How Much Cash Do You Really Need?
We see pitches all the time with a variety of funding needs ranging from $500k to $5M. Startups are doing new and exciting things but often we find that the founder and the team do not have a clear idea of exactly how much they need and why they need it. The ask comes from a mix of heuristic, benchmarking seed or series A rounds on the coast, or a model based upon faulty assumptions.
Seed stage initial budgets are varied and no two are exactly alike. They do, however, share one common thread: they will be proven wrong. The wise founder, knowing this is likely the case, builds a model based upon assumptions that are backed by fact and logic. And then, after establishing a solid case for the actual cash need, the wise founder asks for slightly more than the model suggests and plans on spending less.
By following this approach, the wise founder builds optionality into her plan. She is no longer locked in by her faulty assumptions. And best yet, she does not depend upon customers to onboard at a top quartile rate and for a bottom quartile acquisition cost.
Root cause of faulty numbers
Raising capital and budgeting for startup isn’t something that many people have a lot of experience with. It is an infrequent activity with significant consequences. Mix this task dynamic with the optimism characteristic of founders and you have the root cause for faulty numbers.
Most of the time the founders are convinced of the conservative nature of their assumptions. I don’t think I have ever heard a pitch that didn’t highlight the founder’s belief that the numbers are conservative. This typically falls on deaf ears for investors. They know all too well that all initial models and capital needs analysis are over optimistic on revenue and far too light on costs.
Five step process to a better capital budget
The goal of a founder is to create sustainability. All the pillars of the organization (investors, employees, vendors, and customers) must have a long-term sustainable exchange with the organization for the organization to be truly sustainable. And all valuations come down to sustainability. The more sustainable the organization, the better the valuation.
1. Start with benchmark metrics
So how can a founder design sustainability into the capital request? The wise founder knows that initially she doesn’t know what the employees will need in compensation and culture, what customers will need in value and services, or what the vendors need in terms and margin. She knows, however, that the SaaS journey is a well-trodden path and she can get averages from tools like the Keybank SaaS Survey.
The key to picking the right set of benchmarks is to look for a set of comparable companies and then compare those results to the average of all SaaS businesses after filtering for a few key features: contract size, contract term, customer size, company size, and delivery model.
The reason to find some comparable firms is that there are unique dynamics in certain areas of the B2B SaaS space. For instance, a marketplace will have a different concept of customer lifetime value and acquisition cost due to the two-sided nature of the exchange compared to a workflow application.
Similarly, however, the comparison set you will find will likely be larger companies that have ‘succeeded’ in a few key ways. This means they have figured stuff out that the wise founder knows she doesn’t know yet. Hence the need to compare those results to the benchmark of average results.
2. Use a model that is both driven by and produces KPIs for comparison
Once the wise founder knows what benchmarks will drive her business, she then sets about building a model to see what people and capital capacity she needs to execute on the opportunity. There are a lot of great options for models. A wise founder will build her own if she has prior experience with such things. If not, she will rely on an expert and save her valuable time for more strategic things than fiddling with excel.
The wise founder can download a tool like the Ultimate SaaS Model from GST Labs or buy one from Foresight (https://www.foresight.is). Most likely either of these approaches will require significant work to get the model in a logical format. This means countless hours of manipulation, array functions, vlookups, etc. The wise founder outsources this to a team member with that background, hires the team at Foresight or finds a contract CFO to add their input.
In all cases, the model should be flexible, accurate, contain actuals and proforma, monthly, and have annual and quarterly views.
3. Iterate the assumptions and benchmarks
Most of the benchmarks have intersecting formulas. This means that if you aren’t constantly checking the benchmarks, you will find that your model has flaws. For instance, if you might use a decent assumption that your acquisition cost will be 13 months of your gross margin and that your account churn will be 15% while your revenue churn will be -1% due to expansion. These could be very consistent with norms. However, you might not have missed that the expansion revenue (representing approximately 16% of the annual new revenue growth) also carries an acquisition cost (accounts do not expand on their own). This would put you out of conformance with the global metric of sales efficiency (the amount of sales and marketing spend to achieve $1 of new annual recurring revenue).
The interrelation of these metrics requires iteration. And it doesn’t stop once you start fundraising. The iteration cycle is a monthly process.
4. Keep tight version control
The iterative process of building a model produces a ton of versions. You need a mechanism to track version control and ensure that you know what changed. It is typically a good idea to have one page on your deck with the financial backup to your figures and make sure the version of the model that produced that output is included as a footnote to the numbers. Separately, you should also keep the model secure and protected for every presented version.
This level of care will pay huge dividends down the line. It also has the side benefit of helping the wise founder meet with her management team and discuss the ways in which they are or are not hitting the original metrics. Tracking the versions allows the wise founder to see what the organization has learned as the team executes.
5. Get feedback from people who have done it before
Everyone needs a mentor. Look for a mentor who is not involved in your business, has no equity, isn’t selling you anything, and who has raised a similar round from a similar source (i.e. angel, friends & family, venture, etc).
Entrepreneurs love mentoring. It is a defining characteristic. Don’t be afraid to reach out, but be careful to make it worth the mentor’s time to advise you. This means being teachable, empathetic, and grateful. Acton’s Naïve Networking and Stars and Stepping Stones have some of the best advice I have read for finding and securing a mentor.
The wise founder follows this process before asking investors for their hard-earned money. In doing so, she shows her knowledge of the market and her resolve to protect the investor’s money. The wise founder does not need to point out the ways in which her model is ‘conservative’, her presentation speaks for itself. She can rely on statistics and on her assumption that her team doesn’t need to operate in the top quartile to succeed but could be in the bottom quartile and still achieve success.How much cash do you really need?