THE SMARTER FINANCE BLOG

If you’re in for a long race, venture debt financing could give you the air you need to get to the next peak in better shape. Photo courtesy of Christopher Michel.

Raising venture debt is always an interesting subject for startups. For some CEOs it is completely off their radar, and for others it is a taboo subject. In between these extremes, there’s a growing number of startups using venture debt effectively to buy time for a higher valuation, making it a cheap form (in terms of amount of stock it costs) of financing while the value of your company rises.

I thought we could shed some light into whether venture debt is a good thing for your company by creating a simple model you can use to project its long-term effects on your valuation and on your stock and explore if it makes sense for you. For a sense of the value of this exercise, under a relatively conservative growth scenario, Venture Debt could save the company from having to give away 3% of equity. Before getting into detail about how this model works, it’s worthwhile to spend some time reflecting on a couple of issues you will need to think through before raising money this way: covenants and purpose.

Covenants and Purpose

Many think that some banks and venture debt providers require excessive terms and may tie up the company with covenants that hurt you in the long-run. Our experience with this is that most of the terms and covenants can be negotiated, with the exception of the investor support covenant, which requires the venture investors of your company to agree they will continue to support the company or the covenant is triggered. Even the MAC (Material Adverse Change) covenant, which seems to be the most draconian of all because it gives the venture debt provider the option of not following up on their promise if there is a significant change in the company (based on their definition), can often be negotiated. What you need here is a supportive board that has a venture investor with venture debt experience, working closely with you and your CFO to ensure you get the best deal for the company.

Putting in place venture debt is best done right after a VC raise. You can usually structure it to pull the funds much later – and face only a small portion of the costs before pulling the funds. The goal is to have it available in the future in order to buy time for growth so that the next round comes a bit later, giving you more time to increase the value of your company. This means that  growth should be the purpose for making your case to raise venture debt with your board. Emergency money or, worse, an excuse just to spend more, is what this kind of financing can unfortunately be wrongly associated with. Although if it comes down to using it in the event of an emergency, that can also be a valuable use, but in that case, it’s usually just to give another shot at pivoting and potentially save the company rather than juice value. In any event, raising venture debt with growth in mind, before you need it, will help you get better terms with debt providers and negotiate favorable covenants.

The Model

The basic assumption behind our model is that you’re raising venture debt for the purposes of growing. As such, the spreadsheet helps you look at two scenarios of growing: with and without venture debt. The results, once you input your numbers, are quite simple:

  1. Whether using venture debt made you save equity
  2. Whether using venture debt gave you time to increase the value of your company

If there is a positive number answering these questions, then you should take a closer look at venture debt. We plugged in numbers to show you how it works, feel free to substitute these with yours (red fields are input fields and the two key outcomes are highlighted in yellow).

Click here to access the spreadsheet.

The model begins by assuming a venture raise just happened (Cash at the End of Period 0, $10 million in the example). In the example, you raise $5 million in venture debt, giving away 0.2% of equity (0.1% when you put the facility in place and the other 0.1% when you draw the money), and paying a setup fee of $30,000. Cash burn is the same in both cases ($3 million), except for the venture debt payments. The example assumes a valuation growth of 25% every period (in this case, every 6 months). Note that you pay the bank the initial fee ($30,000 in the example) even though you don’t draw the venture debt of $5 million until you need it in the third semester.

This model is built to show the debt enabling a six-month funding delay in your next round ($20 million in the example) and assumes the same valuation for both scenarios, as it is just comparing financing structures in isolation. The result in the example: you raised money at a valuation of $97.6 million in the last semester rather than raising it at a valuation of $78.1 million six months before. The net value saved was $3 million, leaving you with 3.07% in equity you can keep. Not too bad!

Does venture debt work for you?

If you plug your numbers into our model through this link (red marks indicate input fields), you will see the impact of using debt in addition to equity for some of your financing. The model buys you time, but you need to keep in mind that growth needs to happen.

Venture debt works when it buys you time for a better valuation because things are going well. You pay for this time with debt and not with equity, saving you equity in two ways: initially by raising debt, and then afterwards by using that debt to get to a better valuation. If your growth scenarios come to fruition, venture debt enables you to raise money a bit later than you would, when the value of your company is higher. That is a great deal if you’re good at forecasting. You can also explore the impact of the debt using different growth scenarios, thus further exploring the potential value or the downside. Have fun 😉

Sometimes in finance, long and complex ways actually take you somewhere.

Although the SEC (Securities and Exchange Commission) does not regulate the financial reporting for your privately held company, you will benefit greatly from understanding, and maybe even adopting, their regulations. When serving in a Strategic Finance role, I ensure that the P&L follows this format and then use the historical data, as well as comparable company metrics, to develop company models.

This guidance is actually a very basic concept that defines the formats for financial statements. By adopting this definition for your subscription company, you will present your financials in an easily consumable format. This format also allows for comparable company comparisons that will help you refine your business model, identify KPIs and manage your business performance. Using comparable company comparisons will help you to better forecast your business and add credibility to your forecasts.

Income Statement Format

The regulation calls for what’s known as a “Two-Step” format, in that “subtotals are used to show decision-useful line items such as gross margin and operating income separately from non-operating income and net income or loss,” as stated by CFR Title 17.

Below is the specified two-step format customized for a subscription company. I’ve defined the resulting ten steps as follows:

  1. Net sales and gross revenues. State separately product and service revenue for each business line which accounts for more than 10% of total net revenue.
  2. Costs and expenses applicable to revenues, stated separately according to the net revenue categories. These expenses are known as Cost of Revenue for subscription companies.
  3. Gross Profit and Gross Margin
  4. Operating expense defined as Selling, General and Administrative expenses, or SG&A, and other general expenses relevant to your business, such as R&D or Operations. Subscription companies typically use R&D, Sales & Marketing, and General & Administrative.
  5. Operating Income, which is Gross Profit minus Operating Expense.
  6. Non-operating expenses, such as Interest, Taxes and Depreciation & Amortization (D&A) expense, if relevant.
  7. Net Income, which equals Operating Income less Non-operating expenses. Use if #6 is relevant.
  8. Earnings Before Interest, Taxes, Depreciation & Amortization, or EBITDA.
  9. Change in Working Capital
  10. Free Cash Flow

In my experience, early-stage, venture-backed companies typically have little or no Interest, Taxes and D&A expense. Most have convertible debt, but do not used debt lines. Most are in loss positions, meaning that they do not generate profits. Also, most are capital-light, meaning that they do not buy equipment above the $2,500 amount typically set for capitalizing purchases. Without non-operating expenses, Operating Income will equal EBITDA. In this case, use Operating Income in lieu of EBITDA because the latter implies that ITDA expenses exist. Free Cash Flow is the cash-based profitability of the company and should be added along with a liquidity metric such as bank balance.

The example in the call-out presents a typical format that I use for subscription clients. Please note that all numbers are entirely fictitious and presented solely to illustrate a financial reporting format. Any resemblance to an actual entity’s results would be coincidental. Additionally, these fictitious results do not indicate any view or opinion on the performance implied by this illustration nor do they suggest the size of the business that should adopt the recommendations herein.

Advantages of this Presentation Format

There are three main advantages you will achieve by adopting this format for your subscription company.

First, anyone who worked in finance will be intimately familiar with this format and can quickly grasp the financial performance of your business. You can skip the time needed to explain your custom single-step P&L and move straight into the performance.

Second, this format will allow you to analyze your performance with respect to comparable public companies. The comparison gives insight into key financial metrics such as gross margins and operating expenses, especially when shown as a percentage of revenue. You can back into R&D headcount using salary and overhead assumptions. Using multi-period financials, you can derive estimates of SaaS metrics such as Magic Number, CAC Ratio, and LTV/CAC. This insight will help you refine your business model, identify KPIs and manage your business performance.

Third, your finance team will use comparable company comparisons to better model your business. Actual revenue growth, gross profit and operating expense margins, cash flow and operating metrics combine to set parameters for the forecast. And this gives you credibility in discussing both the short-term and long-term forecast.

Useful and insightful for CEOs

The SEC directives in the case of subscription companies are quite relevant because they are useful and provide CEOs with great insight into the numbers. I’ve seen this approach work well in fundraising and for financial reporting.  Feel free to contact me if you would like to dig deeper on the topic. emersch@burklandassociates.com

For the long and uncertain trek you have ahead, make sure you partner with a CFO who understands the terrain and can master the journey.

Photo courtesy of Christopher Michel.

A few months ago, my colleague and fellow on-demand CFO James Jones, published an insightful article titled “There’s a Time for Everything: When to hire the right finance help for your startup”. In his article, James brilliantly laid out a “Framework for Finance” that advises CEOs and founders on when to engage various types of finance and accounting talent.

As James indicated, there is a time for hiring a CFO, whether full-time or part-time. Once you have determined the timing is right you will be faced with one of the most important hiring decisions for your startup and you need to be prepared. Hiring the right CFO will boost your company’s performance; hiring the wrong one will distract you and will slow you down.

The “textbook” marching orders of a CFO are to “maximize shareholder value.” This implies many things, including a control aspect, which involves making sure the right controls and processes are in place so you can make the right decisions, and a judgment aspect, which involves maintaining an objective viewpoint to help you do what is right for the business. However, you also want to have someone who does the above and has the rare ability to foster relationships within the company to collectively work towards the same goals and objectives.

You are not just hiring someone who understands the process of closing the books and issuing financial statements. Anybody with a financial education can do that. You are hiring one of your closest partners, someone who gets it not only from the financial performance side but from the operational and infrastructure perspective as well. This CFO partner needs to be someone that can not only speak to what numbers on the financial statements went up or down, but can provide the insights as to why they moved and can drill down to understand the operational drivers of your company, turning data into information you can use to make good decisions.

A good CFO will partner with you and your management team so that all are collectively working to “maximize shareholder value,” as the textbook definition of a CFO indicates. This partnering is particularly important in startups as they are often a new experience for the CEO or for their management team.

The Psychology of Finance: how to go beyond the resume

Hiring the right CFO certainly requires, of course, carefully evaluating a candidate’s resume. Beyond this basic requirement is where you need to pay attention. Assuming the finance skills are there, you need to understand what most likely is not on their resume—their ability to build internal partnerships to help you operate the company. This is what I refer to as the Psychology of Finance. Specifically, more often than not, your first CFO will also be your acting COO because they will be the ones setting up basic systems such as HR, Legal (negotiating contracts, including sales contracts), M&A, IT, Supply Chain/Logistics and facilities. A CFO with poor people skills will not be able to champion your internal team to succeed at this.

Partnering with the right CFO that gets the importance of people dynamics will be one of your most important early decisions. When scouting for your partner CFO, make sure you ask for examples and find evidence of: a) the person’s flexibility (how do they manage the unforeseen?); b) the candidate’s preventative or enabling style when managers come up with issues outside the plan (are they about “getting to no” or about “getting to yes”?); and, c) their ability to nurture stakeholder relationships (the acid test here is the extent that business managers have consulted them for advice on key aspects of business/strategy in their past).

Key to ensuring you have the right CFO is to understand their view as to their role in your organization. Along with answers like setting up planning, forecasting, processes, controls, helping to raise money and preparing the board decks, listen for past experience that evidences they see themselves as someone responsible for turning the financial data into information that helps you and the rest of the company make informed decisions. A CFO who understands their role in your startup will ask you questions that evidence they do. These can include questions regarding your style for running the company, what are you looking for in a CFO, how your executive team work together, your relationship with your board or the biggest challenge you are facing right now.

Net, what you are looking for in a CFO for your startup is evidence that the candidate knows the importance that people dynamics have on their role as one of the key executives in charge of steering the company in the right direction. Mastering the numbers with no emotional intelligence is of no use to you when you need sound cover from a CFO. So when you decide it is time to hire your part-time or full-time CFO make sure to look beyond the resume to find the person who can make strategic finance actionable and useful.

Unlike this city in the desert, you only get a chance to set up best practices once.

Photo courtesy of Christopher Michel.

Those going to Burning Man next week will be arriving to a city that did not exist a few weeks ago and will cease to exist in just a few days. It is one of the very few examples of its kind where everything is temporary, and can be re-done better next year when the entire city will raise again from nothing.

Unfortunately, startups do not have the flexibility to start over each year. The systems that are put in place early on form a foundation that will affect the company’s performance for the foreseeable future.

Here at Burkland Associates, we help our startup clients set up scalable systems that not only minimize the friction from everyday accounting, but also ensure that the business runs smoothly over time. While supporting startups with on-demand bookkeeping and accounting services for many years, I’ve identified five important items that should be kept in mind when setting up your systems. Here are some of the details on these five set-up practices, so you can be mindful and avoid unnecessary pains as you grow.

  1. Select systems that scale

Quite often I find that many startups that are poised for fast growth choose bookkeeping systems that can’t keep up. Although Freshbooks, Bench.co, and Indinero seem like simple solutions to start, their automation and integration with outside apps and services are far inferior to other solutions such as Quickbooks Online and Xero. This ability to connect easily to outside services offers the flexibility to optimize accounting systems to each company’s specific needs. As for expense reimbursement software it’s best to choose one, such as Expensify and Abacus, that not only syncs with existing accounting software, but has the ability to structure multi-tier approval paths (although a young company may only have one approver at the moment, this almost certainly will change as the company grows).  The same for bill payment solutions- chose one that syncs and scales such as Bill.com.

  1. Open a business bank account as soon as possible with a bank that specializes in Startups

Opening a bank account early on for your startup not only is the easiest way to begin organizing your company’s finances, but it also offers the opportunity to develop a relationship with an important business ally- your bank. Co-mingling personal finances with your company is a no-no, and the opening of a business account (along with appropriate debit and credit cards) has the added benefit of less expense reporting and reimbursement activity. So, avoid using your personal credit or your savings account as soon as possible. Also, be sure to select a bank who is supportive to the startup community. Here in Silicon  Valley, several banks, such as SVB and Square 1, have developed special services for startups that result in lower costs and red tape for you, with the added benefit that they help their clients network. In addition, when you develop a relationship, there will be someone you know on the other end of the line when you need your bank to work with you.

  1. Don’t handle payroll on your own

With ever changing payroll tax laws, periodic filings, and the need to make sure your employees get paid on time, there is a lot that can go wrong during the payroll process. Make it easy on yourself and hire a low-cost payroll provider that will handle these responsibilities and more. Gusto, for instance, not only syncs automatically with QBO and Xero, it provides your employees easy onboarding, digital pay stubs and direct deposits right into their personal bank accounts.

  1. Introduce simple and appropriate policies and procedures

This is the time to set precedent. Take some time to think of best practices regarding issues that impact your bookkeeping and accounting systems such as credit card usage, expense reimbursement approvals and limits, collection of accounts receivables, client and vendor onboarding, etc. Document these policies and procedures then share and train you crew. Early adoption can help avoid bad habits and ensure that your team is singing from the same sheet of music.

  1. Gain basic accounting know-how

Your startup will begin generating tons of information regarding your finances. However, for this information to be meaningful, you need to become familiar with accounting principles that signal different aspects of the health and growth of your company. Sales, COGS, Gross Margin, Net Margin, Burn Rate, AP/AR, and Cash Flow are only as important as your understanding. Websites such as Accounting for Management, Accounting Coach,  and books such as Financial Intelligence can help, but for a deeper understanding you might want to consult with an experienced CFO or Controller.

Although the five items listed above seem obvious, with hectic days of coding and acquiring your first customers, it is easy to ignore the accounting/bookkeeping function. Yet, you don’t want to;  as an initial focus on setting up scalable and efficient accounting systems will save you time, money and energy in the future. And if you get stuck, there are several terrific and cost effective on-demand bookkeeping and accounting services (like ours!) that can help you get on track.

2017 Copyright Burkland Associates. All other trademarks are property of their respective owners.

No matter your size, you’ll need financial guidance to gain or maintain momentum.

Photo courtesy of Silicon Valley entrepreneur Christopher Michel.

Medium’s blogger John Cutler wrote an interesting article on startup complexity (Complexity is a Startup Killer. Don’t Grow Up) in which he analyzed how the two advantages of a startup – speed and focus – start to evaporate as your company grows. His advice is to resist the complexity that comes with growth and avoid the temptation to: Let features reproduce; Add endless sales tools; Multiply enhancements; Add more people to the Board; Find more and more partnerships; and Hire “experienced” people.”

To this last part about hiring experienced people, Cutler adds “Company experience doesn’t equate to Startup experience.” As an on-demand CFO at Burkland Associates, I’m a member of a team that enables access to startup experience on a fractional basis, enhancing a Company’s ability to scale up with the guidance of a strategic financial resource – when you need it!

A forward-thinking startup rents before buying whenever possible.  Posit the following two scenarios where “renting” a CFO can help you minimize growing pains and burn.

Scenario 1: All the low-hanging fruit is coming your way.

A friend with a green thumb tells me “plants usually die out of an excess – not lack of – water”. Sadly, this is the case for many startups that find money and initial traction come their way relatively easily. I’ve been at more Board meetings than I would like to count in which investors were pushing their portfolio CEOs to scale up faster. On the surface, there is of course nothing wrong with scaling quickly; after all, startups are about speed.

The problem comes when scaling up follows little planning – tracing a horizon based on the initial traction that a talented business development person may have generated.  Planning involves understanding how the interdependencies of product delivery, market expectations, and customer management could evolve.  If you follow short term thinking without considering longer term context you may find yourself in a quagmire in future growth stages.  As your strategic financial partner, people like me can help you craft the right plan.

Burkland CFOs can help develop a sound business model that plans growth looking at likely and unlikely scenarios (developing contingencies for them), and evolves your business in the right direction with models that show how to sustain and improve margins while optimally servicing existing customers.  Smart investors look beyond traction, they want to see “smart traction” that doesn’t dry up and lives up to the market challenges you will inevitably face. A sound plan helps you to attract the additional capital and key resource hires you need as you scale, and becomes critical to sustaining momentum.

Scenario 2: You’re struggling to gain momentum.

If you’re losing sleep, it’s most likely because you’re not growing as fast as you expected and the solution is not obvious. You’re draining cash and not building the business growth story you need for your next round of financing which, by the way, is around the corner.

The challenge becomes one of creating processes to drive efficiency, fine-tune key variables such as pricing and levels of service, and buying time to figure out your market and educate prospect customers. You can’t justify hiring a full time CFO given your size, but you need a strategic minded CFO more than ever to stabilize your business, or face dire consequences. A part time CFO from Burkland is a huge asset in your corner to help you find traction. In this case, renting is a no brainer because a hired gun brings the relevant experience you need to figure out how to start sales momentum in context of a plan, as most of us have seen this problem several times even in your own industry.

Lack of traction can be a blessing – just ask SaaS star Slack, which came out of a failed gaming company – if and only if you have the right guidance to know where and how to tweak your model. A strategic CFO from Burkland could give you the partner and coach you need to help solve the puzzle and develop sustained traction.

Please contact me at pkang@burklandassociates.com to speak further.  Thanks

Make sure you plan ahead; it’s going to be a bumpy ride no matter what.

“Plans are worthless, but planning is everything.”- Dwight Eisenhower

Developing a financial plan is one of the most beneficial actions you can take as an entrepreneur when starting a business. A financial plan is like a spec for your company; it forces you to translate business strategy into a concrete business plan and to establish an operating roadmap that identifies the timeline for your key business milestones. As you develop your plan, your team and your investors will align on the goals and objectives to move your business forward.

A financial plan is also an essential tool for raising capital. Your projections enable you to determine your business’ funding requirements and communicate the financial opportunity to investors. In discussing your plan with prospective investors, you can demonstrate the financial literacy that investors expect from executive teams.

There are three types of financial plans that every start-up needs: a Long-range Plan, an Annual Budget, and an Intra-year Forecast. Here are some details on each.

1. Long-range Plan

A Long-range Plan is the first financial model a start-up should build. The Long-range Plan should include a 3-5 year outlook, with the number of years determined by how long it will take to prove and scale your business model. You should build the plan with monthly detail for at least the first 2 years, and you can plan the remaining years quarterly or annually.

The Long-range Plan should set your vision for the business model and help you to test the sensitivities of your key business drivers. It is helpful to prepare different scenarios of the model so you can anticipate and plan for different outcomes. I generally recommend preparing a base-case, a best-case and a worst-case scenario.

Investors expect to see your projected funding needs and the business milestones that can be reached in advance of each funding round so that they see a path to scale. You should target enough cash raised between rounds to last at least 12 to 18 months. Think of this plan as building blocks and create it as a detailed bottoms-up plan while keeping a top-down view as a reality check (e.g. what % of the market can we reasonably expect to capture?)

One crucial detail that many new CEOs overlook (sometimes fatally) is to ensure you forecast your cash flow, not just your income. Make sure to account for the timing of working capital (accounts receivable, inventory, accounts payable) collections and payments as well as capital expenditures. Poor working capital management causes many early-stage companies to fail.

2. Annual Budget

The second type of financial projection you should prepare is an Annual Budget, which is a detailed monthly plan for the coming year, generally prepared in the quarter prior to the upcoming fiscal year. The Annual Budget is presented to and approved by your Board of Directors.

It is always a good idea to preview your thinking, assumptions and high-level numbers with your investors before you send them the budget and ask for their approval. Sit down with members of the board that are willing to brainstorm scenarios for the year with you to ensure you get good advice and the buy-in from your board members before the actual board meeting.

Once your Board approves your Annual Budget, it becomes your North Star to measure performance throughout the year. Ensure that every executive team member is involved in the process of creating the Annual Budget, as their input and buy-in to the process is crucial to their performance. I recommend you share the Budget with the entire company to ensure everyone is aligned with the organization’s goals (although some executives prefer to omit sensitive details, such as the timing of cash running out).

3. Intra-year Forecast

As its name suggests, an Intra-year Forecast is simply an update of the budget completed during the year to reflect actual performance to date and an updated view of what is expected for the balance of the year. An Intra-year Forecast is an important tool to manage your cash and make the necessary adjustments to stay as close to the Annual Budget as you can. I recommend preparing an Intra-year Forecast at least 3 times per year – at the beginning of the 2nd, 3rd and 4th quarters.

As the quote at the beginning of this article says, “plans are worthless but planning is everything.” In general, reality significantly deviates from your plans. By having a plan, you will quickly identify when business and market conditions have diverged from expectations and you will be prompted to quickly react and adapt. One of the most useful things that on-demand CFOs like us can help you with is to develop Long-range Plans, Annual Budgets and Intra-year Forecasts to help you plan, monitor and grow your business with confidence.

Here are some useful articles that dive deeper on these three essential types of financial projections.
http://avc.com/2010/04/projections-budgeting-and-forecasting/
http://avc.com/2010/05/scenarios/
http://avc.com/2010/05/budgeting-in-a-small-early-stage-company/
http://avc.com/2010/06/forecasting/

Photo courtesy of Silicon Valley entrepreneur Christopher Michel.