As we head into 2017, I have a steady stream of operating plans hitting my inbox. Since many of our investments are companies that are scaling, vs. companies that are just getting started, there are a lot of derivative metrics in these plans.
Q1 is the easiest quarter to make your plan, so most of these companies are getting a free pass for the next three months after fighting the good fight of making or beating plan in Q3 and Q4. For the SaaS and recurring revenue companies, if they missed by more than 5% in 1H16 and didn’t reforecast, they’ve had a particularly grueling uphill climb for the past six months.
While the relief of Q1 was missing last year because of the existential freakout caused by the public markets (anyone remember that?) I know a bunch of people who are hoping Q1 will be nice, calm, and normal. Good luck with that.
Regardless, you can start the year off by being clear on how you calculate your various derivative metrics and make sure that your plan – and the expectations of your board and investors – fit what you are putting out there for the next year. Before you say, “yup – no big deal – we are great at that” go read two posts by Glenn Wisegarver, the CFO at Moz.
- Remember That The Lifetime Value Of A Canceled Customer Is Zero
- How LTV Metrics Lie — And What To Look Out For
If you’ve worked with me, you’ve probably heard me call out CAC as a nonsense metric, since it’s super easy to game. Or maybe you read my post about ICDC (increase conversion, decrease churn). Or, instead of growth rate at a moment in time, you’ve heard me ask for a monthly graph of trailing twelve month growth rate so we can see the actual acceleration or deceleration of growth, which is way more interesting than last months growth number.
There are tens of thousands of words written on the web about SaaS metrics, consumer metrics, recurring revenue metrics, and all kinds of other metrics. Entertainingly (at least to me) there are very few words written about CE / hardware metrics (other than nonsense about how to value CE companies).
As part of getting your metrics together for 2017, I encourage you to go read some of these articles. And think hard about which metrics really matter and where the change in them will impact your business performance in 2017.
If you are the CEO of a VC or angel backed company, will need to raise more money in the future, are doing more than $100,000 of revenue a month, and are growing more than 25% a year, then this post if for you.
In January, you finalized your budget. Unless something went horribly wrong, you made your plan in January, especially if the plan was finalized in February. Assuming things were on track, you made March and declared victory on Q1.
Q1 is the easiest quarter to make. If you miss your Q1, regardless of the type of revenue you have, you aren’t going to make your revenue plan for the year because your budget process isn’t accurate. If you are a SaaS or consulting business, you likely just can’t make up what you missed, especially if your growth rate is greater than 50% for the year. If you sell a physical product, you have a lot of Q4 upside and unpredictability, but now you have to manage your cash to get to Q4 so that you can invest in building inventory to over-perform. If you are a marketplace, you’ve likely got a supply/demand imbalance that you don’t completely understand. And, if you overperformed on sales but can’t implement things fast enough to recognize revenue, you’ve got an entirely different, and especially difficult problem to overcome.
If you aren’t going to make your revenue plan, it’s unlikely you’ll make your EBITDA or Net Income plan. You don’t even have to get complicated and look at Gross Margin or more derivative metrics – if you are off in Q1 and have any sort of growth expectations , you are going to miss for the year.
But, if you are like most CEOs, you think you’ll fix things in Q2 and be close enough to or at plan to keep going on your current budget. And, if you met or beat Q1, you’ll be somewhere between appropriately confident and overconfident about Q2.
It’s June 7th. You likely know how you are going to do in Q2 by now. Every now and then I run across a business that doesn’t have a handle on their first half of the year by the beginning of June, but if you are honest with yourself today, you know whether you will be ahead of, at, or behind plan at the end of Q2.
If you are going to be more than 2.5% behind plan on your revenue line for the first half of 2016, it’s time to rebudget for the second half of the year. If you missed your EBITDA by more than 5%, it’s time to rebudget for the second half of the year. If your GM% is off by more than 5% for the first half, it’s time to rebudget for the second half.
When I say rebudget, I don’t mean “reforecast.” I don’t mean have three numbers – original plan, new plan, actuals. I mean start now, before June is over, and create a 2H16 budget. Throw away your current budget for 2H16 – it’s wrong. Don’t wait until July to realize that it’s wrong. Own that it is wrong right now and come up with a new plan for the rest of the year.
Deal with reality. Your growth rate will be slower than you planned at the beginning of the year. No matter what you do at this point, your EBITDA loss and the amount of cash you will consume over the year will be greater than the original budget. You will have an uncomfortable board meeting in your future. But it won’t be nearly as uncomfortable if you keep waiting to deal with reality.
This is especially true if you have a growth rate of > 100% planned for the year. The smart CEO has already reduced her hiring plan but in an informal way. By creating an entirely new budget for 2H16, you make it official. You also make it clear to everyone, including your team, your board, and your investors where you really are at and where you are planning to go.
Last night I got an email with a Q3 sales update from a company I’m an investor in for a while. They consistently meet or beat their plan and are an extremely well managed business. Their plan for Q3 was aggressive in my book (and they’ve managed their costs to a lower outcome) had an expectation for what they would come in at based on data from as recently as last week. I knew what they thought the upside case was and didn’t believe it so my brain had locked in on a number slightly below or around plan.
I’ve found that the Q3 number is often the hardest to make when you budget on an annual basis – Q1 is easy since you have a lot of visibility, Q2 is harder, but doesn’t have as much growth built in as Q3, then you have a heavier growth quarter with the summer doldrums (Q3) followed by the insanity that is Q4 in the annual cycle. So I usually view Q3 as “hard to beat; challenging to make.”
This company destroyed their number. They beat plan and came in at the upside case. They ran the table on new business. It was awesome to see. And it blew my mind, in a pleasant way, as this is a humble company that doesn’t overstate where it’s going.
As we enter Q4, I systematically look at the performance of every company I’m involved in for two reasons. First, I want to make sure I understand the real trajectory as they exit the year as Q4 is often an outlier, usually to the upside, as a result of end of year purchasing. I also rarely pay much attention anymore to Q4 plans as they are almost always obsolete and instead focus on the cost / burn dynamic in Q4.
It’s harder to calibrate in cases like this when a company far exceeds their Q3 plan. It’s equally hard in the other direction when a company misses their Q3 plan. And it’s really challenging when there is a big step up for Q4’s plan when you start going into the 2013 planning cycle.
I’m curious how y’all approach this, both entrepreneurs when they are thinking about their own planning as well as investors / board members when they are reacting to the early data from Q3 and thinking about Q4 and 2013.
We are deep in budget season as the last board meeting of the year typically includes the 2010 Budget – or at least the “2010 Draft Budget” or “2010 Budget – Draft”. This is also known as “the joy of cramming a spreadsheet into a powerpoint presentation.”
The budgets I see generally fit into one of the following five categories.
- Pre-Revenue: We are pre-revenue and won’t generate revenue in 2010.
- First Year of Revenue: We are pre-revenue but will generate our first revenue in 2010.
- Growing Revenue: We are on a revenue growth curve in 2010 but will lose money every month.
- Becoming Profitable: We are currently losing money but will become profitable in 2010.
- Profitable: We are profitable every month this year.
While I’ve written about this before, it’s worth noting that “profitable” is often used to mean either EBITDA positive, Net Income positive, or Cash Flow positive. These are three totally different things and you aren’t really in a happy profitable place until all three are true.
Of the five types of budget categories above, three (#2, #3, and #4) typically have the “hockey stick problems.” Specifically, the revenue curve in the budget model looks like a hockey stick throughout the year with steep revenue growth in Q3 and Q4.
The hockey stick revenue helps justify additional head count and an overall ramp in expenses. If the revenue plan is correct, this is fine. But the revenue plan is rarely correct, especially in Q3 and Q4. As a result, the expense base in the budget is much too high. One of two things happen – the budget breaks (and gets ignored) or the company continues to operate on the expense budget (or some approximation of it), resulting in a much bigger loss and cash spend than forecasted at the beginning of the year.
There’s another issue – hiring is often front end loaded and the timing is somewhat unpredictable. It’s also hard to “unhire” a month after you’ve hired someone because you are below budget. While some people talk about people as a “variable cost”, it’s a tough variable cost to immediately turn to zero shortly after you’ve hired someone.
Each case is a little different, so let me spend some time on how I think about each one.
First Year of Revenue (#2): The problem in this case is that the company will burn through its capital faster than expected. You can solve for this by forcing the expense budget to look like a pre-revenue budget (e.g. assume no revenue). When revenue starts to ramp, then you rebudget, even if it’s mid-year. Basically, discount all revenue to zero until you start generating it.
Growing Revenue (#3): This is the trickiest of the three cases. You have revenue. You want to spend more money to grow revenue (this is rational). You expect revenue will grow nicely (maybe, maybe not). In this case, I suggest you build the budget and then shift your expense plan forward by one quarter. This delays the spending ramp by 90 days which enables you to see if you are ramping revenue as expected. I’ve rarely seen this slow down the revenue growth and, when it’s clear that revenue is ramping ahead of plan, you can always layer in some expenses explicitly ahead of plan.
Become Profitable (#4): Similar to #3, you start by lagging your expense ramp by a quarter. Equally important, you should manage to a net cash number (cash + borrowing capacity – debt) and make sure you never fall below a threshold that is set as part of the budget process. Once you start generating positive cash flow, you can rebudget, just like case #2.
I find that Pre-Revenue and Profitable companies typically don’t have the hockey stick problem in the budgets. Pre-Revenue don’t by definition since they have no revenue! Profitable companies have usually been through the cycle so many times that (a) they understand how to be realistic about revenue growth and (b) they are so happy to be profitable and self-sufficient that they err on the side of under-budgeting revenue and then expanding their expense base as they exceed plan.
Be smart – avoid the hockey stick. Even when you are playing hockey! It hurts when it hits you in unexpected places.