To eliminate any preconceptions, let me define ‘budget’ for the purpose of this article. A budget is a manifestation of a unique business model created by the business owner and expresses his or her values and aspirations. It’s a detailed plan of how you’ll spend and earn money over the next year.
I spent time last week with a venture capitalist on two funding renewals. Her due diligence requirements include a 12-month budget. She offered the following insight, “I always look to see who’s using their budget to tick the box and who’s using it to run the business.” Let’s take a look at what she means.
There are three ways to define future financial numbers: projections, budgets, and forecasts. I recommend thinking of projections as long-term numbers. They’ll tell the business owner where the company’s financial and operational numbers will be in one, three, and five years’ time. In a similar way, a budget will tell you your short-term numbers, most likely over the next twelve months. Finally, there are forecasts, which are real time adjustments made to the budget during the year to sharpen year-end numbers. These changes are usually made on a quarterly basis and reflect how actual quarterly numbers differ from budgeted ones.
Projections or Longer-Term Numbers
There are three main reasons to create projections. Firstly, they are needed to know the business’ financing needs 6-18 months ahead of time. Secondly, projections are used to value companies. They are also a tool to set goals and expectations: goals for the management team and staff, and expectations for the board and outside investors.
Early stage businesses search for the right business model. They operate in cash mode 24/7 and test hypotheses for product/market fit in real time. At this stage, the entrepreneur’s role is to innovate; the customer’s role is to validate. With all this uncertainty, it seems implausible to create three or five year projections.
Despite this tension, the business owner must be able to envision future growth, competition, and the long-term profits of the business.
She must keep in mind three fundamentals when projecting her numbers. They should be driven by scenario analysis, realistic assumptions, and a clear understanding of the main drivers of the business, namely the key performance indicators.
There are many external factors beyond the control of the business owner, such as competitors releasing a disruptive technology, or key customers unexpectedly going out of business. To avoid being blindsided to potential risks and opportunities, it’s important to envision different scenarios when modelling. The most frequently used scenarios are: best case, most likely or ‘base’ case, and worst case. There is, however, no preset number of scenarios you can use.
When performing scenario analysis, make sure there are 3 types of people in the room. The optimist will imagine the future where every opportunity works out. The pessimist will ask: “What if we’re unable to hire that person?” or “What if there’s an unforeseen delay in launching the product?”. Finally, the realist compares similar businesses to yours and looks at history to see what their path turned out to be. Each person will force you to start over in your assumptions and numbers until, several iterations later, you’ll have a workable plan.
The essence of business forecasting is to predict future cash flows based on realistic assumptions and assigning probabilities to each of them. Learning occurs as you follow each potential path and evaluate each potential outcome.
Always start with your assumptions and clearly document them. A big mistake is to focus first on the outcomes you would like to see. Examine where the numbers come from,their roots, before prematurely congratulating yourself on the outcomes.
Billionaire Vinod Khosla, CEO of Khosla Ventures, and ex-founder of Sun Microsystems provides this warning to entrepreneurs: “The more success you’ve had in the past, the less you challenge your own assumptions in a new venture. The more credentials someone has, the more assumptions he or she makes.”
Get as much feedback as you can around your assumptions. If you have them, ask your investors and board to review them. If you’re a solo-entrepreneur, ask mentors and peers whose wisdom you respect.
Budgets or Short-Term Numbers
In my experience, these are the four budgeting errors to avoid:
1. The business owner is lazy and uses someone else’s budget template. Budgeting is more art than science. You must design your own budget.
2. Never use blanket percentages in your profit and loss statement to project forward 12 months. The lazy business owner will increase revenues by 40%, expenses by 20%, and expect net profit to increase 20%. Instead, frame your budget around the key milestones to hit, the different products you’re selling, or your customer markets.
3. A budget that has been created as outlined in mistake #2 above will invariably show a % cushion incorporated into each important number. I’ve also seen a separate line item at the bottom of the budget that’s called ‘cushion’ and is a plug number to make the numbers more conservative. Both methods constitute poor modelling. Instead, as mentioned previously, each number should be chosen conservatively based upon assumptions and KPIs.
4. The lazy business owner waits until the end of December, or dare I say February, to start creating the budget and ends up stitching together a rushed and feeble plan. Every successful business owner should set at the beginning of each year a financial calendar for the company. Nestled into it is a budgeting timeline that differs for the size of your business.
The business owner who is guilty of making these mistakes has ‘ticked the box’, in the words of the venture capitalist at the start of the article. Although he has a budget to submit, it fails to be an effective tool with which to run the company for the next 12 months.
Budgeting in An Early Stage Business
The budgeting process differs depending on the stage of your company. We will apply the concepts discussed earlier in this article to an early stage growth business, which I define as employing between 1 and 10 staff. In my next article I’ll discuss what projecting and budgeting looks like for companies with 10-100 employees and beyond.
At this early stage of growth, it’s tempting to start with the budget and neglect establishing long term projections due to uncertainty around your business model. Delaying, however, would be a mistake. Budgeting is a refinement of the projections. Always do your projections before budgeting.
The budgeting process launches annually in October or November with final approval in December by your board or your team. Two people can do your budget, likely the collaboration between the business owner and a finance savvy person.
It’s clearly a budget. It’s got a lot of numbers in it – George W. Bush
Start with the structure of a 3-year financial model. Lock down key business or performance metrics for the next 12 months and commence creating your assumptions. In the act of planning the business owner identifies her risks and builds contingencies against them.
It’s especially important to project conservatively in an early stage business. Revenue lines and drivers change often as you continue to mould and develop your business model. One key goal of the revenue section is to show product market fit, indicated by total revenue.
Your focus with expenses is on hiring and people costs. The business owner wants to determine the number of staff she is able to hire, and at what salary level, in each month over the next 12 months. There will be a cash burn analysis at the bottom of your budget to help with this analysis.
This is your monthly liquidity analysis; it tells you how much cash you have left each month to invest in your business. It will also tell you in what month you’ll run out of cash if you continue to follow your plan. Please refer to ‘The Numbers Game’ article in October 2015 where I explain this topic in detail.
Once approved by the board, share your budget with the entire team. I recommend only showing and providing the rationale behind the major line items. It’s important that your team understands the reasoning behind your numbers, but the
details can be distracting to them. Ensure that the monthly cash flow projections are removed. There is no benefit to alarm your team if you will be running low in cash in the future. The budget must make sense to your staff internally
and to your board of directors externally.
We’re in a bull cycle where growing as fast as possible is desired and even encouraged. In fact, last year, Reid Hoffman, the co-founder of LinkedIn, designed and taught a class at Stanford Business School called “Blitz-scaling”.
However, Vinod Khosla provides a strong warning against scaling without having appropriate product/market fit and an established business model. He says: “The more money you raise and the more people you hire, the more difficult it is to
execute on your plan. And that can lead to disaster. It’s much easier to discover your plan when you have less people, and less money. The plan is never complete until the business model is set and that could be a long way down the road. Use
your budget early on to establish your business model, not to figure out how to grow at the highest rate possible.
Forecasting or Real Time Numbers
Successfully implementing a budget is a continuous iterative process, especially during the early years.
Each month report actual numbers vs budgeted numbers and track how you’re doing. Keep an account of lessons learned, unexpected outcomes, difficulties encountered, and changes in future plans. This will be presented at board meetings and used for strategic planning.
If the budget is relatively close to the actual numbers being recorded, then you’re running according to your plan and no adjustments are needed.
However, if there are large discrepancies, new forecasts must be made during the year in order to come up with more accurate year-end numbers. In this case, the budget is not thrown out, but comparisons are now made between actual numbers and the original budget, and actual numbers and the new real-time forecasts.
Having an inaccurate budget should only be viewed as temporary defeat. It means your plan doesn’t work. Many business owners fall into the trap of lowering their year-end numbers. Instead pivot and create a new plan. Repeat this process until you find one that works.
As the business progresses, your assumptions will start to become fact and you will gain greater clarity into your business model. Then, creating a budget moves beyond a boring requirement into the astute entrepreneur’s toolbox for a smarter business.