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Our friends Dick and Jane have decided to disband their company. The last two months had been tough for Dick and Jane – each of them felt the other wasn’t living up to their commitments. Praveena was working hard on the product, but as she observed the tension mounting between Dick and Jane, she started answering calls and emails from the recruiters who had been hounding her since she left her previous job.
One night, a few weeks ago, Dick finally acknowledged to Jane that he was feeling incredible financial pressure. Dick and his wife Mary never really had agreed that Dick should take the plunge and start SayAhh. Dick was struggling to admit that he wasn’t fully committed to this path, even though he had been really excited about starting the company. While he was taking a salary, it was modest, didn’t cover his monthly expenses, and the combination of financial and daily work pressure were causing a lot of friction at home. Dick told Jane that Mary was being awesome and that she’d keep being supportive, but it wasn’t working for them as a couple.
Jane was surprised but calm. She felt it was important to bring Praveena into the loop since since they were all partners now. Over dinner, Dick, Jane, and Praveena discussed where they were at and how Dick was feeling. Praveena acknowledged that, while her relationship wasn’t causing any stress (she was involved with the founder of another company) she was having a lot of trouble working in the unstructured environment of a startup. She admitted that she was having serious conversations with a very large technology company in town about joining them as a PM for a product she was really excited about. Dinner went on a long time, had a lot of emotion in it, but ended without any specific resolution.
Jane didn’t sleep at all that night. She couldn’t believe that she’d missed these signals with each of her partners. She thought they were each as committed to SayAhh as she was. She went through a huge range of emotions dominated by anger, frustration, sadness, and depression before getting a clear grip on what she wanted to do just as the sun started coming up. A mentor of her’s once said “don’t ever make a final decision when you are tired” and she wanted to heed that, so she decided to tell Dick and Praveena what she was thinking when they got to the office, but leave it open for a final decision through the end of the weekend.
The conversation in the office was anti-climactic. Each of the partners had the same sleeplessness night and they all shared that as hard as it was to admit, they didn’t feel like they could go forward as a team for various reasons. It was not an angry conversation, but it was a sad one. But honest. They agreed to disband for the weekend (it was Thursday), have a long, quiet time thinking over what they wanted to do, and get back together first thing Monday morning.
On Monday, at 9am, Dick, Jane, and Praveena decided to shut SayAhh down. Dick had already talked to his previous boss who welcomed him back if he wanted to come back. Praveena had gotten a final offer from BigTechCo which she had a week to accept. And Jane had decided that she wanted to keep working on a startup, but wanted to hit reset, find different co-founders, and take more time making sure the idea was sound before they started spending any money.
They had $32,000 left of the original $70,000 in the bank after paying off all of their bills. The founders decided to split the remaining $32,000 between Jane and Praveena based on their capital investment, so Jane got 5/7ths and Praveena got 2/7ths. Jane took on the task of winding everything down, sending out notes to all of the people who had helped them, and Dick, Jane, and Praveena agreed to collectively hold their heads high, stay friends, and be glad that they called it quits before things spun out of control.
While Jane was building SayAhh’s revenue projections, Dick focused his attention on building the expense side of the projections. He procrastinated for a few weeks because he was deep in product development, but surfaced a few days ago when he realized they had an investor meeting coming up and really should have at least a basic financial model ready in case the investor asked about it.
Before building his projections, Dick needs to make three main decisions:
- Should he build a simple cash forecast or a set of projected financial statements?
- What are the right drivers for each expense category?
- How should he account for unforeseen expenses?
1. Cash Forecast vs. Projected Financials – What’s the difference?
A simple cash forecast is just that – it is a model that helps anticipate cash balances over time. It is simple in that it forecasts how much cash will be coming in the door (revenues + equity financing + debt financing) and then subtracts from that amount how much cash is expected to be going out the door. The expense forecast tends to be organized by what the money is being spent on such as office space, employee salaries, or computer hardware and software.
Building a set of projected financial statements is more complicated. For one, it requires keeping track of not only what the company is going to be buying, but also where the purchased goods/services are used. In the straightforward example of a widget manufacturer, expenditures on electricity (the “what”) can get spread across multiple line items on the Income Statement. Part of the spend may be assigned to Cost of Goods Sold, part to Marketing, and part to General & Administrative, all of which can be separate line items on the Income Statement (the “where”).
Creating a set of projected financial statements also requires understanding different types of expenses. Specifically, is an expense an operating expense (generally speaking, spend on a good or service that is consumed immediately) or a capital expense (spend on an asset that will be used up more gradually over time)? The former will impact the Income Statement, Balance Sheet, and Cash Flow Statement while the latter will only impact the Balance Sheet and Cash Flow Statement (although as the asset depreciates, the depreciation will show up on the Income Statement).
To keep track of all of this, companies assign every expense to a Cost Center (tells where the spending occurs, indicating the line item on the Income Statement that will be impacted), a Cost Code (which indicates what was purchased, e.g. Office Supplies, Salaries, Utilities, etc.) and a spend type (e.g. Capital vs. Operating).
Finally, building projected financials requires a strong understanding of the interactions between the three financial statements.
Due to the added complexity of building projected financial statements and because Dick and Jane are currently focused on cash, Dick chose to build a cash forecast. This is fine for now, but eventually SayAhh will need to become sophisticated enough to build projected financial statements.
2. Choosing the right drivers for each expense category
Just as it was important for Jane to choose the right drivers for her revenue projections, it is similarly important for Dick to choose the right drivers for his expense forecast. Since this was addressed on the revenue side, we won’t go into details on the expense side.
3. Accounting for unforeseen expenses
Dick is confident that his forecast will capture SayAhh’s major business expenses. But how should he forecast unanticipated expenses? Dick decided that unanticipated expenses will be equal to 10% of anticipated expenses in order to provide a cushion in SayAhh’s budget.
4. Putting it all together
With that, SayAhh now has their initial set of revenue & expense projections. Subtracting the expenses from the revenues provides a forecast of cash flow from operations. Dick and Jane are not currently anticipating any additional cash flow from financing (or investments), so these projections are a good indication of SayAhh’s anticipated cash burn, which will help Dick and Jane determine when/if they need to raise more money.
Since last checking in with the SayAhh team, they have spent a few months consumed with building an early version of the product and speaking to potential customers, all the while watching their cash balance steadily diminish. They realize the clock is ticking and have decided that it is time to create a robust set of financial projections in order to provide themselves with a better sense of when they will need to raise more money.
The co-founders decided to divide-and-conquer, with Dick tackling expense projections and Jane tackling revenue projections. Their plan was to combine the two in order to predict their cash burn over the next two years (with a focus on the next twelve months). Jane asked Josh, who provided SayAhh with solid advice on setting up their accounting systems, for help in creating the revenue side of their financial forecast. Josh told Jane to take a first shot and he would comment. Here’s a snapshot of what Jane produced:
Josh worded his feedback carefully:
“Jane, this is a good start. I am glad to see that you are forecasting revenues based on business drivers. In this case, the # of users and the average monthly revenue per user. That’s what you should be doing. However, do you really understand the key underlying drivers of your business? Based on the drivers you chose, I am not so sure you do.
Certainly the # of users matters. But take it a step further. What drives the # of users? Presumably you will have new users, return users, and lost users each month. Decomposing users into these three component parts is important because it will allow you to better understand what is going on with your business, which will in turn allow you develop actionable strategies for improving your business.
For example, assume the # users remains flat for four months in a row. If you only track monthly users, you might assume that you are not attracting any new users and you need to change your marketing approach. However, what if it turns out that your marketing approach is just fine and you are bringing in lots of new users every month, but at the same time you are losing an equal number of existing users? In that case, the problem is that users don’t like your product. You need to fix that problem, not adjust your marketing approach. Take another shot at this and come back to me with a model that you think drills down to the key drivers of your business.”
Jane did some research, had a nice glass of wine, and really thought through their business model. Then she came back to Josh with a revenue model built on a set of key business drivers:
Josh told Jane that her second effort was much better and Jane in turn felt that she now had a much better understanding of SayAhh’s business model. A skeptic might assert that it is a waste of time for a pre-customer startup to forecast revenues since they are guaranteed to be incorrect. When I look at a startup’s revenue projections, I don’t pay much attention to the actual numbers for just that reason. However, I do look at the structure of the model to see if they really understand their business and are actively tracking their key business drivers.
In the next post, we will see how Dick fares with the expense forecast.
Note that Jane’s second attempt is a step in the right direction, but by no means perfect. Tying the number of new users to advertising spend seems particularly questionable, for example. What other problems do you see? What has been your experience/advice in developing revenue projections?
Now that Dick and Jane have added a CTO to SayAhh’s founding team, they’ve turned their full attention to working on their product. Today, we’ll look at the impact of the expenses to date on the P&L, Balance Sheet, and Cash Flow Statement.
Since SayAhh is in the pre-launch development stage, the company doesn’t have any revenue yet. They also haven’t launched a product, so there is no corresponding “cost of goods sold” – the direct cost of delivering their product. This results in a gross margin of $0, where gross margin is revenue – cost of goods sold.
The default Quickbooks setup uses “Income” to refer to “Revenue”. Since the Income (“Revenue”) line is $0 and the the gross margin is $0, Dick and Jane haven’t really noticed this yet. For now, we’ll leave it as is but once Dick and Jane meet with a mentor who is a CFO we expect this will change.
As of Aug 31st, here is their P&L.
The largest expense a company usually has at this stage is salaries. However, Dick, Jane and Praveena have decided to initially forgo salaries which helps them conserve cash in the near term. A company at this stage could also face product development costs from consultants if they decided to outsource product development. However, Praveena has committed to personally get the first version of the product up and launched without outside consultants, so there is no expense here either.
Dick is focusing his effort on getting some early customer validation and is using a Lean Startup approach. Dick’s friend Samir, who is hoping to land a job with Sayahh, agreed to put together several static landing pages and email collection forms. Once these were up Dick launched several AdWords campaigns to test customer interest.
Dick, Jane, and Praveena decided to get a small office so they could work out of the same space. Dick recently had a child and didn’t want to use his house as it was too distracting, and both Jane and Praveena felt like their apartments were too small to all cram into. They made the decision that being together every day was better than working separately, so they signed a 1-year lease at $1500/month (prorated from mid-August) and they invested $1930 in capital improvements to remodel the entryway and install a sign. After signing the lease, Samir suggested that they could have saved a lot of money by using a co-working space but once the decision was made and the lease signed, there was no turning back.
In addition to the capital improvements (which show up on the balance sheet below as “Leasehold Improvements”) our fearless founders bought some tables, chairs, and a few other random things at Office Depot. Both the renovations and furniture purchases are “capitalized” on their balance sheet rather than being expenses on the P&L. While the cash is gone, the “expense” is “depreciated” over several years (depending on the type of asset).
Following is the balance sheet and the changes from July to August.
Our founders had some other expenses, including business cards and a trip to an industry conference where they talked to a number of potential customers. While the conference was educational, Dick and Jane were frustrated with the dull gaze they got from uninterested prospects when they tried to explain what they were doing, but couldn’t actually show anything. On the flight home from the conference, Dick and Jane agreed they both needed to help Praveena get the first product out, whatever it took.
Following is the third key financial statement – the Statement of Cash Flows.
In total, SayAhh burned through over $8000 during the month. Annualizing this number, SayAhh could expect around $96,000 in negative cash flow for the year. However, Jane realized that $3430 associated with the new office space security deposit and rennovations is essentially a one-time expense. This resulted in an annualized burn rate more in the neighborhood of $55,200 ($4,600 * 12).
As Finance Fridays continues, we are introducing the concept of the Cap Table. We recognize that we are still at the very early basics stage, but as we are taking a case study approach to this we feel like we have to set up all of the pieces before we get into the messy guts. Hopefully you are staying with us and finding this useful – feedback welcome!
Jane and Dick, our fearless cofounders of SayAhh, have set up an accounting system and created their first set of financial statements. This week they set out to create their cap table and hire a CTO.
The founders each have common shares that will vest over four years. The vesting schedule protects each of the co-founders in case one gets hit by a bus or decides to drop the project after a short period of time. Also, there is an important tax election called an 83(b) election that they made which allows them to recognize and pay taxes for very small income of the value of the shares. Later, if they sell, the low tax basis and capital gains tax rates result in a lower tax liability than if they didn’t file the 83(b) election.
Equity is split 55% and 45%, but where is that officially recorded? It is not in the three primary financial statements (the Balance Sheet, Profit & Loss, and Cash Flow Statement.) Rather, it gets recorded in a document called the Capitalization Table (or “Cap Table”), which shows the ownership stake each person or entity has in the business.
Below you can see Jane and Dick own 55% and 45%, respectively. As first time entrepreneurs they did not create an employee options pool; we’ll fix that in a little while.
Jane and Dick want to bring in their friend Praveena as CTO, but they don’t know how to structure the compensation. They come up with two options:
- Hire Praveena as an employee and offer her stock options.
- Bring Praveena in as a founder and offer 10-20% of the company as stock.
The benefit of hiring Praveena is they think they could keep more equity and control of the company. But, Praveena hails from the land of big paychecks and is not ready to leave that without considerable equity. With the funds Jane and Dick have, a big salary is not possible. Praveena wants to invest $20,000 and get 20% equity.
After several discussions (and more beer), Jane and Dick agreed with Praveena to bring her on as a cofounder where she invests $20,000 and also gets 15% equity. Praveena is just like the other two founders, where her equity will vest over 4 years. Time to update the cap table.
When you read the cap table, think of it as a series of events that add new columns to the right. Now there are two events: the initial issuance of founders common shares, and then issuing new founders common shares along with creating an options pool. In this manner, you can see both the current equity distribution of the company, as well as historically what the equity holdings looked like.
If the full pool were to be given out, the dilution is fairly significant to the founders. They would own from 55% and 45% down to 36% and 29%, but until options are exercised they are not diluted. Jane and Dick contemplated a small option pool because they had read about the risk of an option pool shuffle, but ultimately decided to make it 20% based on feedback from their friend Josh, a Boston-based venture capitalist.
Our (now three) co-founders begin building out their product. The co-founders have savings to live off of and cash will be conserved by not having any salaries. Next week we will fast forward to when they have a beta product and they build a model to pitch to investors.