This Week in Startups - Financial info to include in your pitch deck | Startup Finance Basics w/ Kruze's Scott Orn | E1640

Episode Date: December 17, 2022

Kruze COO Scott Orn is back with Jason to explain the MOST important financial information that founders should include in their pitch deck ( (0:00) Kruze's Scott Orn joins Jason to discuss the role of financial information in your pitch deck (11:02) Conveying your vision with numbers Check out Kruze: https://www.kruzeconsulting.com FOLLOW Scott: https://twitter.com/scottorn FOLLOW Jason: https://linktr.ee/calacanis FOLLOW Molly: https://twitter.com/mollywood Subscribe to our YouTube to watch all full episodes: https://www.youtube.com/channel/UCkkhmBWfS7pILYIk0izkc3A?sub_confirmation=1

All right, everybody, welcome back to this week in startups. It's time for us to go over the financial basics. Finance basics. If you get your finance right, your company, your startup is going to be tight. And tight is always right with me again. My guy, CFA and Cruz C-O, Scott Orne, is with us. Scott, how you doing? We're sitting here in the middle of a recession, a downturn.

A lot of work going on out there, huh? A lot of work. I'm doing great. The cruise clients are making it through this. And thank you for having us on so we can help educate some more people out there. Yeah, you know, we do this on a regular basis. It's this week in startups.com slash basics. We like to do startup basics because there are basic things that if you get them right in your startup,

you can focus on your team, your product, and your customers. An accounting and your Google sheets, whatever you're using to make a model, diligence, all this stuff is critically important. So let's just get right into it. This is part three of our series. You can see the whole series again at this week in startups. dot com slash basics, but we want to do due diligence part D. Part two. What financial information should you include in your pitch deck? This is critically important. People think, oh, projections,

they think five-year projections, 10-year projections, one-year projections. What do you think, at the early stage is the right amount of financials to include in your pitch deck, Scott? At the earliest stage, like Seed Series A, you're definitely going to want to have two years, maybe three years. But you don't, I really want to emphasize this. Don't overthink it. If you've got a one, if you're a Seed States company, a baby company, and you only really have visibility for the next year, maybe extrapolate out another six months. But don't, don't get too far ahead of yourself. Sometimes I see entrepreneurs get so stressed out and think they're like the Goldman Sachs analyst and project out five years.

and they instantly blow their credibility instead of just focusing on their story, right? I mean, people need to remember that a pitch is really a sales pitch, right? You're trying to get the entrepreneur or the VC interested in the company. And the financial data is meant to support. It's also meant to provide a map to the conversation. When someone like you sees the financial productions for the next couple years, and you see when the company is starting to get to revenue, and you see how much they're going to spend to get there,

that gives you a really good framework for thinking about how much capital does this company need. Yeah, and for me, as being as an investor on the investor side, I am realistic. One or two years, for me as a seed state investor is just perfect. That three out of mind, but I'm going to be looking at that year one. And just trying to bang on the model, I'm going to try to hit it. I'm going to try to push it and see where I can find mistakes or, you know, try to understand the logic and the thoughtfulness that went into it. Because I see this as a map. Hey, you're planning on going to the new world. You think it's this far away. You need this many

provisions to get there. And you're going to leave Spain and you're going to try to get to North America or you're going to try to get to India, whichever direction you're going around Cape Horn. I just want to know that you've made a plan that I'm not just giving you a bucket load of cash and you're going to wing it. So that's where a model comes. And explain what a model is, a financial model at its core. What is the financial model? It's just a very basic Excel, Google Sheets type of projections. Revenue, cost of good sold, which gets you to your gross profit. The cost of good sold is like the stuff you'd spend to deliver your product.

And then you've got just to be super simple, sales and marketing, research and development, and like G&A, like just the kind of the cost of running the business, you subtract those operating expenses from the gross profit and you have your operating income. And for 99% of the startups, opera income is a very, very good proxy for burn. Unless you're like in robotics or something super capital intensive where you're buying a lot of equipment,

in that case, you're going to want something a little more robust, like a three statement model that includes a cash flow and balance sheet. But for, again, for those seed series A, I mean, series A you probably want to have a three stage model too, but for those seed companies,

a glorified income statement is actually pretty effective for helping to tell the story. I think you're analogy about the map and the trip to the new world is great and what I would add to that is something's going to go wrong.

The wind's going to blow the wrong way you're going to hit a storm. You can't anticipate what it is right now. So you want to have some cushions, some insurance, some extra money in the bank. So you don't want to cut it so tight that you can barely reach your milestones.

Yeah. And if something goes wrong, you're in real trouble, right? Hey, listen, if you've got a hundred day journey, you're not bringing a hundred days of You're going to bring $125. You don't want people to get scurvy. You bring extra lemons and you bring a little something extra.

So you're not left short. You know there could be complications. One thing I want to focus on here in the model. Okay, here's the cost of goods sold. People refer to that as cogs. And then they want to see gross profit. Then there's the stuff below that line, like administration, like all the people who do operations at your company sells in marketing, the salespeople, the money you're spending

on ads or conferences or whatever marketing you're doing. and then of course you have R&D. Why do people like to look at the gross profit and then put those things under that line? See, why is there that concept in accounting? They want to know whether this is a potentially lucrative business down the road. High gross profit businesses like software companies tend to have an easier time attracting capital

and they tend to trade at higher valuations when they eventually get public and get bought. So you definitely want to be a startup, Software company instead of an accounting company like us, it's kind of low margin. But hey, you also, if you're in clean energy or sometimes biotech, at least in the early years, can be low margin. Everyone has their cross to bear in their business. And the key is to making sure you figure out what it is.

A software company that's high margin might have more competitors because more VCs see that market opportunity and are willing to fund a Me Too company. What would the gross margin be, that gross profit? before you get into those below the line items, what would that be on a software business or a marketplace business typically? Yeah, so on a mature software business,

it's going to be like in the 80%, maybe even 90%, super high. Now, there's a little bit of a trap here for, especially the early stage startups as they're trying to scale their business. Their costs are going to look,

their costs are going to look, the cost of gets sold, don't scale perfectly in correlation with their revenue. So, you know, this very simple example, example is maybe you have to have some customer support that gets that gets put into cost gets sold. Well, when you hire that one customer support to support your fledgling customer base,

you're amortizing that whole salary into the cogs. And it looks off, right? So you want to be careful. And if in that customer support analogy, you only want to allocate the percentage of customer support for that, that salary that goes right to supporting the revenue, right? You might, that customer support person might be doing other stuff. And you can end up unintentional. making yourself look bad to a VC because you loaded too much stuff in COGS.

Now, the reverse is also true. There are people who try to kind of bait and switch venture capitalists. They're in a low margin business and they drop a bunch of actually necessary product support or development below the line and try to make themselves look like a really high gross merchant. We're actually kind of, I'm sure, have you been seeing that a little bit, Jason? Because I feel like the chickens are coming home. Yeah, people will massage stuff.

Of course. And I think I like your CSR, customer support rep. Let's say that person works from home, and they have a $45,000 year salary, $50,000 year salary. Let's just for an easy number, say they cost $60,000 all in. And let's say that's $5,000 a month. Now, you put that in your cost of goods sold. That's $5,000 a month over 12 months, and you're only selling $5,000 worth of the software,

so it looks like your gross margin is zero. But as you said, okay, let's say that person is only servicing that one customer who's paying $5,000 a month, and they're spending 95% of their other time doing operations at the company. So they pick up the phone 10% of the time to deal with that customer, but the other 95% or 5% of the time, they're doing other stuff. Therefore, that $5,000 should be 5% of it, $250 per month should be allocated there. And this is where you have to work with your management team and your accounts to say, hey, where should this cost live? Like, where does the CEO's time live in the founder?

Where does the salesperson time? And what are they actually doing? And in an early state startup, you'll have one person wearing five hats. Yes. And then as you become a later stage company, you have five people doing one job, right? Customer support team might be five people. So it gets a little easier as you go. But understanding this stuff early is critically important, right?

You might as well just learn it now even when the numbers are low because it sets you up for success in the future. Exactly. And like, you know, talking to your accountant is a great, like, that is such great advice because like AWS spend is another great example. Like, course. Don't just low, like a lot of early. stage startups, they're actually spending way more money on ADWS for their development than they are for the actual customer serving environment. Oh my gosh, what a great point.

Yeah, that's just another simple one, right? Production might be $100 a month and the development instance might be $2,000 a month. Yes, 100 goes to cost a good sold. 2,000 goes in the R&D line. And so you want to just make sure, the big thing, I just see people make this mistake. They show up to a VC pitch and they've got a 20% gross margin. they should have something like 80%. And this is also where projections and also the commentary,

you talked about this concept of the map, right? A venture cap, like you're saying bang on the model. When you're banging on the model, you're probably asking them questions. Like, what's your steady state gross margin? What do you see the gross margin in two years? Oh, we're not a scale yet. So our gross margin is only 40% right now, but it's going to be 80% in two years.

Sure. And we're going to be a lot closer to throwing off cash. That gets someone like you probably a lot more comfortable. Yeah. And, you know, these models are available. If you go to this week in startups.com slash model, M-O-D-E-L, it'll forward you to a page at the Cruz website. That's Scott's company, and it's K-R-U-Z-E,

just so you know the spelling of it. We made that quick URL. We'll send you to the model. You can start playing with a model. Get yourself a great accountant. Work through these details. Understand it. There are some things that are confusing.

Like, what's the difference between somebody who's in sales operations versus general and admin? where should they live? And being able to walk through this model and speak to it credibly is important. What I find is people who are attracted to entrepreneurship and are great at building product, they've never gone anywhere near accounting. But now they're forced to sell their vision. They sell the product.

They explain the customers. They explain the market. But then they fail to explain the business model. They fail to explain the business metrics. So what you're trying to do here is not only learn how to tell the story with words, you want to be able to tell the story with numbers. And it's just two different ways to understand the same thing. Some investors make, they understand the story through numbers.

And I would say probably the majority of investors like to understand the story through the model and the numbers, whereas the majority of entrepreneurs, it is the opposite. Totally agree. Especially as you get later stage, everyone becomes super numbers oriented because the checks are bigger, the outcomes need to be bigger. And if you, if you're a late stage fund, you have a couple blowups, I can really hurt your fun performance. There's one other thing that I think is helpful for entrepreneurs, which is play with

these models before you're pitching. Because I've seen so many founders where we actually either build them a model or they play around with our free model on the website. And they have this epiphany of like, oh my God, I'm not charging enough. Oh, my God. I'm never going to be profitable at this margin profile. And way better to have that before you get in the heat in the battle of a bunch of pitches. Because once you start that VC pitch train, you don't really want to be rescheduling meetings.

And, you know, it's just so much better to think through the basics of your business ahead of time through the model. Here's the thing. If you have the model ready to go, it's kind of like, you know, you go to a restaurant. I don't know if you've ever had this experience. I like to use analogies. It makes it easier for people. You know, some people are like, I'll take it. take the steak. I'll take the pasta. Now, you get somebody who's a wise guy like me, I come in,

I'm like, oh, where's the steak from? I want to know how it's prepared. I want a little more detail. You might just say, oh, I'm Scott. I like steak free. It's good enough. I might be like Neiman Ranch. Where did you get it from? What kind of steak is it? How do you prepare it? You know, and if the waiter knows that, the server knows that. Great. Now I feel like, I feel confident in this restaurant. It's a silly example, but you want to have that information available. Does every customer ask for it? No. Now, here. There's a question for you. You got a deck. It tells the story of your startup. It has some of the finance information. Now, we hear about two other forms of, you know, places for founders to give information

to investors. One is an appendix and one's a data room. So we have three buckets. A deck, which we know should have an overview of a, let's call it a two-year model at a seed stage, maybe a three at a series A. We know the number's two or three. It's not one and it's not four or five. So two or three is where you're going to be in a nice place. I would pick two, but that's just me. Now, appendix, diligence room. What goes in there? Appendix is every kind of stat or supporting piece of information that you think you might get asked about in the meeting.

So you want to have your deck nice and clean, 10 pages, maybe 15 pages, something like that, then have in your appendix, maybe the cash flow statement, maybe that, elongated balance sheet statement. And then also, maybe we talk about a little bit later, but the industry specific stuff for like customer acquisition costs, lifetime value of the customer, what those ratios are. There's a ton of stats that actually can make you look really good in a pitch. And you want to be able to refer them.

It has two effects. First, you just have the information so you can be impressive and talk about it. Secondly, it shows the venture capitalists that you've actually thought about this already. You brought something to the party, right? Again, that analogy of banging on the model, that's a nice surprise to figure out that the entrepreneurs actually already acquired 20 customers. Their average acquisition costs 100 bucks and they're going to, they're on pace to make 500 bucks for a client, right? That's a 5x return on that customer acquisition cost. That's a check

you as a venture capitalist will want to write all day long because that ratio speaks to you, right? You know there's enough, there's something here where they have pricing power and they can acquire customers and they can make money. So the credibility is going to go way up when you hear that appendix because, and don't be afraid if it's small numbers. A lot of founders are like, oh, I don't know. I'm unsure. It's like, well, it's something. You have something. Something is better than nothing. A lot of the folks we talk to don't have an appendix. They don't know their customer acquisition costs. They don't know their lifetime value. They haven't really given it enough thought. And they haven't thought about what they charge and the prices for their product.

So at least if you have something, you say, hey, here's where we're starting. We're going to try raising prices, we're going to try other acquisition channels, and we're going to be looking at that lifetime value because we don't have a lot of churn data, but we do have some. And now I'm thinking, okay, this person is going to explore the unknown country. We'll go back to that analogy. They're going to explore the unknown country, but they've already gone on some, you know, shorter missions. Yes. And they've scouted a little bit. Okay, we did a little scouting. We went out for two or three days to this island, we came back. We know there's an island on the way there.

Oh yeah, we found this other, you know, island chain. So we have an idea of what's out there. We know what the weather's like. There's some rough water here, you know, and we now can feel more confident in funding that mission because at least you've done a little bit of your own homework to make us think you're not just going to get lost at sea. Totally. And there's one other in this analogy, they're reprovisioning, right?

You're out on this journey and they've raised a seed round from long. and Jason Calicanis, they need to have a series A target. They need to know how many months that seed stage check is going to last before they need to do the reprovisioning and fill up, get all the food and get all the horses and everything again. And so knowing what those milestones are, this should be in the pitch deck. This is like right there. Like, hey, these are the three or four milestones we're going to hit on your money, Mr. Calacanis.

And guess what? We're going to hope you make a few intros for us to those top tier series A funds as soon as we hit those milestones. And by the way, we've got an extra three to six extra months hit those milestones in case something slips. All right. So everybody knows diligence. There's a diligence folder in the early days. It's going to have your incorporation documents. You might have IP assignments, some legal concepts. We have some legal basics, by the way, this week in startups.com slash basics. But there's also going to be some legal, there's going to be some finance information in there. P&L balance sheet, I suppose, maybe some bank statements. I'm not sure. What do you think

what do you think is state of the art, let's call it series A. You've got 12 months of revenue and spend. You've got 12 months of revenue. You've got two years of spend. You spent one year in the lab, spent one year with the product and market. You're now at two years and your seed stage funding is running out and you're doing your series A. What should I be showing in my due diligence folder in terms of a financial way? Yep. Well, in the financial way, you're going to want to have that more robust financial model with the balance sheet and the cash flow statement because you may be like another good example is you may be a software company that's really good at collecting cash up front you sign a lot of 12-month deals well guess what your actual your cash

flow is going to look way better than your income statement right and that doesn't necessarily show up when you're just doing like a very simple income statement but it shows up on your balance sheet because your cash balance is going to be higher and your cash flow statement's going to show a much more modest operating cash flow burn because you're collecting all that cash up front now and And if you're a robotics company, it might be a little bit of a difference, but you're actually going to be talking to the series A investors about how much equity plus like debt capital or CAPX finance you're going to need, right? Because you need to be able to show them their balance sheet and the cash flow statement.

Because if you're a capital intensive company and you come into like the top tier VCs that are used to looking at capital intensive companies, if you don't have those outlays represented on the balance sheet and are represented in your cash flow statement, you're going to look silly. Like you're not fundable right away because that's going to scare them a lot. Yeah. And so all of this becomes a lot easier when you got a great accounting partner. Cruz, Scott, thank you for working with our companies. I mean it sincerely, you know, I always feel so safe when I send somebody over there.

I know you're not going to price gouge them. I know you're going to take your time. You know, there's no stupid questions at Cruise. You can take your time. You have chosen to focus on early states. at your company, which makes you just awesome as a partner for me here at this week in startups. It means the world that you take the time to do this.

And it's great to have you as a partner for so long. We've been doing this basic series since 2014. And I keep doing it every year because the information does change. Yeah. Things I used to be able to expense, going to a dinner, you know, having a holiday party, wardrobe, whatever. All these things, they change every administration every two, three, four years, right? and you got to educate people as to what they can expense,

what they can't, the state of the art. Well, also, the market gets harder. You know, last year when we talked, you could just kind of walk down the street and on University Avenue and pick up a term sheet. And now it's like, you're really finding out. So things changed. I was crossing the street.

I was trying to go to, you know, get an espresso and somebody literally threw a duffel bag of money at me. It bounced off the back of my head. I need that duffel bag right now. But here we are. going to be tight, 2023, what's your prediction? It's going to be a little tight, isn't? I think it's going to be tight, but I think we're going through the worst of it right now. And I personally think interest rates are going to stabilize. And the market, we've taken our medicine quite a bit.

And it'll take a little while longer. But I got to, I mean, venture capitalists, they love what they do. They live for finding that next exciting company. And entrepreneurs, we see it all day long. We are still adding tons of clients at Cruz because, like, these people are always going to start a company. Like Vanessa Cruz is our founder. She started her company 10 years ago. She didn't just like start Cruz because she thought the timing was right. She started it because she had a passion for a county. The market was on the floor.

We were just getting ourselves up off getting off the floor. We got knocked on our asses. Totally. 2008, 2009. So the people who start these companies just have a mission and they are not going to hesitate. So I think it'll be a better. I think like summer 2020 things will start coming back. Yeah, I am a Q4 guy.

You're a Q3 guy. Nobody knows for sure. But what we do know is that accounting matters, more so today. And then it did the last three or four years. You got to pass. Many people didn't even do diligence. Now, you better have that diligence ready to go. And you know what?

Now when I talk to Founder Scott, I would ask them for diligence. Oh, yeah. They wouldn't give it to me in some cases. They would say, I don't understand why you want to see this. These other people don't want to see it. Now I'm getting emails. Hey, it was great talking to you. Here, proactive emails.

Yeah. I added you to our diligence room. Here's the term sheet. Here are the terms. Let me know if you have any questions. Is there somebody on your diligence team I can speak with to make this process go faster for you so you can come to a decision? This is the dialogue of 2022 and it will be the dialogue going into 2023.

If you're a filibustering founder who thinks you're above the diligence process, who thinks you're above having tight accounting, tight legal, you know what? You're going to be in for a very rude awakening because other founders are doing a tight and they're doing it right. Another great episode. Where can people find you, Scott? What's the best way to get in touch with cruise? Cruise Consulting.com.

Cruise with a K-R-U-Z-E. That's it. And all these episodes are waiting for you at this week in startups.com slash basics. We'll see you next time, everybody. Bye-bye.