book in order that he wrote them” (I’m on number two – The Sirens of Titan.)  I’m putting a non-fiction book in between each Vonnegut book – No Vision, All Drive was a good choice.

Finally, Amy just wrote about our morning visitor if you want more “bear in the driveway pictures.”  I still haven’t gone running and can’t figure out how to get my butt out of the house.

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