Budgeting a Startup: How Much to Spend on…Everything?
Finally, you’ve reached this slide of your pitch deck. Time to say how much do you need and what you’re going to spend these funds on. Do you know that there are guidelines and “no-goes” that will definitely raise red flags for VCs?
Just a couple of weeks ago a friend of mine asked me to help with his pitch deck.
What exactly can I help you with? — I asked him during our 10 minutes Zoom call.
I’m struggling with proving to VC that I really need these USD $500,000 — was, in a nutshell, his astonishing answer.
On second thoughts, I didn’t find it so astonishing. As I’ve already mentioned in one of my previous articles, even founders with experience who have a seed round behind them are not necessarily certain, how much do they actually need to raise. This uncertainty comes from not understanding all your business financials, therefore it is no wonder that you don’t know why do you need $500,000 and not $420,000 or $42,000. That’s because you’re not really sure what you’re going to spend this money on.
But how can it be? How can you even start a business without knowing how much you are going to spend and what your expenditure channels will be?! You would be surprised how many people actually do just that. And not only the first time founders, but well known, experienced, seasoned entrepreneurs who might had been quite successful in the past and will be in future. If you don’t believe me, go read Andrew Wilkinson’s thread of Twitter how he lost 10,000,000 dollars building a startup. Ten. Million. Dollars. He had a great idea, business experience, a team and even customer base.
However, he’d let his expenditure wander pretty far beyond the guidelines he totally forgot about. The result was gruesome for his whole venture.
So, imagine you’re facing investors and you’re about to draw your startup expenditure map right now. What would you tell them? Would you tell them that you’re going to spend 80% of your budget on marketing and sales and the rest 20% on product development? Or is it better to do the other way around? Luckily, you’re not in a Limbo here, and there are industry benchmarks to guide you. But first things first.
Step 1. Calculate hiring rate and expenses
That’s your first most important type of expenses and investors will certainly ask you who and when you’re going to hire. Hiring goes before marketing, R&D and administrative. Calculate what roles do you need to cover in your startup for the first Q, then Q2, then Q3 etc. Up to 2–3 years perspective. Check out average salaries for these roles and draw a budget for hiring.
Step 2. Calculate cost of goods
How much will you need to actually produce your product or service? It’s easier with physical goods (you add up material + logistics), but for software it is slightly more obscure. That’s why in tech business you’d usually see Cost Of Revenues (COR) instead of COG. In software business you add up expenses like hosting, email automation subscription (Sendgrid?), sms service provider etc. Do you have to include salary in COGs? Yes, but only the salary for roles who actually produce service or product (plant workers or engineers, tech support staff in SaaS).
First, calculate COGs for 1 month, then make a projection for 2–3 years keeping in mind that your customer base will grow and you’ll need more and more resources. Now, when you have these numbers, go back to your projected revenues. If you’re building a software startup your cost of revenue should not be over 30% of your monthly revenue.
If it is, it raises red flags for investors. But not only that. It says that your business model would not most likely be profitable. It shows that you’re either going the wrong way with your hiring strategy, or your product architecture is wrong, or your pricing strategy needs to be improved. Meaning, go cut expenses or figure out how to raise revenue, iterate and get back to step 2.
Step 3. Marketing and Sales expenses forecast
This is usually the hardest graph to draw, especially for unexperienced entrepreneurs. But if you grasp the logic it’s not so complicated at all. There are many resources to check out your industry average customer acquisition cost. The basic formula is:
MCC = total marketing campaign cost
W = salesforce and marketing stuff wages
S = marketing software expenses
PS = professional services
O = Other expenses (like, tradeshows, printouts etc.)
But today you even don’t have to remember all this. There are numerous free CAC Calculators. And of course, plenty of benchmark data published online (how about Statista.com?) Meaning, you can always go and check how much your colleagues spend to get back every $1 in revenue. It’s pretty safe to presume you’ll be spending about the same amount if you don’t come up with some unique channel of customer acquisition. So, you have your revenue projections, right? Now take industry average for customer acquisition cost and see what your marketing and sales expenditure will most probably be to get these numbers.
Are there lines that should not be crossed here as well? Absolutely! But they are also very industry specific. In SaaS business marketing and sales expenses should be from 80% to 120% of annual revenue. Make sure you don’t wander far below and of course far above these lines.
Step 4. Legal and administrative expenses
That’s what many founders forget about, but there are expenses you can’t go without (like, bookkeeping, for instance). Renting an office space also falls into this category. Anyway, add these numbers to your budget and don’t forget to check out Industry benchmarks — 11 to 20% of revenue. If your numbers are much lower or much higher it’ll make investors think that you’re not sure what you’re doing.
Step 5. R&D
You’re building a startup after all. Meaning you can’t stop improving your product or service. Through in all the money you’re going to spend on actual improvement of your product (for instance, if you want to go native in a couple of months). Mind, that user research, usability testing, customer interviews that can be logically considered to be a part of product improvement process, are actually attributed to Marketing and Sales budget and represent a part of CAC. How much is enough? Can be up to 10% in the first year and up to 17% in the next years.
Where to get the benchmarks
Hey, Ana, some of you might say. How do you know that 17% of revenue on R&D is an average for my industry? You can’t be an expert in everything! That’s true, I can’t. But you don’t have to be an expert to go online and download a public company annual report.
Whatever I’ve just told you about — it’s not some secret knowledge you can acquire only through an Ivy League business school. It’s a result of using your common sense. If a company has been successful enough to go public wouldn’t you think it knows a thing or two about ways to spend money?! That’s my sentiments exactly. If you go online and download an annual report of any public company from your industry, you’ll see all these ranges and proportions I’ve been telling you about.
Moreover, investors have access to the same reports and see the same ranges. And they come to the same conclusion: what has proved to be efficient in the past will most probably be efficient in the future. Meaning, if your numbers go far beyond or below the lines they have got accustomed to see in reports, they will only raise suspicions about your experience.
Granted, mature companies have slightly different rates of everything, so it makes sense to take more or less young and growing as a benchmark. But the point is, the numbers are all there. You don’t have to invent a hot air balloon to lift you up from the ground. Sometimes, it’s as easy as going online and buying a ticket.