a16z Podcast - Navigating the Numbers

Episode Date: April 4, 2020

For any business, there are three core financial statements – the income or P&L statement, the balance sheet, and the cash flow statement. While these statements can show investors and the board how the business is doing, they can do more than just keep score on your business – they are one of the best tools you have to run it.In this podcast, a16z General Partner and managing partner Jeff Jordan, who previously ran several businesses and took a company public right after the 2008 financial crisis; David George, who runs the a16z late-stage venture operation; and former CFO Caroline Moon, who leads the a16z financial operations team, break down what the numbers do (and don’t) tell you, both in financial statements and KPIs. They cover the most common mistakes people make when it comes to understanding their numbers; how investors look at a company's P&L; what metrics they use to determine if a business is healthy; and how founders can use the numbers to navigate in times of crisis.

The content here is for informational purposes only, should not be taken as legal business tax or investment advice or be used to evaluate any investment or security and is not directed at any investors or potential investors in any A16Z fund. For more details, please see A16Z.com slash disclosures. Hi, and welcome to the A16Z podcast. I'm DOS, and this episode is all about what the numbers, both financials and KPIs, do and don't tell you about your business. Our guest for this episode, our A16Z general partner and managing partner, Jeff Jordan, who previously ran several businesses and took a company public right after the 2008 financial crisis, David George, who runs our late stage venture operation, and Caroline Moon, who leads our financial

operations practice and helps companies with their own best practices. She's also a former CFO. In our conversation, we cover the most common mistakes people make when it comes to understanding numbers. What investors think when they look at a company's profit and loss statement and why? How investors use metrics to determine if a business is healthy and how some founders may use them to navigate times of crisis. We begin, though, with the basics of the three core financial statements, the income or P&L statement, the balance sheet, and the cash flow statement. The first voice you'll hear after Carolines and mine is Jeff's, followed by David's. Especially in the early days of a startup, they'll just try to do cash accounting. And that's just literally how much cash

you have in the beginning of the period, how much should I have the cash at the end of the month. And that's not the same thing as what a P&L really should show, because your P&L paints the picture of how your business did in a particular period of time of measurement, whether that's quarterly or yearly or the cashless statement then reconciles that with what did you actually collect. And then everything that happens on that cash flow statement then ends up on your balance sheet. And the reason why it's important to be able to present it in that fashion, it's called Generally Accepted Accounting Principles, so Gap Accounting, is because that's how everyone understands that the comparisons are apples to apples when you look across companies.

So when you are trying to figure out how a business is doing, what are the financials that you look at? Typically, the early investing, you don't emphasize financial metrics that much because usually there isn't a mature go-to-market organization. I tend to focus much more on KPI type metrics, users daily to monthly users, engagement, and things on those lines. And then the financials tend to emerge over time. Yeah, I would say I care most about two very high-level topics at the later stage. The first is, can you demonstrate that you can have very persistent growth? And then secondly, how profitable will you be when you reach scale? But

I spend less time for later stage high growth companies staring at their balance sheet than I do KPIs, income statements, and cash flow. Yeah, and the main thing I look for the balance sheet is the comparison for how much traction they have on the income statement and the cash flow documents relative to the amount that's been invested in the company. So for me, the most important balance sheet metric early is how much capital is the company deployed to get to where they're going? So how do you guys know when a business is truly profitable? You know, I do think you go to the unit economics and really understand them. But this is often a lot of art as well as a good amount of science. Some of the most frustrating interactions I've had with companies are where they're presenting

that their unit economics work, but the business isn't working. And so I had one where, okay, we're capital efficient. The unit economics are working. We acquire users. They're profitable in three months. And the company was hemorrhaging cash. It turns out the unit economics actually weren't working. The cash flow statement was the arbiter of truth and the analysis that the company had done on unit economics was wrong. Yeah, I agree. I think lifetime value is one of those traps that people fall into. They're assuming, oh, you know, our customers are going to stay with us for five years, three years, so we've got plenty of time to do the payback. But that's a key driver to whether or not your unit economics work. There's nothing that's less consistent in the market

than how lifetime value to cost of acquisition of the customer. LTV to cash. is defined. What I always counsel companies and I like to see is very transparent calculations of what goes in to the LTV side and the KAC side. So the LTV to KAC metric that I like to look at is for the LTV, so the lifetime value side. I always use gross profit, not revenue. And then I like to use a shorter duration than founders typically like to use. So I like to use three years. Often founders present five years. And the point I make on that is that five years is too uncertain and long of a period of time, whereas three years is much more visible. And then use actual retention statistics that you've experienced in the past to project those three years. The thing that I

really try to emphasize to founders when they talk about these kinds of metrics is, look, this is not about necessarily showing investors. This is how you have to run your business. What am I spending on sales and marketing? What am I spending on my R&D? And how much am I spending on GNA? And is that the right level of investment that I show you making in my company? So you need to be as honest with yourself as possible as to what all these things cost you and what you're really generating in terms of revenue. Because if you can't be honest with yourself, you can't run your business. What are some of the other really common mistakes or things that founders do when presenting numbers that you'd want to help them correct or you'd like to see them do differently?

You know, one tell for me where business is probably struggling is when they come up with North Star metrics, you know, KPIs. And then when they come back to report on them a quarter later, they've changed. And then they come back a quarter later and they've changed again. And what I found a little bit of pattern recognition is when the KPI's change all the time, it's largely because they're not working. And the company's trying to navigate through it. For me, you pick your metric, you report on it. And ideally, your understanding of the business improves over time as your metric and your models are either validated or unvalidated. That leads this interesting question, I think, of the psychology and how you look at your numbers.

So how do you manage your own psychology so that the numbers are a tool, not this obsession, where it's like, my obsession is I want to reach my KPI, so I'm going to keep adjusting my KPI so I do. You know, the reason they've so defined the three financial statements is it's kind of truth-seeking and trying to fool your investors or, for lack of better word, or you're bored. I don't want to let them know how bad things are. By not telling the truth to your key constituents, you often run the risk of not telling the truth to yourself. And so I've had a couple founders where sometimes they fall prey to it themselves, where they believe their own machination and then the board and investors can't help them based on the truth. What do the best founders do, especially in challenging moments, like when the finances and the numbers maybe aren't going your way or you know that you do have to tell a difficult truth? They typically acknowledge it. They take it as, okay, the truth isn't what I wanted it to be.

So now what can I do to change the business to improve the truth? The only thing I would add to that that I've observed from some of the best founders of later stage companies is they're very careful not to drown themselves in KPI's. So you can actually inundate yourself with KPI's, but the very best ones pick out a very few handful of metrics that they think are the most important drivers of their business. And if they see those divert from where they would like them to be, they dig in from there. So, for example, Ali from Databricks always focuses on the productivity of a sales rep, because he believes that indicates health of the business in many different ways. So how well is the sales organization actually functioning? What are the market dynamics? What's competition?

How is the product performing? And you do get a real force for the trees. I have companies that will present you 50 pages of metrics based on the last quarter, and you just drown versus what in here is really important. What are the key ones? Are the one or two that matter the same for every company? Or does it depend on the nature of the company and the stage that they're at? I think to some degree, some of them are the same. For instance, retention should matter to any business model. You spent money to acquire your customer base. How long are you hanging on to them? Yeah, I find they are consistent by type of business. So marketplace metrics

typically have a lot in common with each other, but they're very, very different than e-commerce metrics. You know, the key commerce metrics typically center around the efficiency of customer acquisition. and LTV to CAC, a lot of marketplaces I work with don't spend a penny on customer acquisition. And so it's got organic distribution or something like that. So comparing across models can be challenging. Comparing within models can be very helpful. So for B2B companies, for example, the efficiency with which you spend a sales dollar, whether it's on a rep or marketing or bottoms up sales, inside sales, outside sales,

is always one of the most important things that you look to. Things change. Markets are unpredictable, which is something I think we're seeing now more than ever. How do you use finances to make better, faster decisions, especially in uncertain times? You know, I started my career in finance. I ended up as CFO at the Disney store. So it's near and dear to my heart. The typical finance function is conceived of as kind of keeping score, the accounting control function, just reporting back. For me, that was necessary but not sufficient. The finance function has access to all of the key data. And so I look at them not only to keep score, but to score points to make the business better by leveraging their access to the information and to the trends and to the unit economics to improve the business. A good finance leader needs to work with the CEO to make sure that the company has enough money to not just survive but thrive.

So that is becoming super intimately familiar with the business, not the financial statements, It's not the accounting that goes into developing these things because those just represent what's happening at the business level. They really need to understand how everything works. And then where are the levers that you can change, that you can pull on, that you can push on to accomplish the things that you want to do as a business in the time frame that you need it, all backstop with the cash that you have on hand? When I was managing businesses, I always had a mental model of how the business should work.

And that mental model typically, ideally, was consistent with the financial model. eBay at the time, back when I managed it, was a perfect economy. And eBay as a platform attracted every leading finance professional who was into micro because it was one of the most pure examples of a perfect economy. If there was an increase in supply, prices fell. If you change the fee structure, behavior change. And so it's when businesses diverge for my metal model that you really needed to pay attention. It's like, why is the conversion rate going down? My God, I've never seen go down like that. That's a big warning indicator for me. So I would typically be pretty comfortable running the business until anomalies emerge. And then I just would need to understand the driver

the anomaly. Yeah. And I can't emphasize enough how important it is for companies to understand their bottoms up for how revenue judge generated. I see a lot of people do tops down forecasting. Last quarter, we had whatever, a million dollars in revenue, 10 million dollars revenue. And then you go, okay, and historically we've grown 50% or 100%. And so we're going to model something similar to that for the next year. And so that's our number. And that's got no intelligence built into it whatsoever. What you have to do is double click on that and go, okay, so we made, whatever, $10 million

last year, how was it made? What was the makeup of that customer base? Who's likely to still be here? Who's going to spend more? Who's not going to spend more? Who's going to completely leave the platform? In marketplaces, you often get two shots at bottoms. up because you typically can build a model based on the supply or you can build a model based on the

demand. Get an example at eBay. We would look at the behavior of sellers and we had this many sellers growing this fast, doing this kind of behavior and then you just kind of roll them together and come up with a revenue estimate. Then we'd sanity check it with we have this many buyers buying this frequently spending this much and coming onto the platform at this rate. And then you'd run up that number. And ideally the two would inform each other. So one of the best CEOs who I worked with who I partnered with was George Kurtz from CrowdStrike. He had an exceptional business. One of the things when we were working together that we came to realize was his gross margins were a little lower than most other software companies that we were working with.

He actually made the decision in one quarter based on that to try and experiment where he made gross margin actually be part of the calculus for sales compensation for the reps in that quarter. And his gross margins over the last three years have actually gone from 35% to 70%. So a very operational tactical decision that can have a massive impact on the value of the business. So I wanted to go back to a point, I think, Jeff, that you brought up of having this mental model of your business and hoping that that matches the financials and how then you have those red flag moments. And I think a lot of companies right now are having a red flag moment because of a lot of circumstances vary beyond their control. I'd love to hear, what are you telling founders right now when it comes to how to think about their financials.

You know, this is one of the most significant disruptions I've experienced. And I've had a long enough career that I've experienced a bunch of them, the bubble bursting in 99, 2000, the financial crisis of 2008, 2009, which, by the way, we took open table public in May 2009. So the future isn't dictated. But a couple things come to mind. One is cash is king. You know, the income statement, throw it away.

Just look at the cash flow statement. How much cash do you have? How's the burn? and how are you adding or using cash over time. So cash becomes completely king. Throw out your forecast because the forecast is now meaningless. It was based on a bunch of assumptions that no longer hold. So throw the financial print out and start looking really hard at things like year over year, which typically doesn't lie. And then just do tons of sensitivities. And you got to do it decisively. I always like this thought exercise of how bad could this possibly get.

You know, just let's take the absolute worst. How bad could it get? And because I think people tend to do the opposite. They iterate down of like, okay, we're down 5%. I'm going to plan down 10%. But if it's going down 5% per day, plenty down 10% just met your plans obsolete in two days. And so I found it helpful both from a business prudent cash management perspective, also from a mental perspective. Don't let this just continue to erode and I get more and more depressed every day. Get really depressed one day. And look at reality and then try to change it. Yeah, I agree. So I was a CFO at a company called Adbright in 2008. And I think that at first we didn't want to believe that it could get that bad. But we were in advertising network. And so unless you were Google and even they were impacted by this, your customers weren't going to advertise anymore.

The marketing departments were decimated. So there were situations where we were like, some of this is just going to become zero. Contracts that were signed are now just getting outright canceled. So we made the decision to cut really, deep and as quickly as possible because we knew that even if we got it wrong, at least we could then rebuild the company and do it only once. And then your employees then are told, hey, we've made this big decision. Here's what we based it on. Here's our cash position. Here's what

we've sort of expecting in terms of worst case scenario. You bring them into that circle of trust of what's happening at the company. But there's asymmetric potential issues. If you underestimate how bad it's going to get and don't deal with the situation quickly, the outcome is very well be you lose your company. Yeah, death by a thousand cuts. Yeah. And if you overreact and it doesn't end up being as bad as it would have been, you might have suboptimized your company for some period of time, but it's alive. So for me, the mistake is to underestimate the potential versus overestimating. Yeah. I want to go back to something Jeff said, which was this notion of throw your forecasts out the window. Very much agree with that on the top line, on your revenue.

But you have this whole base of costs that are under your control, those are your operating expenses. And so we've spent a lot of time focused with our companies running sensitivities of, hey, this is your operating expense budget. And what's in operating expenses are your salespeople, your marketing people, your CFO function, your HR function, your engineer's product. Those are all people and costs that you have as a base. what happens to that cost base in order to preserve cash under various scenarios of revenue

decline? And so I think that's the way that you have to be managing your business on a very, very granular level. And especially since companies, especially startups, they staff in advance of growth. And so you have to really be honest with yourself. I want to just also chime in and just say, look, these are all very, very hard decisions. And I think Caroline and Jeff, especially because you've been in the seat of operators during really, really trying times. You're probably pretty diagnostic about it, but suffice to say, it's hard decisions, you know, people's jobs, decisions not to be taken lightly. And that's why there are cases where it's a death by a thousand cuts, because people are reluctant to do those layoffs, make those cuts. And believe me, you don't sleep when you have

to make these decisions. It's so tough. So I don't take that lightly at all. But when you're running a company, number one is making sure the company can make it through to the other side. And so you have to make these really tough decisions. And believe me, I understand how difficult that can be. But you can't kick the can down the road on some of these things. Everyone in the organization knows that the proverbial shit has hit the fan. And so if the leader is unwilling to acknowledge that with the team, that for me creates a crisis of confidence. I always found it way better just to call it what it is, share it. try to enlist the team and do you agree with this version of reality and try to get agreement?

And then it's like, okay, what do we do? But denial and trying to hide it from your team is a failing strategy completely. And I understand the human psychology around that because I think people don't like to give bad news. And so I think the natural impulse is to hide those things. But these are the moments where you have to actually be the most transparent. Talk about why you're doing what you're doing, how much cash you've got left, how much you want to preserve. And what I find is when you do that, when you bring everybody into the fold, they all become part of the solution. So they understand that cash is king and they'll figure out ways to be even scrappier than they might have been otherwise. Jeff, you've lived through some crises already. Go back to a time when you were

facing a crisis where things were rapidly changing. You were having to make some of these difficult decisions. What was a day in a life like then? And what were you doing, especially with regards to the financials. I got a good one for you. So open table in mid-2008, the board decided it's time, let's go public. The market wasn't good, but for a variety of internal reasons for the company, we decided, okay, we have to, quote-unquote, get the puck on the ice. And so we got ready for the IPO. And we did our bake-off in, I think it was August 2008, and did it like on a Thursday. And on Friday, we informed the six banks, whether they got on the offer or not. We told Lean on Friday, they didn't get the offer. They went out of business on Saturday. We told Merrill Lynch,

they did get the assignment to take Open Table Public, and they traded to Bank of America on Sunday. So over that weekend, the number of people dining and fine dining restaurants in America went down by 15% in one weekend. So we have the org meeting Monday morning. I walk in, sit down, all the bankers there, all the lawyers there, and this is not going well. Our business is in free fall. the bank just changed. The consumer's terrified. And so it was pretty clear we could not proceed with the IPO at that point because we couldn't predict it. But then we just said, okay, what can we predict? And so we put it on hold for three or four months. And it turned out that the consumer kept dining in restaurants at 85% of what they had the prior year. And all of a sudden,

we got confident that the business was predictable at that point. And we restarted the process and went out and it ended up being a successful offering. How were you looking at the financials during that time? those come into play as you went through that? We were watching the year over year change in reservations of people dining and reservations made daily, just like, okay, where's this business going? Because if it kept falling, one of the scenarios we're concerned by is more and more people would stop eating as they got more and more nervous about the economy. And we'd go from revenue of X to revenue of like 0.3x. And the business would have been hugely stressed at revenue of 0.3X. So we were watching that, the one key North Star metric of diners per night year

over year maniacally. And that ended up giving us the confidence to restart the offering. How does a startup or a founder right now approach contingency planning around their finances, especially if you're a high-growth startup that's been going through cash quickly and been pretty aggressive with your risk-taking until now? For me, you don't scenario plan constantly, but when a shock hits the system like this shock has hit this system, hit the world, is you want to plan quickly, even if it's bluntly. If I was running a business in this environment, I would get the expected outcome.

Maybe it won't go there quickly. Outcomes a slightly better, but also just what is the worst case? Where could this go? And then you build your response if each of those comes true. And for me, you put much more time into the plan what if than you do in the building the sensitivity scenarios. One of the less productive activities is making that sensitivity beautiful and accurate and it takes

two months to come out with and the company's out of business. Yeah, just take the onest assessment. David and his team has done this for a few of our internal companies. Yeah, what we did is we basically took every company's financials and started with revenue and said, okay, let's start with your budget, and then let's run sensitivity analyses for your revenue. Let's assume you hit your budget, that you're flat, that you don't grow, that you decline by 25% or that you decline by 50%. And then we compared that with a company's operating expense budget, and across all those different scenarios, if you run your current budget of operating expenses, if you assume you don't

grow your operating expenses, and then if you assume you decline your operating expenses, is by 25 or 50 percent. What is your cash runway in each of those scenarios? And we plug that in for each of our companies and gave it to them. And I think it's just a helpful way for them to put some parameters around, hey, if things get really bad, this is what our runway is. And often it helps them just to start thinking about, okay, how do I contingency plan in the event of flat revenue? I had never even thought about that before. If that happens, I only have this much runway. Maybe I should take action. And another thing that I would say, you know, a lot of times companies are building things as the plane is in the air, and they solve their problems linearly

by throwing bodies at it. This is an opportunity to be able to potentially refactor your code base, to shore up infrastructure, to build internal tools to make your teams more efficient so that when you do come out on the other side, that you are primed and ready to just hit the ground running and run in a million miles an hour because you have now built the foundation that you need to be able to really scale your business, a company called Adbright. We were an ad network. This was before Amazon Web Services was really a big thing. And so you had to have your own data centers, which means you had to buy equipment. So we were a very capital intensive business. And what we realized was that we weren't going to be able to afford anymore to be constantly replacing our servers,

because we just did not have the money to do it. And our CTO had been playing around with this thing called AWS and brought it to us and say, one, we can't afford to upgrade our servers even though we need to. And two, this is going to probably in some ways improve our gross margins because now we can flex up and down when we need the capacity. So can we give it a try. This was, you know, cloud-based, anything was still pretty new. This was 2008, I think AWS launched in 2006. So we became a data customer. At the end of the day, when we came out of the crisis, we were pretty much a cloud-based ad-serving company. We deprecated all of our data centers when we just moved everything to AWS.

So what bottom-line advice right now are you giving to founders? One anecdote about the 2008 credit crisis, when housing prices dropped like 30 to 40 percent, if you were to interview people on the street who owned homes, you asked them, hey, what do you think the U.S. residential market has done in terms of real estate values, they would across the board say, oh, it's down 30 to 40 percent. And then they would be asked, all right, what do you think's happened to the value of your own home? And they say, oh, nothing, nothing at all. It's so fine.

It's not down at all. And it's like, well, that's not how averages actually work. And so no one believes that it's going to happen to them. But believe me, it is happening to them. And that is the thing that I want founders to understand. You are not going to be impacted asymmetrically compared to everybody else. You're not going to be that outlier more likely than not. So we've had a lot of advice in here on like confront reality decisively.

plan for the worst case, scenario planned the worst case. And psychologically, that is pretty darn challenging on the founder. I mean, I've lived it. I understand there. So that brings the point that it's just incredibly important for the founder to manage their own psychology. And I think probably the best resource I've read on that is Ben's book, The Hard Things About Hard Things. You flip from peacetime to wartime. People are looking for you to lead. And you've just got to take the horn. But I always was most uncomfortable with my personal psyche when things were going great. I mean, when Open Table was trading for like 21 times forward revenues, which is an absurd valuation, I was jumping out of my skin. But once you confront the fact that, okay, we're in one of those moments and I need to lead out of it, I actually found it after an absolutely miserable X hours, I found it motivating. We can get over this. Let's show them what we can do. For me, the CEO and a founder needs to confront reality quickly, and then they need to lead. And you can lead your company through these things and get to the other side.

Then things will get better again. But the biggest thing is manage your psychology actively. I just want to thank you, David. Thank you, Jeff. Thank you, Caroline, for joining us on the podcast today. Thank you. Thank you.