A Startup's financial health isn't just about updating financial statements and balance sheets — it's about understanding basic business financials, and guess what? It's not that hard. This primer is designed for Founders and operators who know little to nothing about startup financials.
The fundamentals of startup finance are this simple – we record every income item (our goods sold) on one side and then record every cost (operating expenses) on the other side of our financial statements. We subtract the income from the costs – and voila! – profit (or a loss... in the early days it’s usually a loss.)
There’s no special black magic to recording income and expenses.
We’ve probably seen complicated spreadsheets or accounting software that looks harder than figuring out the cockpit of a 747. At some level that amount of complexity is important. When we’re just launching a startup, we want the complexity of a go-cart. Gas pedal = revenue. Brake pedal = costs. Easy.
The spreadsheet we’re going to use (it’s called an “Income Statement”) is nothing more than a place to capture all the income items that generate revenue on one side and the expense items on another. The spreadsheet will automatically tally all the values and tell us whether we made any of that sweet, sweet net income.
We're going to focus primarily on an income statement for now as it captures 90% of what most startups need to manage revenue, operating expenses and net income.
Some startups with operating activities that rely on managing fixed assets, intangible assets, or complex cash flow issues will likely be doing so through accounting software like Quickbooks.
While the income statement is only one of the three primary financial statements, it'll cover most of what we need to get started. Over time we'll add the other two of three financial statements as our needs require them. But for now, don't sweat it.
The first year of finances at a startup company is very different than any other year, so that’s why we spend a lot of time on the nuances. In our 2nd and 3rd year of our businesses we have a bit more financial information to work from, but the main components of our business are still being figured out.
If we had a finance gig at an existing company there are so many aspects to startup finance that don’t apply. At an existing company, we already know how things work. We know how much people make, how much our customers pay, what products they buy, and how our finances worked last year.
In Year 1 of a startup – we don’t know jack.
As an example of this, let’s compare how a startup business and a mature business look at forecasting.
Mature Business Finance
“Our customers pay an average of $175 per year”
“It costs us $50 to acquire a paid user”
“We run on a 10% net margin each year”
“We have no idea if we’ll have any customers”
“We’ve never run any marketing so we have no idea what it costs to get a user”
“We run on anxiety, blind optimism, and Starbucks.”
We have no idea if our customers will buy the product we just invented, what they’ll pay, how much it will cost to acquire them, what people we will ultimately hire, how long (if ever) we’ll earn back the money we invested, and more.
Even our smart investors know we're not worried about "tracking accounts receivables" we're worried about what main revenue-generating activities will exist at all!
Therefore, we need a model that is less about “tracking our financial transactions” and more about “how to make some wild-ass guesses about how things might go and then quickly change everything when we find out how wrong we were.”
What’s important to understand is that startup finance is a combination of “forecasting” the future (which is very uncertain) and “accounting” for the present (what just actually happened). There is a constant back and forth between making a guess about the future and tallying up the results.
The reason there is just so much damn forecasting involved is that it takes years before all of the variables of a startup are proven out. As we discussed a moment ago when comparing a startup to a traditional business, we can’t operate with the luxury of knowing what values to use in our forecasts.
We have to constantly make guesses, test our assumptions for a specific period, then refine the numbers as quickly as possible to adjust our financial forecast.
At a big company, forecasting is often done on an annual basis. While those are still guesses as well, they are at least based on a lot of history and previously-proven assumptions.
A big company may not know how many units of the product they will sell, but they know how much customers will pay, what the product will cost, and how many people they need to employ to run the company. We don’t know any of that.
Therefore, startup finance is heavily weighted toward tons of forecasting and tons of revision. There’s no version where we just make a single forecast for the year and let it play out.
We’re going to be revising our forecasts daily which means our Income Statement (more on that later) will become our operational Bible!
Hold up – this is actually really important – so please take an extra minute to read this carefully!
There’s often a misconception that finance is the last step that happens in a startup company. The thinking often goes that marketing, sales, product, and other aspects of the business do their thing, then the bean counters in accounting show up to tell them if they made any money.
This is what we call playing “Startup Finance Defense” and it’s a lousy way to operate.
If startup finance isn’t deeply integrated into every aspect of the company, we’re essentially leaving all of the key stakeholders who contribute to the finances completely in the dark!
For example, the marketing team needs to know “what is the most we can possibly spend to acquire a customer?” while the engineering team needs to know “what’s the most we can possibly spend to hire the best engineer?”
Where this breaks is when the marketing and engineering leads have no idea how their decisions impact each other. We picture this old curmudgeon finance person just saying “NO! You can’t have the money!” without really explaining how the decisions will impact other facets of the business.
The startup finance person knows that one decision will take resources away from the other – but doesn’t explain that to anyone else.
This is what defense looks like. Finance is just this bizarre black box where no one really understands why things are working or why they can’t happen. For what it’s worth – this is how most companies operate – and as mentioned, it’s crappy.
Conversely, playing “Startup Finance Offense” is about letting everyone understand how their contribution to the business directly impacts everyone else’s decisions and capabilities.
What we’re going to focus on in this course is all offense. We’re going to talk about our Income Statement and forecasts as something everyone in the organization can understand very simply.
On a personal note, as both the CEO and CFO of Startups.com, having intimate knowledge of both the operational side of the business as well as the financial side gives me an unprecedented ability to make complex decisions across the organization very quickly.
I know how a decision that I make with the marketing team will directly impact the efforts of the engineering team down to the dollar. Even if we don’t decide to pursue a career in finance (I was a theatre major, so...) learning the basics of finance will have a massive impact on our ability to lead a startup.
Now let's teach you how to do the same.
Wil Schroter is the Founder + CEO @ Startups.com, a startup platform that includes Bizplan, Clarity, Fundable, Launchrock, and Zirtual. He started his first company at age 19 which grew to over $700 million in billings within 5 years (despite his involvement). After that he launched 8 more companies, the last 3 venture backed, to refine his learning of what not to do. He's a seasoned expert at starting companies and a total amateur at everything else.