Why is Budgeting So Important for Growth-Stage Companies?
Budgeting gives companies a detailed roadmap of capital allocation that aligns with their objectives. By sharing these figures, and a plan for achieving their milestones, companies keep shareholders informed and can attract new investors. Budgeting also gives investors real-time updates about potential capital needs, building transparency and trust.
Internally, budgeting helps companies assign accountability, determine necessary investments, and keep teams aligned. By setting achievable milestones and closely monitoring performance, growth-stage companies can pace their spending according to their growth projections. This provides a clear projection of cash runway and helps when creating future fundraising strategies.
How Should I Approach the Budgeting Process?
Here are some valuable tips and approaches for budgeting, which emphasize the significance of Key Performance Indicators (KPIs) for tracking growth.
- Start Small: Begin by looking at revenue growth targets for the next year and identify the necessary investments in employees, advertising, and research and development (R&D).
- Challenge Yourself: How realistic are your goals? Assess external market risks and identify potential opportunities from industry trends.
- Play it Safe: Watch out for under-projecting expenses and over-projecting revenue. Create backup plans for unforeseen circumstances using an "emergency fund" or by thinking about worst-case scenarios.
- Forecast Flexibly: Keep adapting your forecast based on new business developments. Track budget-to-actual and forecast-to-actual separately to find areas for improvement or change.
Two useful budgeting methods for startups are the Bottom-Up Approach and the Top-Down Approach. Let’s take a look at them:
Department leads forecast their expected costs based on strategic goals, promoting departmental ownership and challenging department leads to prioritize their needs, as opposed to their wants. This approach is best for companies with experienced department leads.
Senior management aligns spending with strategic goals and creates a clear line of authority. This approach is effective when time is limited; it also gives management greater control over capital allocation. It works best when decision-making is centralized, like with founders, co-founders, or CEOs.
What Does Strategic Budgeting Look Like for Growth-Stage Companies?
Here’s a proactive process to follow to create a timely and accurate budget:
- Timeline: Start creating the budget in early Q4 of the previous year. Starting early provides enough time for the budget to guide decision-making throughout the fiscal year.
- Initial Steps: Analyze the previous year's historical revenue and expenses to create an initial budget template.
- Revenue Targets: Estimate revenue targets for the end of the year in terms of number of customers, number of contracts closed, ARR, etc.
- Future Hires and Expenses: Figure out what resources are necessary to achieve your goals, including potential hires and each department’s expenses.
- Metrics: Determine relevant KPIs to track against the budget and adjust it to align with year-end targets.
- Scenario Planning: Consider potential market changes or industry shifts and how you would need to change the budget for different scenarios.
- Holistic Review: Review the budget and outputs to ensure they’re reasonable, attainable, and indicative of productive growth.
- Lock in Budget: Once finalized, create a clearly labeled copy of the budget and share it with all relevant external parties. You’ll compare this copy to future versions of the model and actual financials.
How Do I Plan for Market or Industry Changes?
When preparing for changes in the market, you'll want to create best, base, and worst-case scenario budgets.
What would your budget look like in a highly favorable market? In a best-case scenario, you’ll contemplate expanding marketing outreach, rewarding employees, and hiring additional employees to improve the product or create organizational hierarchy.
What would your budget look like during anticipated market conditions? For a base case scenario, your company will only hire individuals who are absolutely necessary to achieve target revenue, and your operating expenses should remain fairly stable.
What would your budget look like in unfavorable market conditions or an economic downturn? In a worst-case scenario, you’ll consider downsizing resources and reducing additional spending on non-critical expenses, such as marketing, R&D Projects, and bonuses.
Preparing for this range of scenarios will allow you to adapt and respond to changing circumstances. By analyzing various possibilities, you can develop proactive contingency plans and decrease your risks.
Which KPIs Should I Track for Strategic Budgeting?
Tracking KPIs is crucial for growth-stage companies. Some important KPIs to consider are:
- LTV:CAC: The Long-Term Value of a customer compared to the Cost of Acquiring the Customer. In other words, it examines how much your company takes home from a single customer after factoring in the cost of getting them to buy your product or sign up for your platform.
- ARR: The Annual Recurring Revenue, or the value of monthly revenue annualized for a year-long period. ARR allows you to track retention, which is a great predictor of future growth and sustainability.
- Magic Number: This measures how many dollars of ARR are created for every dollar spent on Sales & Marketing. It helps you identify if you’re spending too much on Sales & Marketing, or if you can afford to invest more in it.
- Margin Targets: These measure the profitability of the business. Ideally, Margin Targets won’t decrease year over year. If they do, you'll want to be sure you understand why.
- Cash Runway: This looks at how many months your company would be able to stay in business before running out of cash. It’s important to track in parallel with the timeline of your next fundraise.
- Burn Multiple: This measures the cost at which growth is generated. It helps pace spending in line with growth, and ensures you’re keeping the two in check.
By carefully projecting and tracking expenses, preparing for various economic scenarios, and monitoring KPIs, you can navigate the many capital challenges startups face. Strategic budgeting ultimately improves your relationships with investors and keeps your internal team organized and focused on achievable goals.
If you have questions about implementing an internal budget, get in touch.