Startup Financial Planning
Early-stage founders frequently struggle to put a price tag on their company when still early in development and commercialization.
The ‘why this is’ is revealed by identifying the solution.
First, we need to understand that capital markets are competitive. Interest rate “spreads” are the easiest way to understand risk vs. financial reward. When a U.S. Treasury bond (considered “safe”) pays 5%, then how much more needs to be paid for a riskier investment? For example, a home mortgage, inventory loan, or an investment in a pre-clinical oncology company?!
The more risk taken, the more that should be paid to take that risk. The spread between 5% and whatever the return is represents the size of the risk of failure and loss.
In today’s dollars, the valuation that a company applies to its business when making an investment offering must be defined to ensure a fair return to the investor at the exit, relative to the risks of failure ahead for the company and the price being paid today for both similar and different levels of risk available elsewhere.
The solution, therefore, necessarily depends on forecasting an estimated ROI to a new investor today. This subsequently depends on actually doing the planning to conceive of how much money the company will need to raise, at various points and terms, to reach each milestone that leads to the exit.
So many early-stage companies try to raise money after the initial self- and F&F investment without actually having done this level of planning. They get stuck focusing only on what it’s going to cost to reach the next set of milestones and then trying to raise that amount of money on looser concepts of what they think their solution idea is worth to the world, instead of what investing in it ought to be worth to serious and professional investors.
But the plan-as-you-go style of setting up a startup mostly always fails for this simple reason: planning all the way to exit reveals hidden risks the founders weren’t aware of until they had to quantify the costs and potential setbacks of the company’s entire lifecycle to the hoped-for exit. But when not planned for, if they get far enough to encounter those unexpected risks and setbacks with no pre-conceived backup plans, the first setback often becomes the failure point as investors flee the struggling enterprise.
In effect, when a founder sets a valuation without a fully conceptualized birth-to-exit financial and dependent capital plan of their company, it is the same as doing a top-down revenue forecast.
A well-done revenue model is built bottom-up from bits by counting reachable customers, available capacity, and costs of executing a plan that produces at capacity and acquires those customers. (This itself is only a very summarized explanation. Revenue planning is a detailed exercise that takes a lot of time and research to construct.) But when you create a bottom-up revenue plan, you discover the assumptions you need to make about details you weren’t thinking about and inevitably “don’t add up” or seem realistic. In the discovery of those problematic assumptions, you have the opportunity to work out alternative business and operational methods to overcome those unrealistic assumptions.
Similarly, a bottom-up valuation is built from the company exit – backward, not from the present point forward. In the same way, then, a company forces itself to make a set of assumptions which, in the conceiving of them, sometimes will shout out degrees of unrealism at the founders that force rethinking and replanning.
Therefore, a company should first define what it thinks the final milestone is to be achieved from scaling, and what it believes will make the enterprise worth it to the acquirer (or at IPO, etc.). This involves various methods of comparative and parallel analysis of acquisitions of revenue streams from similar types of solutions sold in the marketplace. (Yes, some solutions are new, without direct comparables. Parallel analysis is the study of what other things were worth, in inflation-adjusted dollars, when those solutions were new.
Next, a company should build a timeline backward from there of each major milestone it should achieve, leading up to the final one, which should represent a significant value inflection for the company, until it arrives back at where it presently stands.
Then, a company can do the requisite and traditional operational financial planning to determine how much it’s going to cost to reach each inflection point (inputs like material & labor, administrative and overhead costs, marketing & costs of sales, etc.) (It should buffer this for risks of costing more or taking longer than anticipated!)
The company can proceed then to overlay a fundraising plan that raises sufficient capital well ahead of the necessary use of funds along the way, balancing when money will be needed against when milestones that add value have been achieved that build ongoing investor confidence.
Finally, bell curve norms of the amount of the company (%) that should be sold at each round, including set-asides for incentive options, can be applied that add the last element needed to construct a mathematical capital model. A model allows one to run multiple scenarios to test assumptions at each point and make a judgment about the exit outcome and the return to new investors in the next round. When a scenario is found that estimates a worthwhile return for investors at each round relative to the risks remaining after that round, the company has achieved a logic-based, defensible plan that impresses investors at every stage! A capital model is also a vitally valuable living tool that can continue to be refined as the company progresses, adding to the founders’ intuition in their continued planning.
In summary, with a fully conceptualized capital plan, a company can calculate the estimated ROI to new investors now, THEN ask whether that seems fair relative to the execution risks ahead for the company, and then trial-and-error various valuations until they settle on one that seems attractive and investable.
When talking about this level of planning, the not-so-clearly stated pushback often received boils down to ‘that’s a lot (or more) planning work than I anticipated doing by this point, or that I even know how to do at this point’. It’s true, this is more planning work than most founders anticipate and goes beyond the education in strategic financial planning that anyone has taught them or asked them to do, especially among a deep well of educational and coaching resources that don’t necessarily have deeply bought-into methods of teaching strategic finance themselves. I continue to believe that Finance is the resource in least supply when it comes to building businesses of any type (from mom & pop to Fortune 500 companies.)
But, does ‘it’s hard’ or ‘I don’t know how’ defeat the need to do the planning to succeed, to succeed? The obvious if the uncomfortable answer is ‘no’. It must be done, or else a very large layer of unmitigated and unforced risk of not having done it is being added on top of all the other risks a startup faces, and investors investing anyway really are just engaging in a slightly more refined gambling night out in Vegas. The analogy is appropriate because remember that in Vegas, not knowing your odds is part of the fun. It’s illegal to count the cards or be a human supercomputer – that’s not fair to the house!! But we shouldn’t be applying house rules to startups. We should know the odds, and we should be paying appropriately and knowledgeably for quantified risks.