This Week in Startups - Budgets, models & what investors are looking for with Scott Orn | Kruze Consulting Startup Finance Basics

Episode Date: February 12, 2021

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All right. I am back with my man, Scott Orne. He is with Cruise Consulting. Go to Cruise Consulting.com. Sist. K-R-U-Z-E Consulting.com. They do our accounting. They do a lot of our startups accounting. They will work with you when you're two people and a napkin with an idea on it and aspirations. They'll work with you when you have 2,000 employees. I don't know. What's the biggest company you work with in terms of number of employees? Biggest company is calm still. Wow. That's a low number of employees. but a large amount of money.

Yeah, yeah, yeah, yeah. I think that company is the company with the largest amount of revenue per employee I've ever invested in. Just if you take the total revenue by the number of employees. And at one point, I was like, how many employees we have? And there was like 50. And I was like, do we need more employees? They're like, yeah, we're going to double it. I'm like, do we need that?

Like, no. I'm like, well, why are we doubling? Well, we can. So we're going to put more work into everything, make everything redundant and multiple languages. So just such a great company. And you and I have been there since the beginning with that fabulous company. So rewarding, isn't it what we do? All right.

Today we're going to talk with Scott about budgets. Budgets are not just for big companies. You do want to start having this kind of hygiene to do budgets, a financial model, and manage your cash. And I have a little tradition I've been doing since 1995. I have whoever's in my operations team send me an email. And with it, they take a screenshot of cash in my bank account. and attach it. And then they put AR, cash on hand, delinquent AR, et cetera, et cetera, just five or six numbers.

And they send it to me every week. You know why I do that, Scott? So like a professional pilot. Because you need to know exactly what's in the bank account. Exactly. I want to be a professional pilot. And I want to look at my air speed indicator. I want to look at my altitude.

I want to look at all that dashboard. And the three people in operations on the team I want to look at it. And what it does is it lowers everybody's anxiety. okay, we have X amount of cash in the bank. We have X amount of receivables. And it just is like stepping on the scale every morning. If you want to lose weight, here's an idea. Get a connected scale and force yourself to get on it every day.

Not just on the days when you fasted, but on the days when you had a double scoop of salt and straw, chocolate brownie ice cream. You got to do that. Okay, so let's go through budgets, financial models, and managing your cash. I think the biggest thing is you talked about, there's kind of like two audiences for this.

The first audience is you and your internal team. The second audience is your board, your investors. And if you don't mind, we can just break this up into two. So you're, I love like the analogy of you're a pilot and you need to see what's in your gauges. I would also add that when you're going into a board meeting,

always take that screenshot of the cash balance. I love that. I've seen CFOs be fired because they didn't know when one of the board members ask them how much cash is in the bank, or they quote the wrong number. So it's literally not like not knowing your altitude in a plane. It's crazy, right? It's crazy. You have to know cash.

And I had a company. I wouldn't say which one, but it was high profile. And they thought they had X amount of cash because their accounting firm and their finance person internally had said, this is where we're at. And what they didn't realize was the founder just never did their diligence of keeping up to date on cash. And all of a sudden, she thought she had three months of cash. She had like three days.

And she just screwed it up. And it was all because things weren't set up properly from the beginning. And cash is a lifeblood of a startup. And so that internal audience, you are going to want to have a financial model. No one expects you to be an analyst at Goldman. You just need to have something at the very least quick and dirty if you're an early stage company. That shows exactly where you are every month. And again, you want to have like a basic income statement so you can see what you're spending,

what you're bringing in, and what you're basically, Most startups are losing money, so what you're losing that month. And then you can take that, divide that into your cash balance and know what your runway is. Super duper important to know exactly how many months of cash you have. I do this like three or four different ways. I say to my team, give me three numbers. One, are burn based on this month and this cash. Okay, so last month we burned 50.

We have 500 in the bank, 50 divided 500, 10 months runway. Then I say, give me the last three months average. So we had, we broke even one month, we lost 100 one month, we lost 50 one month. Okay, 150 divided by 350. Okay, now divided into 500, same number. So that we get a little bit of a blended. And then I say, put the quarterly numbers. So give me the last three quarters or four quarters and show me what we made and lost

each quarter. And so I just tell everybody, there's really just these basic numbers. How much did you spend? How much did you make? and then there's either you just combine those two numbers to find out if you had a profit or a loss. And just know those three numbers, like the back of your hand. And don't surprise your board. And I think that's one of the key things, especially like a lot of founders are great technologists or they're incredible salespeople.

And so, you know, this may not be their favorite thing. But this is a company you've spent years of your life building. The quickest way to be removed from your own startup is to surprise. the board with an unhappy cash burn surprise. Like, that's how you get fired. You know, it's kind of that simple. And so the best companies I see are sending out monthly updates to their VCs within the first 10 days of the month.

And there's the first thing, the first bullet point in that is cash in the bank and then our burn rate and how many months of cash. And so we're talking, this is a lot of the internal stuff. But like, if you can just avoid those surprise. is you're going to build a lot of confidence in your VCs. And if you do need more money, they're more willing to write that bridge check or help you out or speak, you know, be a really positive referral to a new venture capitalist who's going to come in on top. It's really important to have that credibility. It's so important. And you knowing this, I, if again, I like

to use these airplanes as because I watch all these airplane disaster and saves on YouTube. And once you start watching them, you'll get all of them. But almost universally, the mistake people make is they don't know how much fuel, the speed, the height, the altitude, and then the distance to the runway. And runway is a key piece here. Runway is how long do you have to figure out your business before you need to raise more money or hit profitability or break even? One of those three things has to happen or else it's over. And over means you have to lay everybody off and start working on it on the weekends or shut it down. One of those. And so the distance between you and the runway, where you can get more fuel is critically important. That's why we call it runway, because we all know what happens when you run out of runway. The plane crashes. We don't, nobody wants the plane to crash.

And you knowing what your runway is and managing that is super important. And part of that is building a financial model. Now, if you haven't built a financial model, where do you start? For those individuals or the internal stuff, do not start from scratch, especially if you're an engineer or salesperson who's just, So there's, and we have a free template you can use on our website.

There's other, just Google, get a free template. You're going to save yourself a tremendous amount of time. Now, if you are going to, if we could talk about the second audience for a second, Jason, those investors. And to kind of use your airplane analogy, you are Airbus or Boeing and you've, you're going to sell the fanciest, newest version of your airplane to all the defense, the defense administrators. You want that model to be souped up. You need that airplane to be souped up.

up and that's when you probably want to hire a professional to help you start building it. And the reason for that is your financial model becomes a map for your startup's journey. And while internally you're worried about cash and runway, the investors are worried about that too, but they are starting to think in terms of revenue scalability and things like customer acquisition costs and LTV as a multiple long-term value of the customer as a multiple of customer acquisition costs. So you're going to need, and this usually happens at Series A or Series B,

you'll be able to raise a seed round with the simplified internal financial model. But as you start kind of moving up market into investors, everything becomes more of a financial calculation until you get to like late stage where they are literally like, I'm going to give you a $20 million

and I need you to turn that into $200 million kind of thing. Right. It becomes a financial, it's just like the financial model is the determinant of, if they invest. In the beginning, you're selling the promise of a startup. You're selling, hey, what could this be? And who are we, the founders? You're selling promise. And then at a certain point, I think somewhere between Series A and Series B, you start selling performance. It's not about what you're going to build. It's not about your ideas. It's not about your roadmap. It's not

about your mockups or MVP. It's about the numbers. And you need to get those right. In the beginning, you need to say, we have three people. We're going to take, you know, whatever it is, 100K each. We have 500k in the bank. So we're going to spend 300,000. of it on salaries for the next 12 months and we have 200k. We're going to spend a 50 of that on marketing, 50 of it on corporate overhead and we will have a 100K buffer. Boom. Done. It's just like a back of the envelope, right? Done. Exactly. And the professional investors are using your growth rates as a proxy for how big is the total market opportunity. How fast do you think you can grow? What kind of multiples can we get on this company eventually? And how much

capital this company is going to need in the future. Every venture capitalists, even Seed Stage or angel investors are thinking like, I want to build my ownership position, help the company have enough cash to build something that's really valuable and attracts other investors who will then kind of fuel the company as they go. And so if those, if your model isn't thoughtful and kind of professional, your market opportunity might look too small or your revenue run rate might look too small. or you are burning way too much cash. And it's not the end of the world because a good investors, again, isn't going to expect you to be a Goldman Sachs analyst.

They're going to talk to you and ask you these questions. But showing them through the model, through that map that you put the work in, you really thought about it. And probably there's something you understand that they don't at that moment is really the basis for that collaborative conversation that builds trust and gets them interested in the company in the first place. And a really good model really is a proxy for your thinking about the business. And thinking about a business is a strategy. That's what the word strategy is, is how you think and plot about your business. I was on a call. And one of the key things that comes in is the margin and the market size. And your numbers are going to start to tell that story. You're telling the story of your startup and its potential through numbers. And in this case, it didn't add up. And I felt bad for the, I felt bad for the story. the founder because this just happened last night. I'll be totally honest. I was on a call. And

the product, or maybe it was two days ago, the product was for pregnant women in the United States. And their cack was like 15 or 20 bucks, but it was only one experiment. And I was like, well, that cack has got to be higher, right? It's going to be, it's going to wind up being your customer market is going to be 40 or 50. You're making $40 or $50 every time you sell something. So when your cack actually goes up, you're going to be making no money. So you probably underpriced this product. and how many women get pregnant every year? And she was like, four million in the United States. And I was like, so if you get 10% of those,

you're talking about 400,000 women who are pregnant, and you're going to make $20 per. If you even achieve that, you realize, like, this may not be a venture-scale business. And they're like, whoa. And I was like, would the top 10% pay $250 for your product? And then I looked up the competitor, and the competitor is charging $2.99.

So the competitor had figured this out at some point that you cannot sell this product but for $2.99 because you need to have enough margin because the market is smaller. And then we started talking about, well, what's the next two or three products you can do? And all of a sudden it was like, oh, products for pregnant women are not like calm where you resubscribe every year for the rest of your life or Spotify or Netflix. You have this for a certain period of time. So it's a challenging business. You're going to need to see if that technology can then build something that goes beyond

this very small market. That's just but one example, right? The numbers frequently uncover. That's an incredible example. Yeah. Even think about like the multiple, like you were doing that math, $40 at customer acquisition, the competitor's charging $290. That's basically a 7x on customer acquisition cost to long term value.

And so venture capitalists like Jason are going to want to see something like a 5x return on that. You can make it work at a 3 or 4x, but you start becoming a superstar company when you can get that 5x return on those marketing dollars on those customer acquisition dollars. So you spend a dollar, you get five. You spend 10, you get 50, you spend 50, you get 5, 250. And this is what venture scale is. And what I think a lot of founders don't understand is the VCs see all businesses. And then they look at a subsection of businesses and say, whoa, enterprise companies are the nuts. Or break out consumer companies like the 1% of the 1% are incredible, but it's 1 in 1,000. okay enterprise well one out of 50 or 25 hit this incredible money printing machine moment okay and then consumer

subscriptions okay they do pretty well too but they have a lot of churn okay now we're down to consumer products direct to consumer oh maybe those aren't as good but they have worked with certain companies so they have the profiles which is why some VC firms only do enterprise that's why jason lemkin or david sacks focus on that because it's predictable it's high margin etc some people like me might be a little more adventurous. But they know this because they see all of the models. They see all of the bottles, not just yours. Absolutely. And, you know, there's different, in those different sectors you're talking about, like hardware, for example, hardware is a class, like the financial model in a hardware is so important because especially if it doesn't have, well, almost every hardware

business nowadays has some type of software subscription attached to it. We've had companies in the past who were building incredible technology, but didn't quite understand that they needed a complementary second revenue line that could actually bring the total weighted margin of the business up. And so I think the markets kind of learn that. But even when you're doing like a hardware startup and you have that second revenue stream, you need to really model out how much cash, how much investment in assembling and buying from the contract manufacturers and assembling everything,

how much in the whole are you going to go on that? hardware sale and how long it's going to take for you to make up and become gross margin positive positive. It's like called a payback period. And the venture capitalists, like you said, are just so good at this stuff that they look at your model in two seconds and can see, oh my gosh, the payback period is two years on this thing. No way am I investing in this company. SaaS can be the same way. Software is a high margin product, but there's a lot of development and there's a lot of customer acquisition that goes into SaaS. And so you kind of have this like J-curve where you're investing, investing, investing, and then you turn the corner and then all of

a sudden every sale is ultra profitable and that's why people love SaaS companies. You don't need to tell VCs what you're worth. If you explain the model, they'll tell you, right? I mean, this is a key point. They understand it better than you do. I love that. That's great advice. And you kind of want to see what they come back with on the valuation too. Venture capitalists are smart. They're always trying to get kind of less is more to them lower valuation is better for them but especially now the market is so competitive that when you're you're going to talk to multiple bc's you don't want to just talk to one venture capitalist and you're going to want to kind of run a soft bake-off and so you're going to get different

terms sheets different valuations so it's instruct it's important not to negotiate against yourself put the information out there give them some guidance because they may get frustrated if you don't get like if they don't get enough guidance but let them come back to you and tell them what tell you what the company is worth. You're going to see in those numbers how fired up they are about your company, how badly they want to invest. And it's a great exercise for you. Yeah, I mean, if they're not willing to put out a term sheet and come to a valuation, they're probably not interested in the business. And so you can move on to the next venture capital. You don't need to get every VC to give you a term sheet. You need to get two or three to have a competitive environment. You need

to get one to stay alive. So keep that in mind. And you're going to be with 75 of them to get three. if you've got a viable business. And there's no shame in getting the one VC to keep you alive. So many great companies have that story where like, you know, six weeks of cash, finally got that one VC who wrote him a check and off the races, right? So don't, there's a huge distribution of outcomes that come, you know, the companies that are raising the most money early on oftentimes are not the most successful. It's the companies that are battle-hardened, the founders that have battle-hardened,

who are creative, who figure out how to get a great, an investor into the company. It's not a race. It's a, or not sprint. It's a marathon. Absolutely. How do you communicate the model to a VC? Because some of them are going to have some analysts in the room or on the Zoom call, and they

are going to go really into detail. Other people like myself, I just want to have a back of the, you know, envelope discussion about it. My diligence team will go into the super details of it. But I just want somebody to explain to me, here's, you know, where we wound up with cack, here's where organic wound up with, and here's what we pay everybody, and this is how long the money is going to last. I'm kind of, I don't want to say back of the envelope. I do like a model, but I like a top level model. But other people like to go really into the detail. So what should

you do? Should you default to detail or top level? How do you manage that when you're talking to an investor? So I would always have, especially for investors, you want to have a detailed model, but you don't want to go into the weeds so much that they get lost. So I like to do a summary, like a PowerPoint summary or an email summary as you send it over. Even the first tab in the financial model can have a summary of assumptions. You kind of don't, it's like you don't want them to just run amok in that model. You want to tell them, there's kind of an old saying, tell them what they're supposed to see, what they're supposed to learn from that model.

And so you want to do those highlights. You want to do, hey, our revenue is going from one to six to 15 over the next three years. those numbers will excite every venture capitalist in the world. People are looking for low double digit month over month growth. That means you're in the game, right? If you're growing 10%, 15%, 20%, month over a month, you're doubling every, if you're growing 20%, you divide that into 72, you're doubling every three. Three and a half months.

Three and a half months. So that's how the rule of 72 works. You can look that up, rule of 72. I love the rule of 72. I was doing that too. So I got an investor update from one of our clients last night and they had gone, from I think 8 million to 25 million ARR run rate in like six months because they were doing they were growing at like a 10 to 12 percent monthly revenue now of course you can get a little tripped up

on monthly recurring revenue and annual recurring revenue but suffice to say if you're growing at 10 per month you are in the game you have a really good company you're going to be fundable and so communicating just back to your question communicating those high level selling points to them is very very, very important. Also communicating exactly how much capital you need when your cash out date is. And then this is the qualitative aspect. The milestones you're going to hit on their cash. This is critical for VCs because, again, they want to put the money in your company, see you grow, and then they want to pick up the phone and speed dial their five friends who are going to lead the next round. And so they have a, they're looking at companies all day long.

They have a very good feeling for what it takes to raise a series A, a series B or series C. Like I can just listening and talking to you, I can tell you have that in your head too. You know what a company needs to be at. And so if it's if it's working, if the models tells that story, they're going to get pretty excited about it. If you're not telling that story, you should be effectively like demoing your model or demoing your assumptions to other entrepreneurs to your inside VCs or angel investments or someone like us who's helping you build this stuff. Because again, we see everything and we can actually give you some pointers so that. It comes across very clean. But again, summarize the takeaways.

Summise how far you're going to get, what miles are going to be able to hit, and then let them look at the model. Don't just kind of throw it over the wall and hope they draw the right conclusions out of it. Yeah. And the big expense in all of this is your headcount. That's the big expense. So being able to explain, and this is where you've got a lot of moving parts here, just like flying a plane, your altitude, your speed, you know, all this stuff matters,

the wind, et cetera. the length of the runway. And when you hire people and then what salaries you bring them at on, this becomes a very, very big discussion point. And so it's not like you raise, you know, $3 million and you're able to hire 10 people on day one. You're going to be able to hire somebody every 30 days. So those 10 hires are going to occur in months one through 10,

which means you can build this essentially waterfall of, you know, slowly watching your expenses grow. And you can kind of time, like, well, we don't want to have the paid marketing person on board before we have the product finished because they're going to sit here and do nothing. So there is a timing and a little bit of logic. And that's what I feel investors are looking for when they look at a model. They're looking for your thought process on it. And so the ability to build the model from the bottom up, from the top down, from your

existing P&L statement, like you can just take your P&L from the last year and then build it and project it, right? you can you can just say here's where we're going to increase our spend and here's where you know we're going to add three channels for marketing and here's the detail of each of those three channels and the scenarios and then you can build three scenarios here's what happens if we overachieve here's what happens if we hit our targets and here's what happens if we get some bad beats and that will either be break even 18 months of runway or 12 months of runway and when I have a founder explain it to me like that we think we're going to break even by you know month 18 but

if we don't, we're going to hit this number. And if we don't, we're going to hit this number. And here's how we respond to those. So you can actually start to think, hey, if I have to bail on this airplane, I can ditch it in the Hudson, I can make it to Tito Borough Airport. I can make it back to LaGuardia. You have a plan of how to land the goddamn plane. I love it. You said so many awesome things there. And if I can build on a couple things, the personnel is going to be something like 50 to 70% of your spend. So you're exactly right. That's a big component. And the mistake, it's kind of counterintuitive. We're in go-go times. now. Like, money is flowing. You know, it's easy to raise money right now relatively. I see a lot of companies make this mistake in that they have projections that depend on hiring a lot of people and they actually delay hiring way too long or wait until the money's closed and then they kind of get it going. We see companies missing plan because they didn't kickstart their hiring fast enough. I know, again, and this is a, what people may, archaeologists may look back on this podcast five years from now and say, look how bullish things were. Scott and Jason are saying this.

It is a crazy time right now. I've seen all the markets. But right now, you want to kind of start ramping up your hiring as you have a good feeling that the round's going to close. When you get that term sheet, that's the moment to actually kick in your hiring work. Because otherwise, you're two months behind plan just as a default. Yeah. I mean, writing up the job descriptions, writing up multiple job descriptions. What I always do for these positions is, listen, I'm a slightly more sophisticated and battle-scarred founder, but I'll say to my team, I can make this work with somebody who's going to be the community manager for this weekend startups with somebody straight out of school, somebody with three years experience, or somebody with 10 years experience. So I want you to put up

entry-level position at 45K, a 60K position for somebody who's got three to 10 years, and then a 75K position for somebody with over 10 years. And so we'll have a senior community manager, an entry level community manager, and a, you know, and a just a straight up community manager. Put all three out there. Show me a range. I can make it work with any. So now you're talking about like a pilot. They're like, well, I can get there.

I can glide. I can, you know, run it on one engine. I can do a bunch of different things to get this plane on the ground. And that's what comes with reps. And I tell people when you build your model, I like to build models when I'm on a flight somewhere or on a Sunday, you know, put the kids. kids to bed for a nap. I got a minute. I'll just build a model. Hey, what if my business look like this? What if my business was subscription instead of advertising? What if my business had 250 newsletters instead of 25? What if it had just five? And I'll just build different models. So in my head,

I have that framework there and I let it sit, right? And I feel like it's playing chess. To me, building financial models is like a little chess game. You can just do it and get the, I know it sounds corny, but I, and you might have the same experience. I get enjoyment out of building the model once in a while. You know what I'm saying? I love it too. It's, it's, it's a almost like computer programming or it's, it's that visualization of what is possible. And even there's other things that I find that building that model actually helps the founder understand their business at a level they didn't before. Like even your example of like the different community managers, well, guess what? You've got to pay health benefits. You have to pay payroll taxes on those people.

There's another 20 to 25% of costs in addition to that multiplier. Yeah. And so you you start thinking like, oh my gosh, I thought, you know, and there's tradeoffs, you know. And so, and then all those people need a lot of software these days to do their job. And so you start seeing this and it kind of protects you. One thing I see founders making a mistake on is they raise a little too much money. People become obsessed with dilution when really, I mean, you've, I've seen thousands of startups now. It's, it's the ones, the heartbreaking ones are the ones who fall three to six months of cash. short because and they and they had another 250 or a million dollars they could have taken you know

I just was watching uh I was just watching one of these videos where a novice pilot had three different airports and he spent time trying to figure out why his engine was you know he basically was trying to restart the engine he missed the runway I kid you not Scott by 20 feet oh my god he ran out of altitude and he he spent 15 minutes in the air circling trying to get any wasted altitude don't waste or altitude, if somebody gives you the jet fuel, always take a little extra extra extra extra extra. I see this all the time. It makes me bonkers too, Scott. Somebody has an opportunity to add 250 to the round and like, I don't want to dilute an extra 2%. It's like, that 2% is an insurance policy. It's five months of runway. You're burning 50K. Take the five

months. It's like landing your little tiny plane, you know, at LAX with a giant runway. Take the runway. It drives me crazy. And to continue your analogy, even if you don't need that extra runway, you can run the engine harder and faster. And venture capitalists also are interested in kind of the velocity of growth. Of course. And so like it's a difference between trying like to design the homepage or write the homepage copy yourself or hiring someone who's an expert who's done it a hundred times. Like that extra $250,000 buys you lots of little things like that that just let you go faster.

What if you figure out your cack and you just throw it towards getting, if your cac's $25, you all of a sudden get 10,000 more customers. How's that going to look when you go into your next meeting? Exactly. Exactly. All right. Listen. Scott.

We did our four parts. We're helping founders get through this. Scott is a mensch. If you need help, I'm sure his email of Scott at cruiseconsulting.com, blow him up. He loves talking to founders. He geeks out on this stuff. I geek out in a little bit. He geeks out on it a lot.

Cruise Consulting.com slash twist. Cruise consulting.com slash twist. Our partner for startup basics and our partner with all of our startup. They do a great job, including working for the second biggest return of my career. Da-da-da-da-da-da-da-com. Ooh, cruise consulting.com slash twist. All right, Scott. Great job.

And I'll talk to you soon.