This Week in Startups - The Best Financial Advice VCs Give Startups | Startup Finance Basics w/ Kruze's Scott Orn

Starting point is 00:00:00 The best financial advice that VCs give startups. Let's go over this because we see things from our side of the table that may be founders don't see because they're doing one startup every five or ten years. We're doing five or ten startups every month at our firm. We invest in 100 companies. So let's talk. Let's unpack it, Scott. What's the advice you hear most often from venture capitalists like myself giving to startups and why do we give that advice? Yeah, the simplest advice and probably the best advice is always make sure you have a cash runway that can support or overlay your milestones.

Starting point is 00:00:41 VCs are really, because you're exactly right, Jason, you're doing this all day long too. You're seeing companies come in, ask for funding, and you know what's kind of attainable, and you also have a good sense of what it's going to take to get that next round done. So launch, you know, seed investor, pre-seed investor, you guys have a really good eye for what a Series A needs to look like to get in. And what I mean by that is like how much ARR or how much, how many customers, how many users, whatever it is, right? And so asking your investors what it's going to take to raise that next round is probably the most helpful advice.

Starting point is 00:01:14 And then the second advice is kind of the simplest, which is don't run out of money, dummy, right? Like always have six months of cash, maybe nine months of cash at all times, and make sure that you're planning ahead. And sometimes you've got to cut some expenses, even though it's painful. Sometimes you're feeling really good and you're getting inbound term sheets. Maybe you can delay that a little bit and hit the accelerator a little bit more. So VCs have just such a great feel for the market and what is happening at the moment.

Starting point is 00:01:43 It's so true. And, you know, if you were going on a camping trip or the weekend, you wouldn't bring exactly the amount of food and water you need. You bring a couple of extra power bars. You bring a couple of extra bottles of water. You don't cut it close. Why? Hey, what if there's a mudslide or inclement weather and you can't get out? You need to have a little bit of an extra. And you don't have like a charge on your car if you're using an electric one. If you're going to Grandma's house and it's 100 miles away, you don't leave the house with 100 miles. You leave the house with 200 miles. You don't want to have any agita. That's runway. We see it all the time. Conversely, you're right, Scott. Sometimes I see a founder. They're really good at fundraising. Some of them, it's a superpower. And that's a dangerous superpower to have because you can fly too close to the sun. You raise too much money and you just think, well, I can just keep doing this. And then at some point, the hurdle to get the next round becomes greater and you are now

Starting point is 00:02:41 always one round ahead. So you've got such a convincing pitch that you raise your Series A before you have product market fit. I see it happen sometimes. People get excited. Or you raise your seed on a blank piece of paper. And so you're ahead by, you know, a year or two in the funding cycle. And And then you get to Series B, and those investors are like, okay, let's talk about the growth rate. What's your month over month growth rate? Tell me about your churn. And you're like, we're still figuring out product market fit. Or we just got to 100K in ARR. And they're like, okay, come back when you're at, you know, 10 million because this is a series B. We want to see five, 10 million for the series B, not, you know, 500K. You're a, you should be going for your Series A. And you're like,

Starting point is 00:03:21 I spent my Series A already. Ouch. And a lot of times that's the founder has triggered that because venture capitalists are human beings too. They're very competitive. of people. And so they want to win the deal, right? And as you, as a founder, you think it's smart to play VCs off each other and drive the valuation up. And they know in the back of their head, the valuation is probably getting a little too high, but they're competitive. They go for it. They win. And so everyone's kind of ended up in this suboptimal position where not enough product market fit. The liquidation preferences are too high. If you don't just thread the needle perfectly, it's going to be really hard to get another round.

Starting point is 00:04:01 And by the way, who are you going to go back to for more money? You're going to go back to those investors who you just drove the price up on and maybe were a little rude because you were feeling pretty good about things. Well, guess what? Now it's their turn. To return the favor. Yeah. So just be careful.

Starting point is 00:04:17 Be super thoughtful about it. I've also had people who, you know, they raised this $5 million or $10 million round. And they're going for break even. And I'm like, but we're only growing 20% year over year. And we've got $5 million in the bank. And we're only burning, you know, 500K a year. We've got 10 years of runway. And we're growing 20%.

Starting point is 00:04:42 Can we have five years of runway and grow 50%? Can we have two years of runway and grow 100% year over year? Startups are meant to grow. They're meant to go fast. If you're growing under 100% year over year, do you kind of take yourself out of the Venture Olympics at this early stage? I'm talking the first five years of a company. You look at Uber, you look at Google, Apple, some of these multi-decade-old companies or

Starting point is 00:05:06 a decade-old companies, they're growing at 30%, 20% a year. If you're a startup and you're growing at 20 or 30%, you've become a growth stock. And then you become like a blue chip when you start growing at 10% a year. So be careful. Yeah. And to use your grandma's analogy, like it doesn't do you any good to get there after dinner, right? You got to get there before dinner. So like hit that accelerator a little bit. And that's, again, just to bring it back, ask your venture capitalists. Like, you should be having a board meeting every two, three months, something like that. You should be sending them an update email every single month. It's so it's perfectly fine to ask them how they feel in that update email. Just say, hey, please don't reply all or definitely be using the BCC thing. But just get their opinion. They appreciate it. And this is something they're very good at. People like to do things they're good at. And very basic, blocking and tackling, we like accrual accounting, not cash accounting.

Starting point is 00:06:03 Explain it for the 700th time this month's got accrual versus cash. I know we're here at startup basics. You can point people to this timestamp and you wouldn't have to do it a 787th time. You can just point them here. Yeah. Well, cash accounting is literally booking revenue or expenses. the moment it comes in or leaves your bank account. It's like such a literal thing, right?

Starting point is 00:06:27 So you get a check from a customer for $100,000, but that covers 12 months. That doesn't mean you book a cash accounting would be book it $100,000 in one month. Accrual accounting means spreading that $100,000 over 12 months, the life of the contract, the life of the time you're providing service under the deal, and recognizing my mask can be a little bad here,

Starting point is 00:06:50 but $8,000, $8,500, $8,000, $8,500 per month in revenue, the rest goes into deferred revenue. Same thing on the expense side. Say you have someone building your website for three months and they send you a bill for $50,000. Well, you're going to actually accrue those expenses over the whole time period, the three months the developer was working on the website. Don't just plop it into one month and call it a day, right?

Starting point is 00:07:14 And where this gets really important is when you're sitting up there at your board meeting, showing the financials, and you see the VC's, and trying to figure out what the heck's going on. And it's because you've been doing cash accounting and your expenses and your burn rate and your revenue are all over the place. And they don't even know how many months of runway you have because they can't calculate an average burn rate, right? So you need, it also just makes people, for lack of a better word, makes them suspicious

Starting point is 00:07:43 that you're doing something incorrect or maybe against the law because things are bouncing around so much. So you really just want to normalize all this. the stuff. Just accrual kind of just means normalizing, smoothing the spend or revenue out so that it's a trend you can actually follow. And by the way, it's more accurate. That's really the reason to do it.

Starting point is 00:08:01 And it's why the accounting bodies all want to be on accrual. And we want to understand the nature of the business clearly so we can give the best advice. We can fund properly. We can staff properly. And, you know, the number one job of a founder is of a CEO? Keep the plane going. Keep, you know, do not crash.

Starting point is 00:08:22 Yes. Don't run out of money. You run out of jet fuel, game over, you're fired, right? And I'll give you another one. We don't like to get into this too much because now we're dipping into Becky at Wilson-Sincini's category. But if you make representations in a document during a fundraising, you are selling securities, and there's a special word that the government likes to use for selling securities with inaccurate information. It's called securities. fraud. You have a high, high, high benchmark when you say buy equity in my company. Those numbers

Starting point is 00:09:00 have to be right. And there is no saying, I made a mistake. You know, FTX and Sam Bankman-Fried, Elizabeth Holmes, they claim they made mistakes. They claimed other people signed off on it. Does not matter. The buck stops at the CEO's desk. You got to get that right, correct? I totally agree. Even if it's short of fraud, but it's just like you, Jason, as an investor, need to be able to trust the entrepreneurs. And if someone sends you an email, I remember you said you'd get like 20,000 submissions a year, some huge number. And they say, yeah, I'm doing $100,000 in MRR, right? And so the monthly recurring revenue, the natural thing for you to do is 12x that for the year and be like, oh, this company's doing pretty well, $1.2 million in

Starting point is 00:09:50 an annual revenue. What a lot of times, and this is usually a mistake that early first time entrepreneurs make, they've done that cash accounting, they've plop that $100,000 invoice into this month's revenue. And they're kind of like,

Starting point is 00:10:05 maybe not totally intentionally misleading you, but they're taking some liberties. And I think, you know, once you get on, I'm speaking for you, I don't know your opinion, but I know for me, like once I get on a call and I see the person's doing this,

Starting point is 00:10:19 it's really hard to trust them again. Six months later, when there's some other issue, can I really trust you? Should I really be investing in your company? Yeah, we have a credibility building exercise at our accelerator. You can go to launch.com and see the accelerator, where we tell people, hey, when you're pitching, I perceive your credibility going up.

Starting point is 00:10:40 I perceive your credibility going down. And when you do numbers with VCs, the majority of those VCs are very, very astute, finance individuals. In fact, some of them come from finance backgrounds. And Venture is a finance-based business. You're doing portfolio construction. You're placing these investments, aka bets, and you are always thinking about the odds in which they turn out. You do numbers. VCs do math. You do numbers and the inputs don't math. If the math don't math, credibility goes down. So you say we have a thousand customers and in the previous slide you said it's $99.9.

Starting point is 00:11:19 dollars a month. We're saying, okay, you got 1.2 million in revenue a year. You say, okay, so you're at 1.2 million in revenue a year, and you said you were spending 1.2 million. So you're at break-given. They say, oh, yeah, no, we're losing a million a year. And say, okay, wait a second. The math done math here.

Starting point is 00:11:34 You say, oh, well, 800 of our customers are on free trials. Okay, well, you use the word customers. You didn't say users on free trials. You know, and another very one I see all the time is, here's our customers and pipeline and it's one slide and you're like, whoa, IBM and GE and, you know, Sony pictures and wow, what a great client list. It's like, yeah, we have meetings with them coming up. We, you know, they, they added us on LinkedIn. You're like, wait a second, it's a client list. It's like, yeah, well, those two that you haven't heard of of the clients, the other nine are in

Starting point is 00:12:09 the pipeline. Those are two different slides. Credibility going down. Let's make credibility go up And you must understand. When we're investing in companies, and you know this full well, Scott, because you're asked to, you know, do the P&Ls and the books, and those are part in the due diligence process, it will come out anyway.

Starting point is 00:12:29 So own the nascent nature of startups. If your startup was churning and cooking like Netflix or Uber or Airbnb, it would be a public company. So therefore, don't be embarrassed. You got a churn problem, you got a pricing problem, you're losing money. That's the opportunity for us to invest in your company at under a billion dollars because

Starting point is 00:12:54 you haven't fixed those things yet. I totally agree. And just to go back to one thing you said, which just made my head explode because I've seen this before, the booking free customers, I've actually seen startups say like, well, hypothetically, we would have charged them $100 a month. So therefore, we're going to put this in the end. income statement. And it, that is fraud. That is something you should never, ever, ever do. So just all those, all those things you route it off are such great examples. Also,

Starting point is 00:13:24 one other little thing is don't book like your pilot or test revenue and extrapolate that into annual recurring revenue. That is a one-time thing. Super simple way to do this on the P&L, present your reoccurring revenue stream, one line item, one item below that. Just put your pilot revenue. It's people like seeing pilot revenue because that means the dogs are reading the dog food, people are trying out your service, they can extrapolate forward on that. Don't try to get cute and mix that in and try to get that benefit on the multiple. Because we've seen this movie before. Totally. Totally. We understand. Free trials, paid trials, subscription revenue. We understand there's different buckets here. We understand different founders have different philosophies of it.

Starting point is 00:14:11 If you're a Raul from Superhuman, there's no free trial. You give me your credit card, you use the product. This is, you know, like going to the Amman Hotel. It's luxury software. You don't get to try the Amman Hotel for free for a night. That's not how this works. You pay. Other people might be like, sure, stay at my Airbnb for free for a night.

Starting point is 00:14:31 If you like it, pay for the second and third. Now, having a plan, that's something we can all agree on. And, you know, I had Doug Leone tell me at some point, when he asked me my plans, you know, Jason, hope is not a plan. Let's make a plan. And I said, yes, sir,

Starting point is 00:14:52 Mr. Leone, I will get to work 20 years ago, and I built a plan. And then he banged on the plan, Wolof banged on the plan, and I became a better entrepreneur. Make a plan. What should be in the plan? Scott, if you were asked to come in

Starting point is 00:15:05 and help with the plan, people get intimidated, maybe you're a creative, you're a product person, you're a designer, you never built a month, model, you never built a plan, demystify it. What are the variables that you need, the inputs, the answers to those variables that you need to make a good plan? Yeah, well, first of all,

Starting point is 00:15:24 no one wants you to be the Goldman Sachs analyst. No one expects you to be that person, right? In fact, those people make terrible entrepreneurs. So really, like people like you, people like Doug Leone, they are looking for something that's workable and they're going to give you a lot of kind of create it like they're going to give you some room right so leeway is the exact word i was looking for they're not going to scrutinize every single crazy line item what they want they treat it i think like a treasure map almost they want you to they want to be able to look at it and see where you're going and make sure you have enough fuel to get there right so very simple you can just start with something as simple as revenue or if you want to get a little fancier maybe your number of customers

Starting point is 00:16:09 times the average selling price, something very, very simple. Just work downwards. Then you're going to go to cost to cost to cost to get sold. How much does it cost? How much is your web posting or your compute cost every month? How much does it cost if you're a biotech company to run some of the basic experiments that you need to get your products out there? Whatever that is, that's going to be your cost to get sold. And below that, you take the revenue minus cost to get sold. You've got your gross margin. That's one of the first things that VCs are going to look at. And then you just kind of load in your operating expenses. And a lot of that's going to be headcount. So think your marketing team, think your engineering team, think the operations team. And once you get that, you now got your

Starting point is 00:16:51 operating expenses and you've got your operating income. It can really be that simple. I've seen great models that have 10 line items. And what made them great was they were accurate and they were very simple and easy understand, and the cherry on top was the entrepreneur could talk to every single line item and explain what was happening. The worst scenario is that you pay someone to build some crazy fancy model that you don't know how to use and that it gets wholly screwed up, and then you find yourself in a VC pitch, and you can't explain what is happening, because you've never really internalized the fundamentals, the gears in your business. You need to understand if you pull over here, this is going to happen. If you pull over here, that's going to

Starting point is 00:17:36 happen. Super important to kind of, I actually recommend people do a real simple one themselves, and then as they get more advanced, we'll build it for them. We'll build something that they can use, though. That's a really key point. You only need to look back to a bit of history, as I'll tell some founders like Queen Isabella, back to Christopher Columbus, to go to the new world, not to find North America. It wasn't a new world voyage. It was, hey, if we go to that way we can get to India and the spices quicker. He had a thesis. The thesis happened to be wrong. It's a big land match. You're not getting to India going across the Atlantic. It was better off going the other way. However, after pitching and pitching, she gave in, supposedly she sold and pawned her

Starting point is 00:18:19 jewelry in order to back him. And, you know, it took time, but there was a plan. And then there were, you know, rewards for hitting that plan. Rewards included like spreading Christian Christianity and getting the bounty and making Spain a very powerful trading country. So, you know, you had these two people in this dance of, hey, should we make, should we take this voyage? Look at it that way. And if you say, here's the number of miles. Here's the construction of the ship. Here's the size of the crew. Here's what we could get. Here's the range of what we could get. All of a sudden, the person who's got to fund that journey starts to feel safer. Now, you're going to go on the journey. And listen, it's not life or death, but it's years of your life.

Starting point is 00:19:02 and we all die, so you should look at it like that. They're going to back you, you're going to go on the journey, it's a partnership. So be able to discuss how the ship is constructed, how many people on the ship, how many lines and lemons you're going to bring so you don't get scurvy. These are important discussions to have, and if you can't have them, credibility goes down, funding does not arrive. You must build your credibility. And they also just make you a better entrepreneur.

Starting point is 00:19:29 Like you talked about Doug and Roloff banging on the model, banging on the business plan, you probably learn 10 things in those conversations that made the company so much better. So don't get all bent out of shape when the VCs are asking you tough questions. Sometimes they're just asking you tough questions to see how you react, because they're going to be kind of be married to you for five to 10 years, right? Like, they are going to be sitting in board meetings every two or three months, listening to you talk, and they want to make sure you take some criticism. Airbnb, Uber, SpaceX, top questions? How are you going to deal with regulators? Is this legal, you know, how are you going to get convinced them to not kick you out of Las Vegas or New York? And you know what? Airbnb got kicked out of New York. Uber, the last city to fall was Vegas, right? We knew Vegas would be the last city to fall because there's certain people there who run that town in a certain way that, let's just say, you want to be doing things the right way and not the wrong way because you could get a visit from a couple of guys.

Starting point is 00:20:32 So be thoughtful is what we're saying here. Totally agree. Totally agree. We don't have a startup basics around operating in certain markets with people who might have different ways of motivating you to operate your business. So with that, go to cruzconsulting.com. Email Scott at cruisconsulting.com. He's a mensch.

Starting point is 00:20:55 He does the right thing. He works with our tiniest companies. He works with the biggest ones and everybody in between. If things are broke, He fixes him. So he's my fixer. Scottcruise Consulting.com. We'll see you all next time.

Starting point is 00:21:07 Thanks, Scott. Thanks, Jason. Appreciate it.

This Week in Startups - The Best Financial Advice VCs Give Startups | Startup Finance Basics w/ Kruze's Scott Orn

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