The finance numbers you need to understand (and they have nothing to do with valuation)
I spend a lot of my time now working with early stage startups. Among other things, I try to share some of the finance wisdom that I accumulated from the better part of a decade working for one of the largest banks in the world.
What I find is that most startups take one of two strategies with finance:
- Some try to avoid it entirely apart from doing the bare minimum with their accountant when they file their taxes
- While others go completely overboard with lots of financial models, forecasts, and valuations built on mountains of untested assumptions
Rarely do I find someone who is somewhere in between with a laser focus on the few financial metrics that will really make a difference for their startup.
This is where I come in and try to steer them back to what is really important. With just a couple of simple concepts and models you can cut through all of the financial noise that seems complex and intimidating, but is really just a distraction for anyone but a large corporation.
What really matters
To me, these are the two most important metrics to an early startup:
- Gross Margin
- Operating Expenses
To those of you who remember their accounting, you will recognize that both of these numbers are found on the Income Statement. What I always tell the startups I advise is to start here. If you only understand what’s on your income statement, that’s perfectly fine for a long time.
The reason for this is that the income statement tells you whether or not you are making money. It shows the amount of money that you are making from sales minus the amount that you are spending to run your business.
That’s really it.
Things aren’t quite so clear cut for a larger, more mature business with divestitures, lots of non-cash expenses and other complicated accounting issues. But these don’t really come into play for a startup, so really what you see on the income statement is a very accurate picture of how your business is doing.
Here’s an example of a pretty basic income statement:
Simple right? The revenue is what you earn for selling your products, and then all of the different categories of expenses are subtracted from that until you get down to your end Net Profit.
Of course there is more to it, and the other financial statements are there for a reason, but the cash flow statement and balance sheet are primarily used to capture movements that are not as relevant to an early state start-up. And in many cases don’t become relevant until a company becomes very mature and sophisticated.
For a startup, knowing the income statement inside and out means you know the core of your business.
And inside of the income statement, there are two main sections the you need to focus on. Here:
Let’s take a look at each of these sections in a bit more detail.
I really enjoy watching shows like Shark Tank in the US or Dragon’s Den in the UK, where you can watch actual entrepreneurs pitching to potential investors.
Over and over again, you will hear from the investors the same question:
How much does it cost for you to make it and how much do you sell it for?
This question is all about gross margin and this is the #1 thing to know if you know nothing else. And I am always surprised on these shows how many entrepreneurs don’t know their gross margin.
If the startups I work with don’t have this number yet, this is the first thing that we will work on together. Because if you don’t know how much money you are making per product you sell, you can’t know if you’re pricing correctly, if your costs are too high, or if you will ever make any money at all.
Without this, you are basically flying blind and hoping for the best. So if you don’t have this yet, how do you go about calculating it?
As I mentioned before, just think of it has how much you make per product you sold. First look at your revenues or how much you make from selling your products:
Revenue = Units Sold * Price
How much do you sell your product for and how many do you sell or expect to sell?
While on the other hand, Cost of Sales is just what it sounds like, the amount that it costs you every time you ship one unit of your product to a customer.
Cost of Sales = Units Sold * Cost per Unit
And Gross Margin is just a simple combination of these two:
Gross Margin = Price — Cost per Unit
So if we go back to the Income Statement, you could figure out your Gross Profit in two ways:
- By subtracting your total Cost of Sales from your Total Revenues
- Or by multiplying your Gross Margin times your number of units sold
Either way, it’s essentially the same thing.
With this information, you at least know how much you make per unit sold. This is the most essential building block that you need before anything else.
It tells you the absolutely minimum that you should ever be selling your product for (unless you are ok with burning through millions of VC dollars while hoping to raise prices later) and it gives you an idea of how many units you need to sell in order to cover your other costs and eventually make a profit.
But about those other costs, what should you do with them?
Remember that cost of sales is everything that directly goes into the product that you are selling. In other words, for every unit of product that you sell, your cost of sales will go up by some amount.
But there are a lot of expenses that aren’t directly linked to the amount of units sold. Some examples of these would be:
- Marketing / Advertising
All of these expenses would fall under the “Operating Expenses” line in the Income Statement.
The key to understanding these expenses is to know what events actually drive them. Or in other words, what is it that makes these expenses go up or down.
And by understanding these movements, you are able to predict how much you will need to spend on these items in the future.
Let’s take as an example some expenses related to Design. Maybe in the prior year, you were working on launching your product and you had to spend $5,000 on freelance design work in order to get your product ready for launch. But next year, you plan on just selling this one product only, no new design required.
The event that drives the Design expenses is the number of products that you have to launch. Because you are not launching any products next year, you can expect your design costs to be 0. But, if say the next year you are planning on launching two more products, you could expect something like $10,000 in design costs. (2 * $5,000 design cost per product launch)
In accounting and budgeting, this is known as “allocating costs” and the events that you allocate costs to are referred to as “cost drivers”.
And the bottom line is that the more Operating Expenses that you can identify cost drivers for, the better you will be able to predict your Operating Expenses.
Let’s go back to the list we had above and see what cost drivers would make sense for each one:
- Design — # of new product launches
- Branding — # of new product launches, or # of new marketing campaigns
- Marketing / Advertising — # of new marketing campaigns, # of new customers
- Rent — # of office sq. footage
- Salaries — # of employees
Once you have all of your Operating Expenses listed out, a great exercise is to go through just like I did above and brainstorm out what the different costs drivers could be for each one.
Then once you have that information, it’s very easy to look ahead in the next few years and estimate what these costs might look like based on what activities you will need to do to grow your business.
And then what?
Hopefully, it is pretty clear how powerful all of this information can be to an early stage startup and how foundational it is to any other financial planning you might want to do.
With just the information above, you can reasonable project revenues and profits in future years, set budgets for things like marketing and design, or even set prices and sales forecasts as I showed in one of my previous posts about Reverse Income Statements.
These concepts may be simple, but they are very powerful and will give you much more valuable information for decision making than putting together a half-baked valuation based on untested assumptions.
Or if you are one of those people who tries to avoid finance altogether, this is a great way to get started using your financials for better decision making.
Can you do me a favor?
I am thinking of creating a series of online courses about the most important finance topics for startups.
It would be similar to the thoughts that I share here on Medium, but with step-by-step videos, templates, and much more in-depth content.
If this is something you would be interested in:
Or if you have anything specific that you would like to see, please let me know in the comments below.
Thanks for reading!