Five Financial Elements Your Business Needs To Get Right (And Thus Gain A Competitive Advantage)
This article was co-written with Heather Henyon, co-founder, Athena CFO.
To borrow from Charles Dickens, it was, at one point, the "best of times" for this company that we shall call XSOFT, a promising software startup. XSOFT had US$2 million in the bank from an equity investment funding round the prior year, a super motivated team of 20 people that were running in full force, and a slew of various awards that were a testament to its prowess and potential. In terms of finances, the cash was there, they believed it would last them until next summer, and revenues should kick in by springtime. With this picture in mind, the COO made rough financial projections which he updated every now and then, the bookkeeper entered the spend month by month, and the team continued to happily code. The product seemed to be making progress as well, with first sales being made on the platform.
And then, disaster struck: the software development team lead said he would need four more weeks to debug the product's latest feature. The CEO thought, well, that's bad, but four weeks is not the end of the world. But then, the next day, the bookkeeper called. He wanted to make payroll payment; however, the bank balance was almost down to zero. He also mentioned that most customers had delayed their payments, asking for proper invoices, which XSOFT had not yet provided. Cut to three months later, and almost all of the team were gone, the CEO spent most of his time running from VC to VC without much hope of securing new capital, the product development had come to a grinding halt– the company was close to shutting down.
XSOFT had started off as a really promising company, yet it failed miserably. What had gone wrong?
This story –as extreme as it sounds, is often the reality for a lot of young companies. In our daily work with Athena CFO, we see many companies with financials that aren't managed properly. Based on our experience, companies with neglected financials have a severe disadvantage in the market, and often fail to achieve sustainable success. With that being the case, we would like to draw the attention to five financial elements of your company that can be easily managed with a bit of attention, but can endanger the venture if not managed properly.
1. Financial planning
Financial planning means to build a financial model that more or less accurately predicts the future. This model will give an estimate on revenues, costs of goods sold, overhead and cash flow. Obviously, in a young company the model will not be accurate and is based on many assumptions. As the company develops, more and more of the assumptions become reality or can be tested reliably.
A good financial model has a separate section for assumptions, uses lots of formulas linking to those assumptions, goes not only deep (i.e. covers a wide spectrum of revenue and cost components), but also wide (i.e. covers minimum a quarterly or better monthly overview and runs up to three years). In a good model, the timing of funding requirements are easily visible and worst and best case scenarios flow through the model. A very good model has assumptions that accurately describe the key revenue drivers and model along with expense forecasts as the company grows.
Developing a financial plan is cumbersome. It eats up a lot of time of the whole team, time that could be spent talking to customers. But worse: a financial plan of a young company is never how the future really plays out. The company will pivot and change over many iterations; nonetheless, capturing the key assumptions are critical. A strong financial plan helps in various ways:
• It supports the structuring of the team's thinking;
• It identifies the company's revenue drivers;
• It uncovers missing or overlooked elements of the business;
• The process of drafting the plan prompts the team to think about spend, which again leads to financial discipline. Going back to the earlier example of XSOFT, developing a financial plan would have been crucial to ensure its long-term success. With it, the startup team would have seen that cash was limited months earlier, and could have thus assigned resources towards cost discipline and fundraising.
2. Financial infrastructure
Comparable to a city's traffic infrastructure, a company's financial infrastructure is the backbone, the core, of the company. It starts with the streets (an ERP or financial bookkeeping system for smaller companies, inventory tools, sales force, HR tools, etc.), over junctions linking streets (the connections between and into other systems or channels– like the customer's accounts payable functions or the logistics team), and the road rules (i.e. the policies, processes, and governance structures) to the traffic police (the controls and the governance body).
Without traffic infrastructure, a city would collapse when there is a sudden increase in traffic or an accident blocking the road. The same thing happened to XSOFT: for weeks, there was no invoicing– customers didn't pay. It's clear that they hadn't invoiced properly or followed up on payments- a clear credit collection policy would have helped. After all, no customer in the world pays without having received a request to do so. So, in terms of best practices, companies need to ensure that:
• They have the right systems and tools in place. In today's world, there are dozens of suitable apps and tools online available for a minimal charge for accounting, HR, expense claims, CRM, inventory management, reporting, point of sale, document management– you get the point. No company should run their accounting on Excel, or have tedious expense claim processes, when they can easily set up a professional system.
• The systems work. This is somewhat obvious, but often they don't, and specifically do not interlink between the tools, which could help avoid a huge amount of admin work in bridging between them.
• They have a suitable level of policies and procedures in place: too much ties the company down and kills creativity, too little results in chaotic processes, intense coordination of team members who might not be 100% familiar with their tasks cost time and leads the attention of the high management (such as the CEO) on such small details instead of important tasks in order to be able to lead the company to success.
At our organization, Athena CFO, we usually start with a small business accounting system like Xero or Quickbooks, and then integrate other tools like an HR tool, a document management tool or an expense claim tool like Xpenditure or webexpenses. Data can usually be integrated between the tools automatically. Yes, setting up and running those tools costs a bit of money; however, if at the same time you can save on admin tasks, there is usually a business case to be made for it.
A budget is a plan for spending, but also for income, usually broken down by month for the upcoming year- and yes, should be completed prior to the start of the year! Personally, we don't like budgets. They are rigid, they often limit a team's creativity, and they are a lot of work to set up and maintain. But we still believe that as soon as companies grow to a certain size, budgets are essentially required.
There are two components to a good budget: a well-drafted budget, and a well-driven budgeting process. A good budget finds the right balance between a forced down number and a bottom up generated figure. It further supports –similar to the financial planning process– the structuring of the team. It also helps the team to stay within a certain limit spending; it gives them something to work within.
A well-driven budgeting process has three elements: it allows flexibility once the world around the company changes, it is reasonably timed (i.e. the budgeting process happens in un-busy times and does not take too long), and it also aligns the departments of the business to the same company objectives.
For XSOFT, a budget would have meant to allocate funds to, let's say, the development team and the marketing team– within the available funds. For one of our customers, a budget process meant to give the teams a range to work within. They did not know if they could hire the expensive but super good consultant, or if they should rather take a cheaper but weaker recruit. As a consequence, they discussed forever on it, but never came to a decision. Once we put a budget in place, they were able to calculate the impact and the remaining funds, and then moved on to the next topic on their table.
In our daily work with SMEs and small corporates, we are constantly surprised at the low level of reports that are being prepared, discussed, and shared with the team. Shareholders need high level key performance indicators (KPIs), management need to be able to get involved when necessary, and department heads need to be able to drill down into their own strategic reports.
Of course, no one wants a company that has a lot of the workforce reporting most of the time. I have worked with a company where the finance manager could not go to meet the customer and discuss the outstanding payment because he had to prepare the report. But I have also worked with companies that had no idea how much they spent two months ago and did most of their business decisions based on a very short-term memory.
Reports help –again– to structure and to identify a pattern. There is a good chance that once you have set up a regular reporting structure, it will take you only very little time to go through. You will know the drivers of your business without spending much time on the report.
5. Financial Expertise On The Team
Many CEOs I met have a relatively good understanding of financials, some come with an MBA, others however, say: I am not a finance person; I don't want to deal with the numbers. Whatever financial expertise the CEO has, there are usually three levels of finance competence any company needs:
Transactional Tasks A bookkeeper, an accounts payable accountant or a business analyst- these employees form the core of this particular function. They are often easy to source in the market and not too expensive. However, most of them do not have experience in the higher-level financial decision-making.
Financial management The accountant, the controller, the senior analyst: these are the people who translate the numbers into business language. They go to customer meetings, engage with banks, and support the business units in their decisionmaking.
Strategic finance This is typically done by the CFO or the finance director. On this level, finance becomes very valuable for an organization because this person brings in specific financial competences that have an exponentially positive impact on the organization. The strategic finance person should also interact with the CEO and is part of the management team. Often, the CFO reports directly to the company's board of directors as a matter of good governance. A CFO does not need to be expensive though- they can be hired part-time or on outsourced basis; we, at Athena CFO, have such part-time staff available.
An issue that can occur here is when a small company tries to combine all of the above three competence levels into a single role. The problem is that a good bookkeeper is usually not a good strategist, and a good CFO often gets bored building reports. We have worked with several companies where the CEO ended up taking the strategic finance role, bridging between the accountant and the management. While many CEOs might have a very solid financial understanding, taking on this role is not what they should be doing: CEOs need to be out there, developing strategies, talking to customers and guiding the team, not fundraising or reporting.
With XSOFT, a CFO would have ensured a financial plan is in place, they would have seen the cash flow need well in advance, and they'd have thus started the fundraising process. A CFO would also have told the CEO that they need to be vigilant in the company's spending behavior, and they would have put controls in place to maintain a record.
In sum: entrepreneurs are busy. They worry about product development and customer acquisition. However, even the most busy entrepreneur eventually needs to have access to enough funds to run and develop the business– and funds come both from fundraising, as well as from customer payments, and is reduced by spend.
As with most things in life: funds don't just happen. Having enough funds means to be properly prepared, to have the right structure in the business and the right people working on it– internally or externally. This is where being financially well managed can save a lot of hassle, time and money down the line. And often it is a key differentiator from your competition- and thereby allows your company to grow.