How Bold Do We Want To Be With Our 2016 Revenue Budget?
Setting the year’s revenue budget is a risk/reward decision. If we shoot high and hit we leverage our success. The downside is leveraged, too. The best entrepreneurs know how to play to win and minimize the downside, too.
Many companies finalize budgets in January, the point in time when last year’s results are final and this year is all in prospect. There are a lot of reasons to put a big number up. It communicates enthusiasm to the team and motivates them to push hard. We’re not likely to hit high if we don’t aim high. We want to act as if … and tell the world … that we are a hot company and a leading player in our market because that helps us win with customers, opinion leaders, and new hires. And the biggest reason: it enables us to spend more money, which means we have a better chance of making all of the above come true.
A more aggressive forecast enables higher spending in two ways. If we project more revenue in the year, then we will have more cash coming in, and growth companies typically spend all of their cash flow, so a higher revenue forecast means a higher spending budget.
Plus, a bigger forecast means we can tell a more exciting story to investors. So we can bring the date when we project we will raise that big next round in sooner, and then we can really put the pedal down. And we can pitch the existing investors for a bridge, or a bigger bridge on more favorable terms, to get us to the next round, because things are going so well, as embodied in the sales forecast. I’ve seen CEOs do a masterful job of this, as recently as last week.
In the superheated world of Si Valley that existed through last year, it’s a survival imperative to show all the signs of a super-hot company, lest employees and investors lose interest. A highly-aggressive revenue forecast is table stakes for that game.
I am sure you can hear a “but” coming. Pushing up the revenue forecast is a form of taking more risk, just like pushing up financial leverage. At some point luck runs out for most people and things get tough.
An aggressive revenue forecast drives more spending. Revenue is usually weighted to the back half of the year, but spending is not: it has to ramp up now to get things done in time for that second half revenue, and it’s hard to turn off. So soft revenue leads to a big gap in net cash flow at the end of the year. This accelerates the need, but diminishes the ability, to raise that big next round.
Savvy CEOs manage this risk by staging the play-out of spending and revenue carefully: they know when the big chunks of spending need to be committed and set up revenue growth check points that coincide. If revenue is soft, they consider slowing spending down.
Other budget gaps can produce big cash shortfalls, too. Lower than expected gross margins, or a big overrun in customer acquisition cost have similar impact. But this problem is a bit better optically, because we can say: the demand for our product is strong, however, we need to optimize the business model. That’s true if we can find a way to fix the problem quickly. Otherwise the result is the same: the company keeps running out of cash prematurely. I’ve seen a number of situations where a company delivered good top line performance but was never able to turn it into a self-sustaining business, and foundered in a few years.
The cash gap leads to an increasingly strained dialogue with stakeholders. It often starts with “we’re almost there” or “we made our numbers if you count a few things that we know we will close in Q1” and proceeds to some form of “we had headwinds last year but our forecast results are very compelling”. The cash gap has to be filled, at the expense of either employees or investors, usually the latter, since lay-offs tarnish the image of the company. Existing investors are asked to double down at a higher valuation to demonstrate of their belief in the company and signal a strong valuation to new investors.
All of this can be OK, once or maybe twice. The startup game is inherently uncertain, most companies miss forecasts to some degree in many years, and investors have reserves for a reason (if they know what they are doing). Every stakeholder shares an interest in making his or her past investment pay off, so s/he will probably double down and be patient.
If the shortfall happens too many times, or egregiously, then trust is breached, and that is a big problem. The best employees, who have the best options and the best sense of what is hot, start to leave. The early investors, who stepped up on the basis of faith in the team and the business plan, start concluding they cannot win: their stakes will inevitably be washed away by successive layers of later financing as the company continues to miss its goals and burn large amounts of money.
A new set of employees comes in who are more salarymen/women, and a new set of investors who see a recap opportunity, and who are ready to break eggs to make their return happen. On this basis, the company and some of its key people may make its way to an exit that works for the late arrivers. It might even recover and provide some return to the early stakeholders. Or, it may lose access to financing altogether and sell for peanuts.
Of course, a lot of situations are not so stark. Companies miss their forecasts by 10% or 20% and go on to victory, and investors pitch in and/or accept some dilution and still see a return in the end, albeit diminished. Some hothead employees leave but most stay.
Still, the revenue budget decision is a big one. Startups and venture capital are all about playing for the win. At the same time, the best entrepreneurs know how to minimize catastrophic risks and develop a cadre of loyal employee and financial partners, which is why they can be serially successful. So we must choose our forecast carefully. It may be the most important thing we do all year.
Originally published at www.forbes.com on January 29, 2016.