Admit it. You look at your financial model at most a handful of times each year. It’s ok. This is a safe space. Know that you are not alone.
The unfortunate truth is that most startups only reference their financial models (aka operating models) either when they’re fundraising or when they’re preparing for a board meeting.
Founders see these bulky artifacts as necessary evils designed mostly to fulfill governance responsibilities.
It’s risky and misguided.
But it’s also understandable.
To be a founder is to hold one of the only (potentially) highly compensated jobs in the world that lacks training, curriculum, or pedagogy. And truth be told, most founders don’t hail from a finance background. Most often, they come from sales, product, or engineering.
So when someone in the founder’s life eventually tells them they need an operating model, the founder obtains a template, drops in some Excel formulas, and voilà! A model is born. But the moment the urgent need passes — the board meeting concludes, the capital raise finishes, or the debt has been secured — that model disappears into a (digital) drawer.
But that’s not how the best founders operate. The best founders know that the model is a mathematical representation of how they think about the business. What will drive growth? What will determine expenses? And the best founders know that when done well, the model is a guide to prioritizing what actions to take and which experiments to run to unlock the next major milestone.
Let’s start with the end in mind.
Startup Planning 101: Where to Start
At any given time, a startup is working backward from one of three outcomes:
- Raising the next round of venture capital.
- Reaching profitability.
- Securing an exit.
Once you know which hill you wish to climb, it’s time to map your journey. That involves three stages:
- Predict your KPIs.
- Set your targets.
- Determine the activities required to hit those targets.
Simple, right?
Yes, but …
The single most common planning mistake founders make is that they only think top-down.
See if this sounds familiar:
You eventually want to raise your next round.
You ask some fellow founders, read some blogs, check in with your board, and determine the revenue number you need to reach.
You translate that revenue number into a number of customers, an average contract value, a conversion rate, and a number of leads.
You then communicate that to the team, and everyone charges forward.
Planning done!
So why doesn’t that work?
Because it ignores history.
Good planning is done bottom-up and top-down. The art is how you close the eventual gap when those two exercises disagree on the outcome. (And they almost certainly will.)
So what does that look like in practice?
Startup Planning 102: The Bottom-Up Plan
Bottom-up planning is your revenue and expenses hypotheses for the period ahead.
Begin your bottom-up revenue build by asking:
– How many prospects do we need to reach before we get a lead?
– How many of those turn into actual leads?
– How many of those turn into pilots?
– How many of those will close to a signed contract?
– How much will each customer pay?
– How many signed customers will churn?
– And how long will that entire dance — from lead to signed contract to cash received — take?
You don’t have to guess the answers; let history be your guide.
Then move to expenses.
To suss out your variable costs, ask:
– How will you generate MQLs, and at what cost?
– Who will convert MQLs into sales-qualified leads (SQLs), then pilots, then closed contracts?
– What’s your total customer acquisition cost (CAC)?
– How will you support pilots and existing accounts?
– What will hosting fees cost, given the size of your business and your growth assumptions?
To determine your fixed costs, ask:
– What level of product and engineering staff will you need?
– What will your selling, general, and administrative expenses (SG&A) be? (For example, salaries, travel, litigation, etc.)
There is no right or wrong answer. Base your estimates on your quantified past and your expected growth; then be ready to adjust as data comes in.
Startup Planning 103: The Top-Down Plan
With your bottom-up plan complete, it’s time for your top-down plan.
Answer this question: What do the capital markets expect of your company? Said differently, you know the kind of round you wish to raise. What will investors who invest at that stage expect from a business such as yours?
- What does your revenue growth need to look like?
- What should your gross margins be?
- When should you see CAC payback? Or is there a minimum magic number?
If you don’t know, gather data by looking at public company comps. Ask members of your cap table. Talk to your corporate counsel — they see more term sheets than anyone. Or, seek the expertise of investors you’re grooming for your next round.
Here’s what to do when your bottom-up KPI assumptions are insufficient to reach your top-down targets.
Often, your bottom-up assumptions will not line up with top-down market demands. If the gap is too large, there are three things you can do:
- Come up with a set of modified assumptions that you believe in to reach the targets.
- Create a different revenue/expense plan that will extend your runway, giving you more time to hit your targets.
- Change course. For example, do you need to shoot for profitability or an exit instead of your next raise?
Or you might decide that you’re better off with a small inside round first before eventually seeking a large growth raise.
A reasonable question to ask: If top-down targets rarely line up with bottom-up assumptions, why are bottom-up KPIs so damn important?
Because there is near zero chance you will hit your desired numbers.
Depressing, huh?
By the way, I don’t mean because you’ll come up short. I just mean that hitting your plan exactly is kind of like a lottery ticket. It’s so specific as to be impossible. You’re going to come in above or below.
But beating or missing plan by $1M doesn’t tell you much. How is that information actionable?
Here’s what I mean. If I miss my plan by $1M, that’s a lagging indicator. It doesn’t tell me why.
- Did we not have enough leads?
- Did we have enough leads but fail to convert them?
- Did we have enough leads + a reasonable conversion %, but our average sale price came in short?
- Did we close all of the businesses we wanted to close, but the customers failed to pay their invoices on time?
- Or did we close the customers we wanted, but they churned faster than expected?
Unlike the $1M miss, the answers to those questions are actionable!
Armed with a bottom-up plan, you’ll be able to pinpoint the reason for the variance.
And that’s the trick…
Planning doesn’t end with the numbers alone.
OKRs: Your Goal-Setting Structure
I don’t care if you use OKRs. Truly. I’m not a religious devotee of the model. What my partners and I care deeply about, though, is having SOME goal-setting framework in place. For the purposes of this piece, I’ll stick to OKRs. But if you’re a believer in V2MOM, EOS, Balanced Scorecard, or even the Eisenhower Matrix, go with God.
Assuming that there is a gap between the top-down targets you need to reach and the historical bottom-up KPIs of your business, you’ll need to effect change across your business. You may need marketing to drive more leads, products to expand the feature set, or sales to improve their close rate. All will take very specific work.
And Objectives and Key Results, aka OKRS, clarify both what you’re going to work on and, conversely, what you’re not going to work on.
Objectives align your company on what matters most in reaching your plan. Key results move what “matters most” from an ambiguous idea, for example, “close more sales,” to something tangible, such as “raise pilot conversions by 25%.”
If you need to work on CAC, your objective might be: “Create a more efficient, effective marketing engine.” Then your key result might be “Lower CAC from $5K to $4K.” And your action might be to launch a customer referral program.
If you need to grow ACV, your objective might be to “launch a new, more expensive product.” Your key result would be to increase ACV from $12K to $15K. And the action you’d take to get there would be to build the go-to-market plan and launch the product.
The Trouble With Forecasting
What if, after all that, your company still doesn’t meet its forecasts?
Want the bad news first?
It won’t.
No startup is on track for forecasts all the time. Invariably, the actual numbers will upend your expectations.
The cycle goes like this: You plan. You execute. You get data. And then, you refine your hypotheses until you can predict what will happen on both the revenue and expense sides of your business.
Back to my example of a $1M revenue miss:
When you only have a top-down plan, you don’t know why you missed your target, so you can’t identify the corrective actions needed to get back on course.
Thanks to the bottom-up plan, you’ll be able to see the underlying assumption that was off. And then, you can shift the next set of OKRs to prioritize a course correction.
For example, if you missed on MQLs, you’ll know to examine your marketing funnel, sources, and channels. If your team couldn’t convert MQLs to SQLs, you’ll know you need to work on your top-of-funnel sales techniques, such as demo and discovery. And so on.
Startup Planning 104: Order vs. Chaos
“Thinking is the hardest work there is, which is probably the reason so few engage in it.” – Henry Ford
Startups are chaos. Beloved, joyful, rewarding chaos. Your company is young. Your track record is still in flux. You have more questions than answers.
Making good planning core to your startup journey will likely bring some order and calm where it may not otherwise exist.
Let the hard things be hard. But let the things that are well-served by a plan have a dead-simple, damn-fine plan.
I can’t promise that you’ll hit your numbers. But I can promise that if you don’t — you’ll actually know why. And a very wise cartoon once told me that knowing is half the battle.*
*h/t to GI Joe