CFO Value-Add and When to Hire a CFO? (Part 1)

This is a sizeable issue to address, so I will break down the article into 3 parts. Part 1 will set up the framework. Part 2 will dive deeper into examples (caution: a little bit of math ... but nothing complex, I promise). Part 3 will address the "when" question for start-ups based on median data on capital raised by funding stage (more math, but, again, failry simple).

Why Is This an Important Question?

For the past several months I've spoken to a couple of companies, most of them without a dedicated finance team (or even a professional) where it is clear that they do need, if not help, at least some guidance about their... broad financial situation (even if it's just a "sparring partner" to discuss strategic issues, but not exclusively -- the topics span from capital raising and managing your capital stack to more mundane issues like cost control and day-to-day liquidity management), yet it is also clear that they don't really know how to approach this question: Do I need to hire a CFO now? And if not now, when?

This is, no doubt, a very valid question, and I don't think I've seen a lot of materials that try to tackle it (which is understandable -- it is challenging, and you don't want to leave people with "it depends" at the end). At the same time, these decisions are made with some sort of logic in mind, even if it's not explicitly stated (and not hiring anyone right now is also a decision, even when not made with an explicit rationale).

While there is really fine line between spouting out general business advice a la Michael Scott ("you have to play to win, but also you need to win to play", that sort of thing :)) and discussing very concrete cases that might be hard to generalize from, I will try to leave you with an as concrete framework as possible, that will give you a binary answer based on the certain inputs. Basically, this is how I would have answered this question. All right, let's go.

Part 1. How to Think About Value-add from adding a CFO to your Team?

An important caveat, before we begin -- when I say a CFO, what I actually mean is a set of processes, starting from basic reporting all the way to slightly more complex issues, related to budgeting and budget control, procurement, liquidity management, tax issues, etc. These processes are part of a system, and it can be thought of as a "buffet menu" for an operator -- based on your current situation and projected growth plans, you can decide what processes will help you, and take it from there. It means that, sometimes, you don't need a "grown" CFO, but bringing in an experienced controller who will set up a clear management reporting pack for you might be something you would wish to consider. Once you have that, you can start thinking about budgets, and on it goes. But we are getting slightly ahead of ourselves -- let's start from the first principles.

When you decide to hire someone (it can be a temporary consulting gig or a full-time position -- doesn't matter), you must necessarily believe that the value-add will outweigh the costs (which are known). So, how to estimate the value-add?

I would suggest that the most important metric here is the value of the business -- why do anything if it's not going to impact the business value? That, in turn, depends on three important inputs:

- the trajectory of future cash flows, which is influenced by two variables:

- the amount of capital employed in the business, and

- the returns on that capital; and

- the cost of capital employed.

So far, it's fairly simple (it gets more complex when we add another dimension -- ideally, you need to think dynamically about these). Hiring someone means extra costs, and that lowers your returns on capital, all things being equal. Very straight-forward.

Now comes the hard part for an operator -- you need to be able to translate your expectations from hiring a CFO into effects on these three metrics, that will at least make this decision breakeven for the business (it's not perfect yet, but it is a start). This is the "it depends" part that is always difficult to formalize (but not necessarily, at least in some cases). Let me provide three examples (for each of the variables), that might be of some help.

1.1. The prerequisites.

Ideally, it helps if you as a founder come prepared. The easy part here is understanding how much capital you have employed in the business and your current financial performance (your operating margin, working capital and capital expenditure needs, if applicable). It also helps if you have a good idea of where you want to see these metrics in the shorter and medium terms (say, next 3 years).

The harder part is formalizing the expectations from a potential CFO hire. Not discussing these explicitly before making the decision to hire (for operator) / join (for a CFO) is a mistake! This discussion a) allows for a chance to address any potential misalignments before they even begin, and b) will be a decent guide as to how these discussions might progress when (inevitably) your opinion as an operator will differ from the opinion of your CFO.

Let me give you an example. I've met a founder who thought that a quick grocery delivery business must have 50%+ returns on capital. I don't think it is possible -- this is essentially a retail operation, and anything higher than 15% (i.e., an industry average) is going to be very difficult to achieve -- retail is a very competitive industry, the margins are usually not that high (mid single digit at best), and a high asset turnover is crucial to generate returns (exceptional offline operations like Costco might be close to the required asset turnover to get close to 50%, but the margin profile is going to be very different, and for a reason). Bottom line: 50% is an unrealistic expectation (in my opinion -- the math just doesn't add up). This is important -- if you are more conservative (like me), you as a CFO might not want to be part of a company that (in your opinion) will not achieve its goals -- and it is better to arrive at that decision sooner rather than later. However, if you honestly think this is doable, this is a very important step towards creating that bond with the operator (that you will need when things will not be turning out the way you both planned :)).

Also, when you want to challenge (and I mean this in the most productive way possible) the operator, that first discussion will likely tell both of you everything you will need to know about each other.

Now, the examples (see Part 2).