One of our portfolio companies is going through a significant change in plan. They have consumer and B2B sales and as we learn about the market opportunity it is looking like it makes sense to focus more on the business side and less on the consumer. Accordingly, the founder produced new financial projections that match how we now see the world. She actually came up with four different scenarios, Base, Low, Medium, and High, which was a good framework for enabling us to understand the range of possible outcomes for the business.
Once we understood the range of outcomes I asked which of the scenarios we should adopt as our budget.
The founder said she was aiming for the High case, but noted that it was aggressive, and that her general thought was that the higher up through the scenarios we got the better. She then asked ‘Why do we need to adopt one of these scenarios as a budget?’. Here’s why I think it’s a good idea:
- Budgets give the CEO and the board a benchmark for assessing performance of the company. A budget quantifies desired performance and hence makes it clear when things aren’t working well enough and something should be changed. With a budget the CEO knows when he is missing his targets and should come to the board with a new plan. Without a budget he will be left guessing whether that’s necessary.
- Budgets enable planning for the next round of financing. The key elements are projections of revenues and costs and the amount of time until cash runs out. If on budget there is 15 months left until cash runs out preparation for the next round can be deferred for nine months. If there is less time preparation needs to happen sooner. If there is 15 months on plan, and then revenues come in lower than expected the options are clear – bring the fundraising forward or reduce costs. Without a budget the environment is less certain and planning is more difficult, particularly if there are a number of investors who you need to agree the fundraising strategy.
- A budget provides more certainty to employees over their targets and the amount of money they can spend. Ambiguity makes their jobs more difficult. (Note that many companies set sales targets for individuals that add up to a number greater than the budget. They do this to give scope for individuals to miss target and the company to still hit budget.)
The final thing to say is that budgets are generally set for twelve month periods but things change faster than that at most startups and it is very common to rebudget two or three times during the course of a year. In many ways quarterly budgeting makes more sense than annual budgeting, but in practice the process of agreeing revenue and cost projections is too burdensome for most startups to conduct quarterly.