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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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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.

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  • Giff

    Great post brad but I laughed when you wrote that companies *generally* fall into these five categories.

    I guess there is also “we have no revenue, we will have no revenue, and we have no intention of ever having revenue!” Now that board meeting wouldn’t be pretty ;-)

  • http://twitter.com/reecepacheco @reecepacheco

    I've been hit with real hockey sticks. It's not fun.

    I imagine it's similar when it happens in a board meeting.

    That being said, you need a hockey stick to 1. play the game and 2. to score goals. Important to remember. ;)

    • http://intensedebate.com/people/bfeld Brad Feld

      Unless you are playing football.  Or tennis – hockey sticks are pretty useless on the tennis court.

      • http://www.petelatshaw.com Pete

        We used to play street hockey on the outdoor tennis courts in the winter…it's a great surface, but you have to watch out for the net posts. They will body check the crap out of you if you're not paying attention.

        With #3 you don't want to accidentally choke off growth, but how often is that the problem? The one quarter shift is good practical advice especially for internet companies. It gets tricky for companies targeting the enterprise if the plan requires a direct salesforce ramp. It can take awhile for reps to develop business and territories, and they ultimately have to deliver the hockey stick. A lot of books have been written about this problem. I like Steve Blank's thinking on proving out the sales model before investing in sales capacity. But it's a lot clearer in theory than in practice!

        • http://intensedebate.com/people/bfeld Brad Feld

          Where I grew up we played street hockey in the street!  The cars were the danger, not the net posts.

          Totally agree on Steve Blank’s thinking – http://steveblank.com/ for anyone interested

  • David Semeria

    CF positive trumps paper earnings by a country mile!

    • http://intensedebate.com/people/bfeld Brad Feld

      Indeed it does!

  • http://intensedebate.com/people/Greg4 Greg4

    I'm a little surprised that startups, with inherently unpredictable revenue, don't rebudget on a quarterly basis as a matter of course. It wouldn't be that hard to do analytically, and I would think the board would demand to see that thought process (e.g., "revenue was 30% over/under forecast, what does that mean for the hiring plan?").

    Also, what does everyone think of using contract resources to adjust expenses? It seems much easier to scale those costs up and down faster. These days, the search and transaction costs seem pretty manageable. The trick is finding non-core areas where you don't need all the learning to be in-house.

    • http://intensedebate.com/people/bfeld Brad Feld

      I find quarterly rebudgeting to be too much chaos and overhead.  The only time I like to see a rebudget is in Q2 if there’s a material miss in Q1 (since Q1 should be so easy to make).  Many startups that I’m involved in do two semi-annual budgets – that’s both manageable and typically very effective.

      Regarding contract resources – I’m generally biased against them in startups.  I find that things work much better if everyone is fully on the team.

  • Rob K

    Brad- Good post, but this "caution" is slightly at odds with your "add another zero" mantra

    • http://intensedebate.com/people/bfeld Brad Feld

      Not really.  Separate the “future vision” (over the next X years – where X could be five) and the next 12 months budgeting.  Every business should deal with both of them.  It’d be a huge mistake for a startup to anchor on one vs. thinking about both.

  • DaveJ

    Accept mystery.

  • DaveJ

    Another thing companies with hockey-stick projections do is, when they see that they are 20% below projection in Q1, they look at the year's budget and assume that they can easily make it up in Q3/Q4, since that shortfall will be a relatively small fraction of the Q4 number. But instead they should assume that they are on track to be 20% below in all quarters – mathematically this is the best assumption (and if anything, it will probably get worse).

  • Mark MacLeod

    Great actionable tips. Thanks

  • http://intensedebate.com/people/bfeld Brad Feld

    Correct.  And – if you miss Q1 (which is the easiest quarter to make), I now force a rebudget for the balance of the year in all cases since I’ve been burned by this so many times in the past.

  • http://www.facebook.com/brisbourne Nic Brisbourne

    A beautifully clear post Brad. Very helpful.

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  • Jim

    Brad, serious companies engage in deep actual planning that justifies revenue growth and commensurate investments to achieve such. Unfortuantely, that is a long lost art today, especially in VC-backed companies, or so I find, compared to VC-backed companies back in the 1980s, early 1990s. Larry Bossidy and Ram Charan espouse the virtues in their excellent book "Execution." Unfortunately, today, I find exceptionally few CEOs (or VCs) that have that level of experience.

  • Zack

    Brad – this is great advice for entrepreneurial companies of all stages. As a venture lender, I see tons of plans and can vouch for the hockey stick problem in case 3 (growing revenue). Too heavy a reliance on growth rates leads to inaccurate and often-times hurtful expense forecasting, which can really hamstring companies in a year when the top line doesn’t materialize as planned. Often, the end result is the need for more capital at a price which is not too entrepreneur friendly.

  • http://www.venturearchetypes.com Nathan Beckord

    When building financial forecasts– especially in the context of presenting them to existing or future investors– I find it helps to build what you truly expect to happen over the coming year, then stagger sales by 2-3 months and double expenses and see what happens to cumulative negative cash flow. We keep a tab open that summarizes this figure so we can see the level of sensitivity to these changes. But the challenge is to avoid the tendency to present what you think investors want to see…if a company presented what they really believed to be both 'realistic' and 'worst case' forecasts, wouldn't most investors want to automatically apply a haircut anyway? (i.e., since they're so accustomed to overly optimistic hockey stick projections…the metaphor perhaps is grade inflation)

    • http://intensedebate.com/people/bfeld Brad Feld

      Smart approach!

  • http://twitter.com/markstoneham @markstoneham

    It hurts more when you get whacked with your own stick. I find the best resource when revenue forecasting is a sense of reality, and as a CEO it's a hard thing to attain in all the excitement of growth (or anticipated growth).

    If you get yourself in a situation where you are ramping the numbers because someone in particular expects them to, then expect to feel your stick coming back at you in six months – as Brad says, Q1 is easy… Instead, use your board to cross-check your own sense of reality on growth. It's not weasling out on taking decisions, but regard them as a resource that isn't 24/7 on the same thing that you are and might have a more balanced view.

    It's always better to get the revenue forecasts right than expenses. If revenues miss it's always a surprise. Costs are very predictable and happen in slow motion. Nobody likes (bad) surprises!

  • http://dminkin.tumblr.com/ David

    I like that I'm in the trickiest of all cases. Also, I'm not entirely clear–how does one shift their expense plan forward one quarter? So what does that mean for our expense plan in the present?

    • http://intensedebate.com/people/bfeld Brad Feld

      Build the model that you plan to have prior to the “move the expense plan forward one quarter.”  Then – after you’ve built your plan, shift the expenses forward by three months – basically repeat Q1 in Q2, then Q3 is what your old Q2 was, and Q4 is what your old Q3 was.  This will take a little massaging since things don’t work out perfectly on month / quarter boundaries, but you basically control expenses in Q1 and Q2 (so your first half of the year is approximately Q1*2) and then you start scaling in Q3.

  • http://www.facebook.com/StartupTrek Steve Bell

    Here's the thing… it's not just a revenue projection! The underlying customer relationships, business development contracts, and contractual understandings are what creates revenue. The management team's integrity, right?

    If a startup's management team is projecting revenue that may or may not happen, with the numbers coming in from a sales force, or b-d director who really isn't sure.. then that is a "wishful thinking" scenario, with low probability of execution.

    Right? Otherwise… what am i missing here…

    -steve b.

    • http://intensedebate.com/people/bfeld Brad Feld

      While I agree at a conceptual level, this is what gets put forth as a “revenue projection” in many cases.  The underlying problem is not “management integrity”, it’s a combination of “spreadsheet math” + “optimism” + “pressure on the cost side to expand the expense base to grow.”  This is easier to deal with when you are a profitable company – when you are still losing money all of the bad inputs tend to creep in all at once with no governor on them.

  • http://www.ajira.com Nari Kannan

    Brad:

    One of your best posts! Great advice for young companies, especially on staggering expenses by a quarter while letting revenue lead!

    – Nari

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