BEING CFO AT A VC-BACKED STARTUP— THE HARD PART

PART 3.? Performance Metrics and Financial Statements

As Common’s business grew and evolved, data became more available and useful.? While the volume of relevant metrics is not unlimited, it can become overwhelming.? Of course, depending upon the business the specific metrics will vary.? But there will almost certainly be customer focused metrics such as CAC (“customer acquisition cost”) and churn; LTV (“life-time value of a customer”); NPS (“net promoter score”); and payback period for customer acquisition.[1]? Computing these by cohort will become important as management and the Board will want to get a handle on trends and whether the economics of the business are stagnating or improving.

CAC leads you into a whole different world in which the goal is to measure the effectiveness and cost of your sales team and your marketing spend.? Compensation for sales teams will almost certainly be performance based, so you need to measure it, audit it, and make sure that your incentive system is encouraging the type and level of performance that you want and need.? Even when everyone is acting in good faith (which may not always be the case), it is easy to create unintended consequences.? This is a point worth emphasizing.? Goodhart’s Law is worth quoting here: “When a measure becomes a target, it ceases to be a good measure.”? The pressure to meet sales goals can be intense, impacting behavior throughout the company—from the C-Suite to commissioned salespersons.? Many companies, both public and private, have found themselves in deep trouble because of failures in this area.?

As the volume and types of data you are tracking grows (perhaps explodes) the entire company faces a daunting challenge.? “Single source of truth” became one of the most often-used expressions at Common probably reflecting the fact that finding it continually proved elusive.? I recall that at one point in time we literally had hundreds of dashboards created to provide crucial data to different teams.? Ensuring consistency was not easy and required cooperation among business teams, Finance, and our data specialists.? It was a challenging process of continual improvement.?

Beyond these detailed business metrics, the management team and the Board will be focused on burn rate and the related zero cash date.? In an environment like 2015-2020, when financing costs were close to zero and capital (including venture capital) was plentiful and not overly discriminating this certainly seemed less pressing and less problematic.? It takes little imagination to understand that in the changed circumstances of today the CEO and CFO will both have a great many more sleepless nights, and the management of cash burn will be treated (correctly) as existential.

Before closing out Part 3, I would like to make a few points regarding accounting statements. If you have no interest in accounting or financial statements, you can skip the next three paragraphs.

Lots of financial folks are quick to criticize accounting statements and standards—and there are many good reasons to do so.? Picking just two examples, the accounting profession was incredibly slow to overhaul its treatment of leases and still insists that R&D expenditures be expensed notwithstanding their obvious capital nature.? Beyond that you have the limited utility of balance sheets which are based largely on historical costs, written down when circumstances demand.[2]? On the other hand, I have found that the income statement provides more than a historical record of company performance.? It is an ideal lens through which to view a business and understand its fundamentals.[3]? As simple as it sounds, it can be incredibly illuminating to focus on the difference between gross profit and operating profit and the cost components of each.[4]

Equally important is appreciating the operating leverage of the business (the percentage of costs that are fixed v. variable).? High operating leverage will be a drag on performance early on as you grow into your fixed costs.? In the longer term, however, it will allow operating profit to grow at a faster rate than the company increases revenues.[5]? Here again, it is not always clear what are fixed costs and what are variable.? In traditional manufacturing with significant plant and equipment, costs may be easy to characterize.? But in a business where human capital predominates this can be much more challenging. ??Moreover, many variable costs will not follow a smooth curve but will increase in discrete jumps.? Having good insight into all of this—and not fooling yourself—is vitally important at an early-stage company where there is limited operating history, and everything depends on how the business will scale. You absolutely need to understand your “fully loaded” unit economics and how it relates to growth.? I distinctly recall that several of my presentations to our Board were titled, in bold print: “IT’S ALL ABOUTY UNIT ECONOMICS AND GROWTH.”

Pro forma financial reporting has become a widespread and accepted practice in companies both private and public.? The story is that these numbers give investors, creditors, and others better insight into how the business operates and how management evaluates performance.? Perhaps.?? However, like so many valid ideas they can and have been taken way too far and regularly abused.? WeWork’s “community adjusted EBITDA” is just one particularly egregious and well-known example of this.

Being an effective CFO requires bringing insight, thoughtfulness and a critical eye to the spreadsheets, financial statements and charts that are your everyday tools.? You are one of several single points of failure in the company’s efforts to make the tactical and strategic decisions necessary for the growth and success.? Your vantage point is unique, and your contributions should reflect this.

PART 4.? Budgeting and Forecasting

Budgeting and forecasting are hard—for different reasons.? The budgeting process is hard because there are many different competing interests and priorities that need to be reconciled into a single plan that maximizes the expected financial performance of the business over the budgeting timeline.? We tried several different approaches at Common.? A bottoms-up approach began with individual teams providing requested authorizations to Finance.? A more top-down effort started with Finance delivering preliminary budget allocations and teams responding with requests for modification.? (These were always in one direction.)? In the end, I believe an iterative top-down approach proved most effective though it required a longer budgeting timeline and many more conversations.?

Our CEO set overall corporate goals for the upcoming fiscal year (with input from senior executives), and these were discussed and refined both in the office and at our fall multi-day executive offsite meeting.? Once these goals were finalized teams presented to Finance their plans including deliverables and requested budget allocations, headcount increases etc.? Several rounds of discussion followed until a final budget was prepared and ready for presentation to the Board.? There were times when the Board wanted to set more aggressive targets, and this necessitated some rework.? Once the budget was established it was “THE BUDGET” for the next fiscal year and became the benchmark for measuring performance during the following year.? Quarterly performance was always reported against budget.

A budget is a detailed financial plan for the relevant period.? Obviously, it is forward looking based upon a myriad of assumptions and implicit relationships among pretty much every line on the company’s income statement.? The future often doesn’t go according to plan and there were always times when executives and team leaders asked for resources and expenditures that had not been budgeted.? Unfortunately, this was rarely because they were ahead of plan.? One strategy that I hated was for the executive to approach our CEO directly to get a request approved.? To his credit Brad might express his view on the business case but never imposed a decision on Finance.? Here is a warning for CFOs at early-stage companies.? You cannot make these decisions in an ad hoc manner.? If you do you will get swamped, and all your financial planning will be for naught.? You need to have well-defined processes, think in terms of trade-offs, and unlocks.? One lesson I learned the hard way is that in the initial budgeting process you need to make sure that goals and targets are set properly and that they are not “aspirational.”? While you don’t want to get sandbagged with intentionally low targets, it is equally unproductive and more painful to get a whole bunch of unrealistic goals that set everyone and the budget up for failure.? ?This requires appropriate messaging from the top—and clear instructions from the Board.? As CFO you need to be thoughtful and supportive but recognize your unique responsibilities.?

Forecasting is an art.? Your model contains a host of very precise numbers and therefore it suggests that the output is also precise.? But it is anything but.? This is true whether you are a commercial lender calculating a debt service coverage ratio, an investment banker underwriting a leveraged financing or working up a company valuation or a CFO projecting company performance over the coming one, three or five years.? At one of our Common Board meetings, at the end of a presentation by our head of real estate on the pipeline and projected openings, a Board member asked a deceptively simple but profound question: “What is your over/under on that projected number?”? In other words, how confident are you in that number?? Where are your 50%, 75% and 100% confidence levels??

Predicting the future performance of your company is fraught with difficulty.? Will the team make the right decisions on product, new markets, advertising, and marketing spend?? Will projected demand be there?? Do you have the right individuals in the most important positions? Do you have enough resources for the growth you anticipate (hope for)?? Have you properly forecast COGS? SG&A?? And then there is the macro-environment and how it will impact everything you planned.? Clearly, we didn’t see COVID coming in early 2020.? While it ultimately challenged all of us in unforeseen ways it did not in the end prove to be the existential threat we envisioned all through the spring of that year.? However, notwithstanding my comment earlier about budgets essentially being set in stone, our 2020 budget went into the trash, and we began reforecasting and reporting to the Board monthly (sometimes more frequently) as circumstances evolved.?

Looking back over my years at Common I am more convinced than ever that it is the job of the CFO to be a conservative voice, perhaps at times unpopularly so.? Human nature being what it is there is a natural desire to be optimistic, believe in the ability to meet and exceed goals and achieve the exceptional growth that is the company’s very raison d’etat.? All of that is great and is what makes achievement and success possible.? The CFO needs to wholeheartedly support that but must also ask probing questions, expect full and thoughtful answers, insist on robust data and apply the most rigorous analysis possible.?

Forecasting as a banker, advisor or investor is difficult and the stakes can often be high.? Being the CFO at a startup or early-stage company is different and arguably more difficult.? You are leading the finance and FP&A teams, which together are forecasting the company’s future—a future that cannot exist without growth and outside investment.? Knowing that dozens or even hundreds of individuals are counting on the company to support themselves and their families, raises the stakes enormously and imbues the entire process with pressure, gravity, and a ton of responsibility.

Conclusion—The Really Hard Part

I decided to write this series of articles because I got a thought into my head that I just couldn’t get out.? The hardest part of being a startup CFO is knowing whether everyone’s efforts, hours worked, meetings, conference calls, travel, funds invested, and sales growth are, in fact, creating any shareholder value.? The metrics—TAM, CAC, LTV, ARR; calculations of monthly, quarterly, and annual sales growth; net promoter scores; state of the sales funnel; worry about cash burn and runway; discussions about COGS, SG&A, income statement format and so much more—are all just subsidiary points to the overriding question of value creation.? Building a valuable business comes down to earning a return on invested capital greater than the cost of capital.? While there is lively debate and no shortage of academic papers written about how best to compute the cost of capital, in the context of a VC-backed startup it is the latter point that can cause a great deal of doubt and agony.? With no earnings or positive cashflow even on the horizon it is hard to know if you are on the path to success or implosion.? To grow the top line at the fastest pace possible dollars invested in the pref stack pile up.? You know your investors are looking for outsized returns measured in terms of 10X or 100X.? It requires discipline, focus, confidence in the business model, and an abundance of faith to make progress and overcome obstacles, fear, and doubt.?

Perhaps most important of all, it requires confidence in your colleagues, their commitment, drive and talents, and a collective desire to travel down a new and unchartered path in the hope of achieving something meaningful and satisfying.

It is hard to top that.

[1] I have never been a fan of payback period as a financial metric as it suffers from a host of weaknesses the most obvious of which is the fact that it ignores the full extent of the return on the investment.? However, in the context of a startup it can help to focus attention on how quickly a cash investment is being returned.? Since cash is literally the oxygen of the business at this stage, it is valuable to track it in this manner.? Beyond that, everyone seems to love easy to compute and understand numbers.

[2] Of course, the balance sheet is where your cash “resides” and to that extent it provides real time market values.

[3] In the finance course I teach I spend a great deal of time making sure my students understand the statement of cashflows (“SCF”) and can derive it from the income statement.? At least at Common, with virtually no depreciation expense, limited capex and working capital—until Covid made receivables a major pain point—the SCF provided less incremental information.

[4] It is not always obvious where on the income statement a particular expense is best reflected.? Decisions can have a major impact on results of operation and influence choices on the allocation of limited resources.? We spent hours and hours debating these points to better understand our business, gain insights and report to the Board.

[5] Obviously, a lender would have a very different perspective on operating leverage.