BUDGETING PROCESS IN A STARTUP
Image by Gerd Altman1. The Budget is an Offshoot of the Business Plan
- It is a strategic tool.
The Budget is a detailed roadmap translated in financial lingo compliant with the mission and the vision of the business as expressed in the business plan. It is strategic as it forces to question the validity of such said mission and vision, as exceptional events, occurring long after the preparation of the business plan, may make the potential success of the mission an illusion to quickly forget, pressing for a quick pivot. Because the period generally accepted for a budget, the twelve months of a fiscal year, is limited, it provides the ways to achieve certain strategic goals with higher visibility than the master business plan.
- A budget is not just a slice of the business plan.
Business plans are living documents. If the budget was a cut and paste exercise, its preparation would last one or two days, enough to allocate tasks among team members and roll their execution. It is rather the result of a thorough assessment of the changing environment at the present time, and of the optimal distribution of resources necessary to accomplish the objectives of the organization in a near future, i.e. within a one-year horizon. Every year this assessment is a fundamental exercise. Hence the importance of the assumptions that will drive the budget. The budget preparation is most useful as a collective opportunity to raise critical questions to optimize operations. Unlike the business plan that is exclusively strategic, the budget deals with another layer of projections, delving into operations in detail.
The major goal of the budget is to evaluate the optimal path to reach objectives, both in terms of output and allocation of resources to deliver this output, to maximize the business cash flow, under the strategic vision laid out in the business plan.
2. What the Budget Achieves
- It helps to drill down the planning at levels not considered in the business plan.
- It allows management to react quickly when changes must be rushed.
- It fosters better communication throughout the organization.
- The Budget empowers and unites the team. It is not built only for the benefit of the board. Everyone in the team must buy in the budget, otherwise frictions will quickly appear in its execution.
- It motivates managers to do their utmost to achieve the budget goals if they are made accountable for implementing the budget, and by tying their compensation to the agreed targets. Setting targets at a reasonably challenging level prevents from tempting budget slack.
- It is a guide for cash management.
3. Who Leads the Budgeting Process and Who Contributes to the Budget?
The smaller the startup, the smaller the team involved with budgeting. CEOs are involved in the budget, at least to provide the guidance, reinstate the vision and affirm strategic goals. The person in charge of the whole process in large startups, those with more than 100 employees, is the head of finance. In smaller startups, the controller, who is often the top, if not the only, finance person inhouse, is in charge of preparing and moderating the budget. In very small startups, under 20 employees, the CEO is taking the responsibility of preparing the budget, gathering information, interacting with other contributors, reaching an agreement as for the assumptions and the targets, and finally solidifying the budget to be adopted at the last board meeting of the year prior to the budgeted fiscal year.
Other members involved are the lead salesperson, and the head of development. In larger startups, the heads of the main lines of businesses are major contributors.
4. The Logic in the Budgeting Process
The logic is identical to the business plan logic. It starts by the identified and validated market opportunity. How best to address this market opportunity at the operating level with the existing resources (human and capital) and constraints? Would the acquisition of additional resources change the game? Budget participants must agree on a set of assumptions that they deem achievable with high probability, for the volume of activity, sales prices, and their estimated evolution during the 12 months under review.
The finance person in charge of the budget translates the data into a financial model that will make obvious the stress points where management will have to provide adequate amendments. If the proceeds of sales and other commercial contracts do not fully finance operations, it is worth wondering whether an external financing should be sought to fund the gap and balance the budget. By splitting the year in twelve months, according to the calendar year, stress points are better traced and alternate solutions to fix them easier to envisage.
5. Formatting the Budget
There is only one budget and not three - operating, capital expenditures and cash budgets- as some argue. Hence the preferential format is an income statement leading to a cash flow statement. Do not stop at the income statement. You would miss critical information that could lead to the total depletion of cash reserves. Most importantly, projecting your working capital requirement under the right assumptions is key for startups. Funding the gap between receivables and payables must be correctly anticipated. It is the role of the CFO to get it straight, sometimes imposing to slow the growth of a product line whose customers are slow payors, as it would affect the cash position and threaten the survival of the company. CEOs and CFOs alike sometimes use the Budget format to simulate various options, as one does with any financial projection model. It is fair game if they do not abuse it, as this is not the main goal of the budget.
6. The Process
Generally, the budget process for companies using the calendar year as their fiscal year begins in October to have by year-end a budget approved to move to execution on the first day of the year. The sequence runs as follows:
- Preparation of the forms by the finance team.
Each manager is handed a specific form highlighting the area of interest. These forms are not cast in stone as managers may have some relevant thoughts to refine assumptions necessary to better capture data to project.
- Kick-off meeting, headed by the CEO, stating goals and constraints.
- The thread to follow:
- Starting point: build the assumptions on the market, the competitive forces, the potential customers, the advent of new equipment technologies, as well as inflation and level of interest rate. Never assume it is a repeat of last year. In my experience, I found a persistent inclination of managers to extrapolate data from the year before, applying an arbitrary growth rate across the board. You must reject these assumptions as ludicrous.
Though it is tempting to take last year budget as a starting point to build this year budget, in a fast-moving environment, it is an unforgivable mistake.
- Assess the timing of the expected launch of products/services.
Experienced manager shave generally a good appreciation of what it takes to move from a prototype to a commercially viable product. Less experienced managers tend to underestimate the time to reach commercial launch. Depending upon the industry your business is part of, testing may take up to 9 months. Budgeting these events properly can save a lot of money. - Estimate volume and prices that can be reasonably expected.
This must not be taken lightly. Seek as much validation as possible. Budgeting is not an exercise in vacuum. Pricing optimally is not trivial.
In case of a startup addressing a new market, the head of sales is relying on assumptions based on intelligence gathered on potential customers, disrupted competition products and the fire power of those bound to be disrupted.
- What is needed to achieve these numbers: Budgeting for costs.
- From Development and Engineering: is the present team up to the task? Do they have to recruit? If so, for what job? Will they need additional equipment, tooling? If so at what time during the year? Capital expenditures may be a heavy expense. It must be well anticipated. Several times have I seen CEOS asking the board to approve a request for buying an equipment, because the estimate included in the budget -therefore approved by the board- was short of the real number.
- From Marketing: Will launch campaigns be necessary? What kind of channel would be ideal?
- How corporate expenses (general and administrative) will be affected by the growth? Is it time to bring inhouse functions that were performed with outside consultants? For instance, if the company headcount reaches 50, a HR specialists would not be a luxury to have.
- Work out the headcount required and all associated costs, including workspace, office equipment, furniture etc.
- Last, review what assets have become obsolescent and budget for their replacement, if needed.
- The Iterations
A smooth budget process led professionally should not require more than three iterations. When strong disagreements between managers burst out, an arbiter (the CEO) must, after debate, rule in favor of what is believed to provide the best outcome to the organization. This is done on the spot.
- First iteration: the “ideal” Budget.
There is nothing wrong in starting with an aggressive stance. Sales leaders tend to overestimate projected sales in a first approach. In the same token, the head of R&D tend to inflate its budget. The Moderator must have a reasonably good understanding of the bare necessities versus the extravagance of hiring redundant engineers and developers and buying the most lavish equipment. The latter is contrary to the spirit of a startup, and of course downright inefficient.
- First roundup led by the CFO/Controller or CEO.
The budget moderator gathers all information from the first iteration, assesses realistic versus unrealistic assumptions, and evaluates gaps between resources and uses of funds. Then two options are possible: some companies elect to pursue the one-on-one discussion without revealing the parts of the budget not relevant to the discussion. Other companies, in a vast majority, hold a joint meeting to provide the ground for a productive, transparent debate on the strategic directions of the business. CFOs, or CEOs in early-stage startups, are faced with making hard choices, due to limited resources. During the first iteration, discussions can be heated to either reduce expenses, or increase estimated revenue.
- Back and forth compromises
The outcome of the one-on-one discussions or of the joint meeting is to improve information so that each responsible group will alter accordingly its own budget in relation to the whole organization. The result must be realistically achievable.
- Budgets are Always Balanced.
- Internal resources match the uses of funds.
This is the case of most corporate budgets.
- What if there is a gap?
Is it worth funding the gap with external resources or seek to reduce expenses and very likely revenue also? This question is asked in all fast-moving startups. When acquiring market share, speed may be of the essence, and CEOs must convince their board that seeking external funding must be on the agenda.
- The million $ question: must management minimize risk and keep a healthy cash position, or must they seek funding to execute on a fast growth pace? The world of startups is divided along the line between these two options.
- Aggressive vs. conservative budgets.
Let’s make clear that an aggressive budget is not a budget where expenses go uncontrolled. An aggressive budget is one with goals set to challenge the team to perform beyond the ordinary. Conservative budgets are the ones everyone promptly agrees will be achieved. Most corporations sign off on conservative budgets. Technology startups balance the act: they must be conservative in maintaining their costs at their lowest while being aggressive to acquire customers and grow at a fast pace.
- Accountability and ownership levels.
Every manager contributing to the budget owns its budget. Promoting accountability and tying part of the remuneration to the performance relative to budget are healthy practices, that have become common.
- Once the budget is signed off, it is fixed.
Conclusion: the budget is a most useful collective document.
Budgeting is not a waste of time despite a process taking tens of hours of executives and managers’ time in a 4-to-6 weeks period. It is the universal document that all organizations employ to visualize the steps to grow operations while keeping the cash balance in check. It cements the team together, provides a forum for re-assessing strategic issues, resolves all issues related to the roadmap for operations in the year to come, and, last, brings confidence to members of the board of directors that the CEO and his team are optimally executing the plan.