Case Study: Why A Great Financial Model Is So Important to Your Business’ Future
The #2 reason that startups fail is because they run out of money. If that isn’t a statistic for founders to pay attention to, I don’t know what is.
On the other hand, correct me if I am wrong, but financial planning does not sound sexy to anyone outside of the finance world.
And founders tend to be creative people. People who want to work on solving a problem. They don’t want to sit at a desk staring at excel all day. They want to build their vision.
Unfortunately, this is exactly how great startups run into cash flow problems. The skills and experience required to run a business are not typically the skills that founders have. How can a founder be expected to build a product, attract clients, hire great people, keep employees engaged, get for investors interested, 1,000 other things AND manage cash? It’s unreasonable.
After reading Buffer’s CEO post about laying off 11% of their workforce, it made me realize that this is a good case study for startup founders. It shows that you need to take financial planning seriously. Thank you, Joel, for being so transparent with your company.
We can all learn from other people’s mistakes and it would be foolish not to.
Let’s look at what led to Buffer laying off 11% of their team. As we go through each key mistake it will become apparent that a solid financial plan would have helped them to avoid this situation. Creating a solid plan with scenarios, cash flow projections, consistent monitoring and understanding the risks that you are taking on is key to moving your business forward.
- Over Aggressive Growth Choices
Here, Buffer used historical revenue to project the future. Since they were growing fast, they assumed a similar growth rate and to reach higher levels of revenue.
Growth is a lot trickier than you might expect. I have seen entrepreneurs create projections many different ways that are unreliable. Beware of the following:
- Using historical growth rate on a young or growing business. This does not work because young businesses do not have enough history. Solely using historicals will take you on an unrealistic path. And growing businesses need to be evaluated based on current market feedback, not on history. The company is growing, but it will not always grow as fast as it did the previous period. This is because in the beginning, revenue will increase a lot, but that is not sustainable. In all businesses and industries, growth rate decreases over time.
- Applying a flat month over month growth percentage. The first issue with this is that it is too simple. Look at the historical financials of any company. No company grows like this and you need to take into account seasonality. Businesses have good months and bad months, taking into account the factors that drive each will enable you to create more reliable projections.
- Applying a flat number increase, for example $50 thousand per month. Although, to some extent I can see the rationale behind this, it is flawed. Here you might be saying, I can close one additional $50K client per month. That might seem to make sense, but as you grow your sales will go up and down and this leaves you with the same problem as flat month over month percentage growth.
What needs to be done here is evaluate the market. Look at comparable companies and analyze their historical growth, measure and compare industry metrics and benchmarks, take seasonality into consideration and keep your ear to the market by listening to people on the front lines: your sales and or marketing people.
- Lack of Accountability
The transition from a 30 something to ~100 people took a toll on the business. This growing pain is something that all startups experience. All of a sudden everything seems to break: systems, processes, infrastructure...Things start slipping through the cracks. People get hired with a rationale that was not really well thought out or even worse because they were a warm body that fit the skill set.
Although, I wouldn’t attribute this to a mistake directly to financial planning, it is definitely something that affects cash and needs to be taken into consideration in the financial model. There is something about putting the hiring details on paper (Excel) and seeing what happens to cash that makes a founder think…”Hmmmm.” Hiring people is expensive. And firing is even more expensive and difficult for everyone at the company. It is a serious decision that should be planned in the financial model.
- Trust in Financial Model
The financial model that Buffer used didn't actually meet their needs. It sounds like they built it themselves. Founders who do not have experience working in finance and accounting will be challenged and unpleasantly surprised by this role.
A solid financial model:
- Has at least three scenarios or uses variables to apply scenarios: 1. What you think is the most likely case to happen is. 2. The worst case scenario, and 3. The best case scenario. Your actuals will likely fall between 1 and 2 or 2 and 3.
- Uses comparables to support revenue growth and operational expenses.
- Analyzes ratios and other industry metrics to support the plan’s assumptions and goals.
- Is monitored often. Review your company’s performance and compare it to your model. Are you hitting your milestones? Whether you are falling short or going beyond, you need to adjust your plan. If you don’t adjust your plan you will run into problems. For example, if you sold more than you planned you may need to invest to support those new clients. If you do not properly support those clients, you risk losing them.
The main thing here is that you do not want to find yourself in a position where you need to raise money before you’ve hit milestones. Investors just aren’t interested in underperforming businesses. Do you blame them?
- Explicit Risk Appetite
Here, Buffer never went through the exercise of establishing whether or not they needed to be profitable or whether they were ok with burning cash. Probably in hindsight, they will never do this again. If you do not think about the future and plan for it, you may not like what happens.
Creating a solid financial model includes cash flow projections. You must define your threshold for cash on hand. Usually you will do this in months. For example, you are burning 100K per month, and you want to have 6 months of cash on hand, then you don't want your cash to get below 600K.
Monitor this at least once a month and make changes to your plan as necessary. Let’s say you have missed revenue projections last month, you need to revise your projections going forward. That may mean waiting another couple of months to move to nicer offices or making that VP hire, but the steady growth will be better than a rocky future.
- Over Enthusiastic Hiring
Remember Fab.com? Buffer’s situation was not so exaggerated: what they did was hire people in anticipation of meeting their financial projections. Makes sense, right? The problem was in the assumptions of the financial model.
You can drive yourself crazy with circular logic: If our revenues grow, we will need to invest now to support that new revenue. But if we invest now in supporting the new revenue and revenue does not grow we are losing money.
In this situation, evaluate as much information as possible: what is the likeliness that you will reach your projected revenue growth? What is the market saying to you? What are you hearing from current clients?
Take into consideration the risks associated with not investing to support growth and growing versus investing to support growth and not growing. Is there a middle ground? How can you be more flexible? Try to think of all of the possibilities and different ways you could handle each situation and plan what you are most comfortable with.
- Team Restructuring
As the company grew, Buffer decided that they needed their team to go from generalists to specialists. But then they decided that generalists were better.
This generalist versus specialist debate really depends on the company and its size. Small companies need generalists and large need specialists. But what about companies growing from small to medium? It really depends on the business.
The main issue here is that no founders know everything and mistakes are going to be made. Financially planning for future mistakes enables a company to be flexible. Make sure to keep a buffer in your cash on hand number. Otherwise, mistakes can cost you your business.
As you can see four out the six mistakes that Buffer sites as to why they had to lay people off are directly attributed to the financial plan, and all of them affected the business' future and financial planning.
I hope this case study will help you to think critically about the way you are creating your financial model and it will show you the benefits of always trying to add flexibility to your business' plan.