Navigating financials for tech startups
I finished listening to an Andreesen Horowitz podcast of the important financials and metrics to pay attention to, and thought I’d share a summary. The focus is primarily on what to look at in the 3 statements (Income Statement, Statement of Cash Flow, and Balance Sheet). Link to podcast at bottom of page.
Let’s dive in. I’ll post some of the important bits from the podcast, and weigh as much as I can.
At the early stages of a company, no need to analyze the financials too much since there isn’t a lot to look at. Instead, the focus should be on key KPI’s (e.g. user engagements metrics for B2C), and the financials will emerge over time.
I would certainly agree with this statement. Building an Income Statement for a 6 month startup with very little sales may not capture the momentum that a startup is experiencing - the story behind momentum can only be shown through specific metrics (e.g. cohort analysis to measure activity).
For later stage companies, two topics matter a lot: can you demonstrate persistent growth, and how profitable will you be when you reach scale?
Diving a little deeper into this topic, beyond the scope of the podcast: the structure of the capital deployed (equity vs. debt) will have an effect on the growth rate of the company. Finding the right balance will be important, and once the Self Sustainable Growth (SSG) rate is found, the determination will need to be made for how much more debt the company should take on to grow further (not an easy answer… added leverage can cost you your company if you’re not careful/lucky).
In terms of profitability, there will likely need to be reconciliation between Return on Equity (ROE) and Return on Capital Employed (ROCE). ROCE is defined as the tax-adjusted EBIT divided by the total net debt & equity employed. Depending on the amount of debt used and the cost of debt, the ROE could be significantly higher.
Regardless, the financials need to draw a picture of how efficiently the company capital has been used to attain profitability in the later stages of a funded startup.
A startup should use the financials to run the business. Closely monitor the amount spent on Marketing, General & Admin, and Research & Dev, and determine if the numbers make sense.
I think the big takeaway here is to realize that line items matter — and that there should be a healthy level of scrutiny applied to where the internally-generated funding or the external funding is going. As they say in personal finance wisdom, every dollar should be given a job - a similar argument could be made for a company.
When forecasting next year’s growth, it is critical for businesses to know how they make money, and use the “bottoms up” approach to forecast line items - as opposed to using a “top down” approach.
The idea above is actually one of my favorite thoughts from the podcast. The investor went on to say that many startups, when taking a “top down” approach, may say that they did $10 M in B2B revenue last year, and historically they’ve grown about 10% YoY, so next year’s forecast is $11 M. While that’s the quick & dirty way to do it (especially if you’re in a case interview for a consulting gig), it’s likely not the most analytical approach.
Instead, the investor urges the startup to double-click into the different drivers behind the revenue and cost numbers, and challenge the underlying assumptions. So, you did $10 M in B2B revenue: which corporate accounts are likely to stay, which ones are likely to leave? Which accounts will likely grow subscriptions, which ones will likely churn? What role will price discounting strategy play for revenue over the next 12 months when onboarding new accounts?
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Check out the podcast from a16z below.
Cheers, Sonny
