Build to Prove

I call myself a build-stage CFO, meaning that I tend to work with companies that have found product-market fit.  They’ve passed the “prove” stage.  My goal is to get them to the “scale” stage, where the foundation of the house is sturdy and they can start to build more stories onto the building.  I’ve succeeded at this a few times and yielded to a full-time CFO after a significant fundraising round.

Startups being what they are, sometimes this goes the other way.  That is, a company hits build stage and either the world changes, or the niche they thought they’d found isn’t so attractive after all.  Then they have to pivot, and sometimes, that means moving back to prove mode.

Moving back to prove mode is hard.  You have people on payroll who no longer match the direction you are going.  You’ve built processes and reporting that may not be relevant anymore.  The cap table likely has people who invested in one vision who need to be brought along to the new one.  The sooner you do this though, the better.

For a CFO, it means a few things.  Likely you need to skinny down the infrastructure you built.  Almost certainly you will have a re-forecasting exercise that will involve a new way of showing KPIs and financials to the Board and other stakeholders.  Probably you will be part of letting people go and opening up hiring in a different part of the business.  It is also possible that one of the people you will need to let go is yourself.  Because I am “on demand”, I can scale myself and my team down (another reason to hire a fractional person).

The bottom line is that startups that hit the build stage have not hit escape velocity.  Far from it.  Sometimes they start to fall back to earth and as a CFO, I’ve had to develop tools in my toolkit for when this happens.

Feature It

Generally speaking, as a CFO you have 2 types of bad news to deliver.  The first type is where there’s a blip that you should report, but you and the CEO are pretty convinced that it’s not worth a long navel-gazing session with your investors.  A simple example that falls into this category is higher than expected G&A spending because your law firm forgot to invoice you for 3 months and you didn’t remember to accrue for this.  So, yes, it makes the numbers look worse than they really are, but if you can present the numbers in a way that doesn’t highlight this in bold underlines, that’s probably all for the best.
The other type of bad news is something that is impossible to hide.  Many CFOs are tempted to do this.  An example: new SaaS bookings are way behind even though the revenue curve for the current month or quarter is fine.  Quota deployed against bookings goals is way behind.  Hiring got away from you and you suddenly added 10 people when the budget called for 3.  You had projected cash lasting 18 months but now it sure looks more like 12.
If this happens, don’t hide it – feature it.
Meaning, present the financials as you normally do, but highlight the miss and make it front-page, bold-type, and unmissable.  Make the discussion about the bad news.  If you have conscientious investors who want to help you find solutions, they will.  In the closed-door executive session, they might have less-than-generous things to say about the company’s or management’s performance.  That’s fair.  Let them have that discussion instead of the one about why they had to uncover issues through forensic analysis because you tried to gloss over or hide it.
The same general rule of thumb goes for sharing numbers with your CEO.  Some bad news should be featured, early and often.

Bookings, cash and revenue

Frequently I find myself explaining accounting concepts to non-accountants.  It’s actually a part of what I do that I enjoy; I’ve taught courses as an adjunct in the past and the teaching was the fun part.  The rest of being an adjunct… well, the less said about that, the better.
One construct that seems to come up a lot, and can be confusing if you don’t spend all day thinking about this stuff like I do, is bookings vs revenue vs billings vs cash.
Bookings are closed orders.  Take the example of a subscription software business that sells a $10 per month service.  If you sell a 1 year subscription, that’s a $120 booking.  2 years, $240, and so on.  It is not revenue.
Revenue on this deal is $10 per month, recognized monthly, starting when the software was turned on for the customer.  Not when the deal is signed – when the service is turned on.  Similar concept in businesses that ship physical products.
This is different from cash.  You might get paid up front, in arrears, as you go, or 50/50 up front and at the end.  But when you collect the cash has no impact on revenue.  If you never collect the cash, this is bad debt expense (although if this happens a lot, you might need to adjust revenue).
I won’t get into the accounting debits and credits for all of these, but they can get complex quickly.  Imagine you have a subscription where the fee is $10 per month but you give away the first month for free.  The booking is $110, and the revenue is $9.17 per month over all 12 months.  From a revenue perspective, it’s the same as an 8.3333% discount.  Again, when you collect the cash for this is irrelevant.
This comes up a lot in membership based businesses where the first month can be free.  If there’s no term for the membership, then the revenue is just zero.  If there is a term, you recognize revenue ratably over the period.
The inverse of this is also true – if you sign a real estate lease with a rent-free period, your rent during the rent-free period isn’t zero.  For a 10 year lease with rent of $10 per month (just making the numbers easy), if you get the first six months free, your monthly rent expense is actually 10 * 114/120 = $9.50. The part you didn’t pay in cash for those 6 months gets carried on the balance sheet as an accrued liability. If you pay your rent late – which I don’t recommend – that doesn’t affect that rent is still an expense.  The total value of that lease is $1140 – it’s sort of the opposite of a booking from the company’s perspective.
Depending on your team, you too might find yourself explaining this frequently.  I have found certain board members in particular struggle to keep this straight.  It is the CFO’s job to make sure terms are clear and consistent, and as always, surprises are at a minimum.

Payroll

I had a TechCXO partner meeting last week.  I always learn a lot at these and this session was no exception.

One of my colleagues who is a long-time CFO told us about a rule he had in his companies about people who see payroll data.  Which is: you cannot get another job here that doesn’t involve payroll.  Once you see how much everyone makes, you either stay in that role, or you have to leave the company.

This seemed extreme when I first heard it.  But the more I consider it, the more sense it makes.

In truth, many build stage companies trust this extremely confidential information in the hands of office managers who double as the people who “do” HR, which includes running payroll.  Few of these people have bad intentions.  Many are inexperienced.  And not many things blow up culture faster than exposing this information in the wrong way.   Once that toothpaste is out, you cannot put it back in the tube, and it is very difficult to clean up.

So, today I plan to have a reminder conversation with everyone who works with me and handles payroll data.  Not because I don’t trust them – mostly because once you’ve seen this information a thousand times, you can lose sight of how sensitive it really is and how important it is to keep it confidential.

On a related note – another build-stage company payroll risk I frequently see is the “single press of a button” problem.  Meaning, one person can both enter payroll and submit it without an approval step.  I understand why this is tempting in the early stages, and yet: it is a really terrible idea.  (The same goes for bill pay and especially wires, by the way).

Systems like TriNet and ADP actually make it hard to do an approval step in their PEO implementations, which I don’t really understand.  That said – always put in a second pair of eyes on this.  That pair of eyes too is probably bound by the same rule that my partner puts in place: once you see payroll, you can never go back.

It’s strategic

A sentence that usually sets off alarm bells for CFO’s is “It’s strategic”.  This is usually code for a decision that seems to make no economic sense, but is so important to the business, the company “has to” do it anyway.  Examples of this include, but are not limited to (1) an acquisition that the numbers don’t really justify, (2) launching a new product line that’s not correlated with the current one, (3) geographic expansion to a far corner of the world, (4) overpaying for a certain employee, and (5) going all-in on a particular trade show exhibit or booth construction.

Mainly, I have 2 issues with this approach.

First of all, most things that management teams call “strategic” are actually tactical.  M&A is a tactic.  It should get you into a market segment, a geography, a product category, and be tied to a broader strategy.  In theory, your company will have done a build/buy/partner analysis against that strategy and decided that M&A is the tactic that best gets you there.  Even in build stage companies, where deals are often opportunistic buys of smaller or faltering competitors, it’s only a tactic.  If you’re chasing a deal because it’s “strategic”, something has gone awry already.

Second and maybe more importantly, a major decision that cannot be grounded in numbers of any kind is almost certainly going to go badly.  For example: an acquisition that is dilutive on its face should get to being accretive because it helps you raise prices, lower costs, increase sales volume, cut G&A, something that has an economic return.  This return should be based an assumption that an investor can see clearly and question, including seeing the sensitivity analysis around it.  After all, it is their capital or stock you are proposing to use.

If an acquisition does none of these ‘strategic’ things, and is still dilutive except with heroic assumptions, it doesn’t make sense.  Full stop.

Trade shows are trickier.  I shiver a bit when I hear that a particularly splashy trade show presence for a build-stage company is necessary because I know from experience that nine times out of 10, it leads to heartache and lost ROI.  I shiver even more when I hear that it’s for “brand building”.  Brand building is a very expensive game.  And, if we’re spending a lot to build our brand at a trade-show, I would advocate that this needs to be part of a broader strategy including customer service, how we package and deliver our products, fit and finish, you name it.  You can’t overspend at CES and make these other things go away.

As CFO, you have to keep your eye on what matters.  In my experience, something that is truly strategic will show up in the numbers.

 

 

 

Accounting and finance people

In an earlier post, I suggested that there are 2 kinds of people in business, those who have the money and those who need the money. I stand by this oversimplification. To it, let me add another one about accounting people vs. finance people.

As someone who became a CFO having never been either, this took me some time to figure out.

Accounting is about portraying the past as accurately as possible. Debits and credits. Extreme attention to detail. Process. Tying out pennies. Having the equity roll work exactly a certain way. On average, this attracts a certain personality type: precise, introverted and someone who operates well at ground level. This kind of person is absolutely essential and vital to have in any business and especially one that is growing quickly. They provide the data for the early warning systems. They strive to eliminate ambiguity.

Where I’ve had to adapt is in describing how the output should look and what it all means. I can look at a balance sheet and quickly tell if something doesn’t make sense. Deep in the weeds accountants, even really good ones, most often cannot. Frequently this has frustrated me; when I get a statement that can’t possibly reflect reality, it makes me doubt the accounting that was behind it.

Although sometimes this is right, I’ve had to unlearn this reflex. That’s because this is finance. Finance is about making sense of the results, communicating them, and trying to predict the future. It’s about a lot more than that but this is it at its heart.

Finance people, of which I am one, often lack the patience for accounting. It’s a little more right brain than left. Yes, you need the skills to build a pivot table or a model. First though, you need to know what you are looking for. Ambiguity is your friend. This is the part that CFOs are good at, or should be. That mindset is very different than being particularly OCD about the accounting for stock-based comp.

Over time I have learned to appreciate both and tried to adapt in particular to working with skilled accountants. I respect what they do, and know that I couldn’t do it. I hope that they can appreciate what I do as well.

Integrity

A colleague once told me that as CFOs, we don’t really have measurable output. Salespeople have bookings, engineers launch products, marketers drive leads, manufacturing has a whole set of statistics. Our only product is integrity.

This saying is always playing in the back of my head when I’m asked to pull things in a certain direction. Can’t we show that cash will last 18 months instead of 15? Can’t we show that those months where we got rent abatements were profitable? Can we just up the size of a few deals in the pipeline so that it looks a little fatter?

It is difficult to push back against this sometimes. It is also difficult to push back against what you can show is expansion that is way too fast.

This happens all the time, and I mean all the time, in the SaaS world where companies flush with cash feel obligated to spend it as quickly as possible on a much bigger sales and marketing operation. Their investors often want this too. Sometimes growth does not materialize, for which there are usually adequate warning signs (examples – not enough leads per salesperson, salesperson tamp is taking way longer than expected). A good CFO can see this coming a mile away. But there is tremendous pressure not to “be negative”, so many say nothing. Then one day there is a reckoning, and a restructuring. For some CFOs, this is when they too find themselves looking for a new job.

I have left a client over this before, and I’m sure it will happen again. I understand the prsssures in growth build stage companies and consider myself an optimist and someone who helps management teams set stretch goals. We’re not A/P at IBM after all. But I remember always that my only product is integrity.

Choose your words

Recently I’ve had to get particularly pedantic with a couple of my clients about language. Specifically, how they talk about certain metrics in the business.

A common one things that young companies conflate are bookings and revenue. It’s not just an accounting nuance that they aren’t always the same thing. It’s an important business problem to be solved. My client that sells fashion online? The credit card swipe is nice, but until we ship, it’s not revenue. It’s actually a debt: we owe someone a hat. In the SaaS world this debt is called deferred revenue and it sits on the balance sheet for a long time.

Another is on the opposite side: cancellations and churn. Or for my co-working client, cancellations and move outs. If someone cancels on November 10th, their move out is December 31st. Without getting into which one is more important to track, they are different and tell you different things about the business.

These distinctions matter a lot when you’re looking at unit economics (more on this topic later). Put simply – per widget that I sell, how am I doing? A widget can be a hat, or a square foot, or for a staffing company, an hour. My new client services cars in mobile trailers. Our unit is the trailer (like a store). It makes sense to know how each trailer is doing. But I could argue, and might continue to, that once the trailer exists, it’s the appointments that matter. Optimizing those is the whole ball game.

My point is that this stuff actually matters. Once you choose a unit, it becomes the root word, so to speak, in the language that your team and your investors are speaking.

2 kinds of people

Someone smart once told me that in business, there are 2 kinds of people in the world: those who have the money, and those who need the money.  I have a lot of “2 kinds of people” sayings in my life, but this one pops up for me all the time.

I don’t mean this in an Ayn Rand kind of way.   It’s more of a practical saying to think about what’s going on in a transaction, a term I use loosely.

Example: you’ve just raised financing and “have the money”.  Now is when the non-formula lenders of the world will offer you options for having more.  When you “need the money”, and they have it, you often can’t get it.

The corollary is that you shouldn’t try to raise financing when you have your back all the way to the wall.  This is something that seemingly every startup knows, and yet the number of close calls I’ve seen suggests that it’s an axiom often unheeded.

Example 2: you have sold to a customer but haven’t collected on your invoice yet.  They ask for changes to your product, or a little more help installing it.   They have the money.  You need it.  It’s difficult to extricate yourself from this, especially if it’s an enterprise B2B sale.  If you are in a B2B world selling with real COGS and lead times, always try to get 50% up front.  Extend credit reluctantly.  It seems tempting and almost always comes back to bite build-stage startups.  To use a phrase – you don’t “have the money”.

Example 3: you have a consultant who is performing poorly in all areas except sending invoices.  We’ve all had consultants like this.  I’m not suggesting that you don’t pay someone for services rendered under a contract you’ve both signed.  I am suggesting that because you have the money, and they need the money, you have the ability to force timing on a much-needed conversation.  At some point, even if they have been very difficult to get in touch with, which happens, they will contact you.

Example 4 (last one): you are running a company that is shutting down.  I have personal experience with this unpleasant experience.  However, once you have fulfilled your legal obligations to your employees and the taxation authorities, you actually are in the unique position of having the money while your vendors need the money.  The axiom holds true even if “the money” you have isn’t sufficient to meet your obligations.

Which is why — while it’s natural to be in a position to need the money (that’s business after all), ideally your CFO can keep you in a position where you don’t need all of it.

Board compensation

Recently I got a call from a CEO who asked me a question about options for a Board member.  This got me thinking about some of my build-stage company experiences in the world of Board compensation.

Generally, build stage companies do not compensate their Board members who represent the early investors.  These directors usually represent their general partnership’s interest on the Board so their compensation comes indirectly that way.  Or, if they are Board observers, they had to negotiate for that right and so winning the right also to be compensated for it would have been pretty challenging.

They will all almost always have their travel reimbursed.  I have seen this run the gamut, from very successful senior partners at top firms who fly inexpensively and try to split the costs among portfolio companies, to Board observers who appear allergic to any hotel other than the Four Seasons.  Ironically, these are often the ones who want startups to remain “scrappy”, meaning cheap.

I’m making a joke, but they are onto something – build stage companies don’t have a lot of resources.  This also goes for options, for which there is a fixed pool.  Occasionally, I’ve seen a Board member who spends a lot of his or her time actively helping the company receive an options grant.  Unfortunately it happens more when the Board tends to be “clubbier”, meaning the investors all know each other.  Or, it happens more with first-time CEOs, and/or management doesn’t feel it has clout to push back.

Usually these grants top out around 0.5%, although more often I have seen closer to 0.25%, which is about where many advisory board members’ grants land.  Startups have a limited option pool and granting them to a Board member who is there to represent his or her fund’s interests takes those options out of circulation for others.

It is not the end of the world, but once this cycle starts, it is hard to stop.  Better not to start it at all.  If you do, try to signal that this is going to be rare.  I usually recommend a polite, professional and protracted discussion that is not over in an afternoon.

I also recommend that instead of doing one grant for X% that vests over 4 years, do it as a smaller grant of (X/4)% that vests in a year.  Continued service is a requirement for continued vesting.  The signaling of this is important — plus, it is nearly impossible to shut off vesting for someone on your Board even if that person is missing most meetings and falling asleep in the others.

I’ve seen options grants for Board members that vest in 3 years instead of the more standard 4, so in this case, just divide by 3.  Close enough.

One final note: outside Board members, on the other hand, usually do receive some compensation in the form of a monthly stipend.  Usually this is on the other of $1,000 per month in the build stage.  An options grant on the order of 0.25% usually accompanies this.  By the time an independent Board member is added, the company is usually closer to “scale” mode,  0.25% is a more significant grant than it was a short time ago in the company’s life.   Which, despite how much this might hurt, is a sign of success.  Enjoy the high class problems when you have them.