One thing that’s almost sure to be true about a financial model is that it’s going to be wrong. In the best case, it’s wrong because the business exceeded projections. In the worst case, it’s wrong because the business failed to meet sales projections and/or underestimated expenses – and now the company is in serious peril. However, there are a number of steps a startup CEO or finance leader can take to mitigate the risk of a worst-case scenario.
Your first step is to build a financial model. If you haven’t built a financial model yet, there are a number of resources available for creating a B2B SaaS financial model, including one in this excellent post from my colleague, Brigitte Hackler. I’ve also shared my thoughts on the “infrastructure” of a good financial model for a Series A company in a previous post.
Once you’ve built a financial model, it’s only as good as the assumptions it’s built upon, and the range of possible assumptions is virtually infinite. But building the financial model is just the start – to realize its full value, you must measure accuracy consistently, iterate as you learn, and refine the assumptions over time.
In his post “Accelerate Your Startup: Tuning the Engine,” David Skok writes about understanding the three different startup phases to get spending (investment) right:
- Searching for product market fit
- Searching for a repeatable & scalable sales model
- Scaling the business
With this post, I primarily focus on the first phase – searching for product market fit. In that phase, by far the most important thing is managing cash responsibly to achieve the next set of fundraising milestones or to reach cash break even. And one of the key ways to manage cash responsibly is to create and manage to an accurate forecast. Responsible financial management is all about putting yourself in a position to seize opportunities while mitigating risk.
Here are five tactics to employ that will allow you to seize opportunities and mitigate the risk of an inaccurate forecast:
1. Until you have a predictable sales engine, forecast revenue extremely CONSERVATIVELY.
Your revenue forecast should be one you’d bet your house, car, pet, and/or favorite pair of shoes on. Many businesses fall into the trap where they feel the need to create aggressive and ambitious sales targets to drive urgency for the team and to appease expectations for outside investors. Don’t fall into this trap.
In SaaS, to hit growth targets, a business must frequently hire ahead of sales. But if the sales don’t come as expected, you get hit with a double-whammy: less cash coming in from customers than expected and higher headcount expenses. Yikes – not good. A good way to address this is to create two forecasts: (1) a financial forecast on which you base your hiring, investment, and expense decisions and (2) an external forecast on which you set team targets, quotas, and external expectations. For a company with a board of directors, the financial forecast is usually the same as your board approved budget.
2. DON’T build a lot of cushion into your expense forecast.
This may seem counter-intuitive, especially when compared with the previous tactic to forecast revenue conservatively. It’s tempting to build cushion into the forecast because there are always additional investment opportunities or surprise expenses that can pop up – and you want to have the flexibility to say “yes” to those opportunities. However, this can build a lack of discipline into the decision-making process.
If it’s too easy to say “yes” to those opportunities, then you don’t have to consider the trade-offs. When an unexpected expense arises, the team must have a real discussion on how to offset it – by saving in another expense line, by offsetting with additional revenue, or by acknowledging that the business is willing to decrease its runway to make that investment. This also sets the business up for a cost-sensitive culture and capital efficiency.
3. Compare actual results to your forecast EVERY MONTH.
Understanding variances to your forecast will help you to refine the assumptions and make them better over time. Building this discipline will also force you to consider trade-offs when your expense forecast is too low or you fail to achieve your revenue forecast. It’s a way to hold the business accountable. Don’t hide your head in the sand if you aren’t hitting the forecast – make yourself aware, understand what’s driving it, and adjust. Ignoring the problem won’t make it go away and it’s way better to confront it.
4. Update your forecast at least quarterly.
Similar to comparing actual results to the forecast every month, this provides the opportunity to implement better assumptions and adjust your plan to accommodate the previous quarter’s performance. If the business exceeded its revenue plan, you will have the ability to invest that additional revenue in incremental resources. The earlier stage the business or the shorter the cash runway, the more frequently the forecast should be updated. A pre-revenue company should update its forecast monthly.
5. Don’t blindly assume you will make up a sales shortfall in the following quarter.
Updating the forecast quarterly as advised above includes updating the sales forecast each quarter based on actual data and capacity. If you miss the sales forecast in a quarter, it’s tempting to roll the shortfall into the next quarter or spread it over the remainder of the year so you can still achieve your full year target. Only do that if you have the sales capacity to hit the increased forecast. Otherwise you’re just kicking the can down the road and will find yourself in the same position (or worse!) the following quarter.
When properly implemented, these tactics can help early stage SaaS CEOs and finance leaders give their businesses the best chance to find product market fit. Building this discipline early will also pay dividends down the road when you’re scaling the business!