Setting budgets: not sexy but crucial

Setting budgets is a cornerstone process of every company, regardless of size. So with no apology for covering the basics, what does best and worst practice look like?

We’ll start with the fundamentals, and then look at common pitfalls for Seed stage companies, signs of maturity for Series A companies and end with a best practice example.

The Good

Good practice starts with a three to five year strategy, a one year budget, plus a funding strategy. These will have come out of a discussion focussed on the key assumptions and variables as well as the level of risk that the Board is comfortable with. A Financial Director or even a part time finance lead will be invaluable in creating the budget and facilitating the edits. This will free the CEO to think much more critically and focus on the longer term plan.

Any material variation to previous plans or milestones should have already been addressed ahead of the budget discussion. Ideally a budget spreadsheet (usually Excel) with full calculations accessible, will be shared along with a pdf deck providing context on three to five year strategy. Specifics on key metrics and the rationale behind the main assumptions should be included here; this helps focus the conversation on the really important stuff later on.

Ideally, all Board members will get to review the deck about a week ahead of time, before a main face-to-face meeting (of about three hours) on key feedback and edits. A final version (subject to edits) agreed in the room, would then be shared and approved via email by the Board and locked down as the budget for the year. Where the gap between stake holders is significant an additional workshop session might be needed.

This process should happen one to two months prior to the end of the financial year, albeit with the assumption that the budget may move slightly as the current year has not yet been closed.

Understanding the biggest drivers on cash burn, how these might be manipulated and the resulting impacts are important. For example, asking the question, “what if we opened in Paris 6 months later?” When there are some key unknowns, there should be suitable flexibility to accommodate them. For example, if there’s a need to see what Q2 looks like ahead of pulling the trigger on a big initiative, providing an overlay of multiple situations that can be viewed side by side will allow for informed decisions and reduce the need for more sit-down meetings to discuss alternative plans. Overlays and scenario analysis are a very useful tool to get to an informed outcome. The CEO should ultimately make a proposal on which scenario they wish to pursue and a Board session should finish with a description of how the company plans to report against the budget, both in terms of format and frequency.

The not-so Good

A budget that describes a 12 month period, but with no links as to how it will take the business forward in the long term, is not good. Likewise, a budget where the outputs are surfaced but background as to how they were arrived is not, can lead to an unstructured process of Q&A and a lack of alignment and even trust at management level.

Creating a budget three months into the year will never produce the most considered and objective approach and assumptions are never a good idea where they don’t reflect previous trends in the metrics. This tends to happen most frequently with CPA efficiency and pace of hiring.

A CEO that insists on ‘selling’ to the Board when it comes to the budget. The budget is important and is the simplest way to track the progress of the company against expectations. Whilst it is acknowledged that during a fundraising process the CEO should be ‘selling’, this often continues well into the relationship with new investors. The budget should be realistic and deliverable. The Board should be completely transparent about the risks associated with the budget. It can be really challenging if a CEO pushes forward with a budget which attracts challenge and then materially underperforms. It should be a collaborative and open process.

Common pitfalls for Seed stage companies

• • A budget that’s driven largely by ‘where we need to get to for the next round of funding’ in terms of topline growth and figures and doesn’t engage with how deliverable this is. What you need to look like at the next round of funding is a data point/consideration, not the end point.

• • Over-optimistic assumptions that lead to a re-forecast half way through the year

• • A lack of balance: too defensive or conservative a position after a management team have been burned by a rocky year previously

• • Cost assumptions that tend to be more accurate compared to revenue

• Experience: this is nobody’s fault, but knowing what questions to ask – of themselves as a management team and the Board – can be lacking in Seed companies. Getting a grip of useful data to ensure the robustness of assumptions, particularly around revenue, is a ‘sooner-the-better’ quality.

Signs of maturity in Series A stage companies

• • They have taken hold of monthly reporting and financials

• • Timing and process is largely more structured, with the financial lead in the room able to talk through pertinent points, rather than the CEO having to manage the process entirely

• • A three year plan is modelled out but the discussion is still largely focused on next year

• • CEOs ask better questions. For example: building in cash controls (meaning a few ‘versions’ of the budget) and questioning resource allocation (“my CTO tells me he needs X but that feels like a lot of people”).

• • Assumptions (especially revenue and cost) are backed by sensible data

• Starting to get to grips with how to manipulate and move dynamically through the year using various levers

Series A company – a best practice example

Across all the portfolio companies I work with, there is a range of approaches. Taking best practice from each would give the following process. This process should work for the company, the Board and investors.

Approach: A finance lead helps the CEO build a robust model, highlighting the big drivers and assumptions. They work on these iterations closely together. The budget has also been well-framed within the three year plan. The logic is shared in a standalone deck which includes significant detail on items such as COGS (cost of goods) and CAC (customer acquisition cost) assumptions and genesis over the next 36 months. All the main drivers are talked through and the timings rationales are explained in a balanced way. The hiring plan and key levers regarding cash trajectory are also set out. The CEO proposes what he thinks the correct trade-off is between growth and efficiency which is largely based on conversations with similar companies and his detailed understanding of the data. After an intense discussion about “should we run faster” vs “are we taking too much risk” the Board is aligned around the plan and this is confirmed by email. All reporting is then against this budget.

Benefits: The Board is able to feel aligned and it’s clear how the short term connects to the long term. Having a CFO lead the process allows the CEO to maintain some distance and perspective.

So there it is. Anything less than a realistic, thought-through budget that the company, the Board and investors can get behind can really get in the way of a company’s progress. So knowing the pitfalls and modelling best practice can make all the difference.

Image: Michael Longmire