What Goldilocks Can Teach CFOs About Budgeting
After working with hundreds of startups and serving as the CFO of Oracle, I’ve developed a practice I call The Goldilocks Budget, a probabilities-based approach which helps companies of all stages improve their budgeting process.
Why are we mixing the age-old fairy tale Goldilocks and budgets?
Because it is a story everyone is familiar with and I’ve found the concept of “too hot,” “too cold,” and “just right” offers a simple framework to the often complex process of budgeting.
The reality is that CFOs or finance leaders often face this exact situation when it comes to budgeting. Budget “too hot” and you’re overly aggressive, which can lead to disappointment when goals aren’t met. Budget “too cold” and you’re overly conservative, which can lead to not accomplishing any stretch goals.
The Goldilocks Budget provides an approach to achieving this balance while driving better results, enhancing communications, and transparency with your board and senior leaders.
Follow along to learn how baby bear got budgeting “just right” using probabilities …
For instance, if a company achieves its budget four out of five years it is budgeting at an 80% probability:
So how does this play out in real life?
Review how many times in the previous five years you achieved your budget. If you achieved it four out of five times, is that a good thing or is the organization aiming too low? Conversely, if you missed four out of five years (for only a 20% success rate), is the budget unrealistic and a source of frustration throughout the organization?
This exercise shows why it’s important for CFOs to be in sync with the CEO and board of directors on the following questions:
After reviewing and discussing that history, the next step is to ask: what is the best budget for our company this year, for our sales quota, revenue projects, and cash flow targets? This question lays the foundation to create a budget that accounts for three potential scenarios across four different categories — sales and marketing; revenue budget and revenue forecasts; cash budgets and cash forecasts; and Wall Street guidance (for publicly traded companies).
Key components of a Goldilocks Budget:
Based on our experience, we’ve identified the best practice probability of achievement across these four categories. Taken together, this typically establishes the framework for optimal performance and the best results.
Step 1: An ambitious sales quota
Recommended target: 30% probability of achievement
Elon Musk recently talked about the frequency with which Tesla has fallen short of ambitious car production and financial targets. When asked about the misses, Musk was unfazed, noting he does not “set targets that [he knows] can’t be met.” He continued: “In order to have a good outcome, we must strive for a great outcome…”
That mindset — striving for a great outcome — captures perfectly the approach that should be taken to sales targets within a Goldilocks Budget.
Sales revenue in the Goldilocks Budget consists of new revenue and recurring and upsell revenue. Sales represent the most ambitious budget targets, falling into the “too hot” category, but this is for good reason: fast growth is the lifeblood of venture-backed companies, and clearly it is the sales and supporting marketing efforts that are the catalysts from that growth.
It’s best practice to aim high here. Set ambitious reach goals. Even if they’re not fully achieved each year (and percentages say they won’t be), establishing more aggressive results will lead to better results. From our experience, companies using the Goldilocks Budget reach their impressive goals.
Step 2: A revenue budget that reflects reality
Recommended target: 50% probability of achievement
Experience from Goldilocks Budget practitioners has shown that a revenue budget should be established with the target of a 50% probability of achievement in any given year.
This mirrors another industry in which the goal is to be as competitive as possible: sports. In High Output Management, former Intel CEO Andy Grove pointed out that in professional sports, which is highly competitive, optimized, and measured, 50% of the players win every game, and 50% lose every game.
This is obvious, but that’s the point: hitting your revenues in any given year is a win-lose proposition. You either reach the number of you don’t. That’s why it’s essential to set a target that is reasonably aspirational so as to create a clear yet achievable benchmark for revenue generation.
Step 3: A strategic cash budget
Recommended target: 70% probability of achievement
No matter what the business, the phrase “cash is king” most likely resonates — at least part of the time. Cash on hand provides a security blanket. It bolsters confidence, it reduces stress, and it generally is a strong indicator of a healthy business. Yet, having too much in reserve for too long of a time can be a problem.
With that in mind, best practice for the cash budget is a 70% probability of achievement. You should get there in most years, but the 70% probability still leaves room for the reality that at times cash will be tight because of challenging situations, and in other instances cash will be used to invest in and grow the business — even if that means less cash on hand in the short term.
The cash budget helps find a balance between what are often the conflicting roles of senior leadership: the CEO’s job is to dream big, while the CFO’s job is to make sure the organization never runs out of cash.
A 50% probability of achieving the revenue budget combined with possible expense surprises creates too much risk for venture-backed CEOs and CFOs. They want to insure that their cash burn, measured in dollars, and their cash runway, measured in months, at least meets their plan.
Best-practice CFOs have a solution for this: the reserve. The reserve is budgeted as an expense line, set aside for unforeseen expenses or revenue shortfalls. The amount of this reserve should be sufficient for the company to achieve its cash budget 70% of the time.
This gives the CFO, CEO, board and shareholders confidence that the company has the cash resources it needs to survive and prosper. The reserve has an additional benefit for the C-Suite. It allows the CEO and CFO to under-promise and over-deliver. By doing so, they build credibility among the board, investors, the leadership team, and employees.
Step 4: Going public — Wall Street guidance
Recommended target: 90% probability of achievement
For companies preparing to go public, another key metric gets added to the Goldilocks Budget: Wall Street guidance, which is typically more conservative than the budget. That’s because when JP Morgan analyzed 203 recent tech IPOs, it found companies achieved their first- and second-quarter estimates over 90% of the time, but when Credit Suisse reviewed 534 tech companies that went public since 2005, it found that companies achieved their revenue estimates 73% of the time.
In other words, public companies track to 90% achievement in their first year post-IPO, then shift to about 70% achievement in later years.
There are also a few key considerations to make when choosing your budgets as a public company:
- Assess your operating environment. Each organization needs to view its Goldilocks Budget in the context of the current and anticipated operating environment, and assess the level of risk that may impact achieving budget goals.
- Use quarterly forecasts to ensure the Goldilocks Budget stays relevant throughout the year. Once approved, the budget never changes, but the reality is that the world does. Best practice companies build updated forecasts quarterly that track and account for changes since their budgets were approved.
- Avoid Q4 over-optimism. It’s a common and tempting pitfall to add a bit of extra revenue in the third-quarter budget projection and then project an even bigger jump in the fourth quarter. Don’t let this happen to you. The most important revenue of the year is the revenue run rate at year-end, which establishes the base for recurring revenue the following year.
- Understand the exception: a mid-year course correction. While it’s best practice not to change a Goldilocks Budget once established for the year, there is one exception — the need for the midyear course correct. If you are far off your year-to-date budget in June, it may make sense to reformulate your budget based on current and expected realities.
Once you gain consensus with your board and CEO on the most useful budget probabilities, you have put your organization in an excellent position to succeed. You can grow as fast as possible, investing in new programs while at the same time being able to under-promise and potentially over-deliver on your cash budget.
Bottom line: don’t settle for a budgeting approach that is too hot or too cold when you can develop one that’s just right for your company.