How to Build Strong Financial Foundations for Early Stage Companies

in collaboration with Ruchi Kasliwal , Head of Finance & Operations at Novo Insurance?

As startups look to raise capital a significant amount of energy is spent scrambling to get their finances in order. Time and time again, I encounter early stage companies without clearly defined financial metrics. How much have you booked? What is your qualified pipeline? What is your revenue and how is it broken down? The adverse impacts of this reality can have far-reaching implications. First and foremost, it’s a massive time suck. Most founders simply don’t have the bandwidth to implement foundational programs while actively fundraising. If that foundation is already in place, it not only saves time but sends a signal to potential investors that you understand the importance of good financial structure. It also demonstrates that you have a handle on a major operational part of your business.? Many founders are first-time leaders, and good financial foundations are an opportunity for them to show that they have what it takes to manage a company.?

Further down the road, strong financial structure is a critical part of scale. Founders need to be able to spend their time building the product and taking it to market. If they have to dedicate time to fixing financial reporting, it’s immediately problematic. Additionally, failing to prioritize sound financial practices can put startups in a position that punishes them for success. In our industry, outside factors can drive exponential adoption overnight — just look at Zoom, and how quickly it became ubiquitous when the pandemic hit. To be able to take advantage of those moments in time, a startup can’t be furiously trying to retrofit bad foundational architecture when they happen.?

So what can startup leaders do right at the outset to position themselves for financial success? I sat down with my friend and former colleague, Ruchi Kasliwal, a veteran financial leader in the SaaS and enterprise software space, for more insight.?

YK: Why is it so critical to have strong financial foundations in place in the early days, even before a company is generating revenue??

RK: Founders should be thinking about their cash all of the time. It’s not an open pit of money, and founders need to understand how they are spending and where, what the best spending strategies are at any given time, and most of all, how to be frugal. It’s impossible to know how things will turn out. Even a good business can fail if cash management is poorly executed.?

If you use all of your funding on spend that is not absolutely business critical and won’t help you grow is a trap many startups fall into. It makes it difficult to get more funding, because you won’t have solid financials or a clean balance sheet to show prospective investors. It’s not a good representation of a founder’s management skills, either. A company is not built on an idea, it’s built on the execution of that idea, and good financial hygiene is a strong way for a founder to signal that they can execute.?

YK: How does a first time founder know when the time has come to implement a dedicated financial system? When do they need to bring in an outside hire to manage finances??

RK: As soon as a startup has revenue coming in and enough expenses to outgrow the one-sheet Excel model, it’s time to start building the foundation for a good financial system. Expenses are going to keep adding up, it’s important to have an automated system of some kind that provides a single source of information.?

The first dedicated finance hire for most startups is typically in the 12-18 month time frame. If a business has real revenue coming in, or expenses that exceed $50K to $100K monthly, it’s probably time to bring in a finance person to lead the organization. Keep in mind that this person doesn’t need to be a hardcore accountant or a senior financial executive, startups can bring in a very good mid-level accountant that is able to manage multiple fields. Try and look to outsourcing for simple tasks, like Accounts Payable/Receivable or payroll. It saves a headache and is cheaper to maintain.?

YK: As the company and team grows, what should the first finance leadership hires look like??

RK: In terms of growth and scale, the most important hire might be a good financial planning and analysis (FP&A) person on board, someone who can show company leadership different ideas and models, what will happen if they go this route versus that, or target this market or this segment of customers. They can illustrate how much cost will be endured, and how much a company can afford to expand. A multifaceted FP&A person can look at things in a holistic way, providing high-level guidance over granular detail, insight that helps guide a company’s growth over the next 2-3 years.?

A lot of startups go in and hire as many people as they can without a real plan in place. Finance teams are no exception, and should be careful not to over hire early. Have one or two people in place, a good controller and FP&A lead. Utilize the skill sets they bring, along with contractors and outsourcing where needed, and then build a team over time.?

YK: What kinds of technologies and tools should founders invest in to build a strong financial system that can scale with their company??

RK: Quickbooks is a very good foundational tool to start off with, and the biggest advantage it offers is that it’s very easy to transition to bigger scale tools. It’s simple to understand, and the founders understand their customers. It’s a great generalist tool. When getting into complex accounting, it has some limitations, but startups shouldn’t be running into complexity of that level until far further down the road.?

Don’t try to implement big software from the get go, these tools not only cost money but require resources to manage that can be better used on other things that are more business critical. You have to have the right ROI before you look at big money software.

One thing I would recommend to any founder is to keep things simple and maintain good hygiene from the very beginning. It’s hard to become fit and healthy after 20 years of bad eating, and the same goes for a company’s finances. Start small, but pick systems and tools that can scale rapidly, because you don’t know when your business might grow exponentially without warning. Look at Zoom during the pandemic, for example. Successful startups require tools that can scale quickly alongside them.?

YK: In the early days, when revenue might not be reflective of a startup’s long-term potential, what metrics can founders use to evaluate the financial health of their organization??

RK:: A lot of different metrics come into play, but one thing every startup should keep in mind — especially early-to-mid-stage — is not to look for bottom line positive profits. The market isn’t going to look at whether your bottom line is net positive or net negative, the market evaluates startups based on their growth potential. How is this company going to survive, scale and sustain in its market? Metrics that make this picture clearer include churn rate, renewal rate, ARR, metrics that are key indicators of a company’s health. Retention and cash flow management are critical, too, because how well a company manages its cash determines the rate of reinvestment it can make in product, sales and acquisition.?

Founders should be focused on metrics that measure the growth and health of the business, and that help them identify ares of need. Annual Recurring Revenue or ARR, is probably the most important single metric and certainly the one most commonly misrepresented by startups.?

YK: How should founders define ARR, and why is it such a useful metric??

RK: ARR is a term thrown around left, right and center in the VC and startup world. A big ARR comes across as a great indicator for the health of the business, but founders need to be very careful about how they define its parameters. ARR should reflect only a company’s fixed subscription value, no one time fees like set-up or implementation, because they’re not going to show up on an annualized basis.?

Once a company has properly defined and calculated its ARR, leaders can glean important information from dissecting the data into smaller pieces. Distinguishing ARR from new versus existing customers, for example, can tell a company whether it’s actually growing or simply maintaining the status quo. Or, if ARR is the same year-over-year but you’re actively adding new customers, this can be indicative of high churn.

ARR is an especially important metric when it comes to valuation, it demonstrates the potential growth of the company in future years.?

YK: What other metrics should founders pay close attention to??

RK: There are a few additional metrics associated with ARR that founders should be aware of, most notably annual contract value (ACV), new annual contract value (NACV) and lifetime value of the customer (LTV). Let’s start with ACV and NACV, which are most commonly evaluated together.?

Say you have a new customer signed up for $10M a year in annual contract value. The following year, they renew and sign up for $30M. The additional $20M is now their new annual contract value. That shift in ACV to NACV can help a company identify where it is succeeding, and why. Was the increase driven by the product, or new capabilities within your portfolio? Or was it simply the result of internal growth for the customer that required them to expand their use of your product? This exercise can provide significant insight into how your product is performing with customers.?

Lifetime Value of the customer, or LTV. This is a forecasting term often associated with customer acquisition cost, or CAC. Similarly, it provides insight into product performance by measuring how long a customer sticks with it, what the full value of the customer is over the lifetime of that product, how sticky the product itself is, and how willing a customer is to continue spending money on it once they’ve become users.?

YK: What is revenue run rate, and how does it differ from ARR??

RK: In very basic terms, revenue run rate is your revenue generated within a certain period multiplied by the number of periods you’re measuring. If you’re earning $1,000 a month, for example, your revenue run rate is going to be $12,000 on an annual basis. For many startups, revenue run rate and ARR are generally the same. There are a few key distinctions between the two depending on type of business and the components of the solution being sold, but this is nuanced, core accounting. At its highest level, founders should think of revenue run rate as synonymous with ARR.?

YK: Can you talk about cost of goods sold (COGS), and how founders should be thinking about their margins at the outset??

RK: Cost of goods sold are generally direct expenses incurred to generate revenue. The most basic way for founders to determine COGS is to ask themselves a simple question — if I had not generated this revenue, would I have incurred this expense? Companies should focus on minimizing their COGS, because it helps maximize gross profit, which is COGS dedicated to generating revenue.?

For startups, gross margins should always be on the higher side because most are not old-school manufacturing or brick and mortar businesses. They are online, digital businesses with minimal associated overhead. Hosting cost for a cloud-based business and personnel costs are the biggest expenses a B2B software startup should have in the early days. As a result, margins should be pretty high — around 80-85% is what I would expect subscription gross margins to be. This is true for companies in the $5M to $100M range.?

Net margins, on the other hand, are never going to be positive at the outset. Startups can have negative net margins for up to five years, and that’s totally okay. Startups shouldn’t be concerned that they’re not making money, they should be investing heavily in R&D and to bring their product to market. These kinds of expenses will be primarily R&D in the first couple of years, then shift to sales and marketing from year three onward as a company grows its business and works to determine the best market fit.?

YK: What advice do you have for founders about working with finance??

RK: Founders shouldn’t think of finance as just bean counters, they should consider them their partners in crime. They are the people who are going to provide a different perspective, and data to support that perspective. A clear partnership is critical, as is open communication. If a founder is thinking about going into a certain market, they should rely on finance to go and research that market. What are the regional requirements? What are the tax implications? These are areas that finance needs to weigh in on before major directional decisions are made.?