Startup Finance 101: Tips and Tricks for Success

As an entrepreneur, you are likely to channel your focus on planning and executing your ideas. You are motivated towards solving challenging problems for people and create a better world. You most likely didn’t aspire to become a founder only to spend most of your time crunching numbers on your laptop. Despite what you think of finance, it is the lifeline of your company. Taking timely care and responsibility of your company’s finances is essential to keeping your company running healthy and growing.

Failing to manage your company’s finances can have unpleasant consequences. Whether it be suddenly running out of money, failing to raise funding or failing to turn to profit, it is well known that among the 90% of the startups those fail, 83% of them fail because of cash flow problems. I want you to learn about the essentials of startup finances. You will learn about common financial problems in startups and how to avoid them so that you can make better decisions when it comes to managing your company’s finances.

Here’s a list of common financial problems faced by startups which I will be explaining in more detail.

Not knowing what numbers to keep track of

Lacking commitment and regularity

Underestimating expenses

Outsourcing financial duties

Assuming growth is always good

Raising Investment when your runway is low

Not knowing what numbers to keep track

There are just three numbers that you should keep control of and four numbers that you should calculate to understand the financial health of your startup.

Bank balance

Your bank balance is the amount of money you can spend that you currently have on your bank account and the cash in hand.

Money coming in

Money coming in is the amount of money that your startup is making.

Money going out

Money going out is the amount of money that is spent on expenses of your startup.

Your bank balance, money coming in and money going out can be traced by maintaining a general ledger for recording your transactions. Traditionally, this is maintained in a T-accounts ledger book but that is very time consuming. I recommend using a software instead, since it saves a lot of time, minimizes mistakes and you have 24/7 access to your finances. Do whatever feels comfortable to you, just make sure you have good control over your numbers.

You can find your burn, runway, growth rate and default alive from the three records mentioned above. Here’s how you calculate them:

Burn

Your burn is the rate at which your startup is losing money. It is calculated by subtracting the money coming in from the money going out. Calculating your burn is useful for finding out how much runway you have. To calculate a more accurate burn, you can take an average burn of 3 or more months.

Burn = money going out - money coming in

Runway

The runway is the number of months your startup can survive in the market, given that your burn remains constant. It is calculated by dividing your bank balance amount with the average burn rate of your startup.

Runway = bank balance / average burn rate

Growth

The growth rate is the rate at which your revenue is increasing or decreasing. It indicates the capacity of your startup to grow. On average, a growth rate of a good startup is around 5-7% per week, whereas a great startup has a growth rate of around 10% per week. The growth rate is calculated by dividing the difference between your current week’s revenue and previous week’s revenue with the previous week’s revenue.

(Money in (current week) - Money in (previous week) )/ Money in (previous week)

Default alive

You can calculate your default alive state once you’ve calculated your burn and growth. Assuming that your expenses remain constant and your growth rate continues, the default alive answers whether you have enough cash to reach profitability in time. You can use a startup growth calculator to find your default alive state: http://growth.tlb.org/. You can move the scales up and down to see how changes in growth rate, revenue and expenses affects the amount of capital required and the time it takes to reach profitability.

Lacking commitment and regularity

Whether you’re a one man startup or a team of tech enthusiasts looking to build a startup, taking proper responsibility for your finances and adopting good accounting hygiene can help you better understand the numbers that drive your business. Make sure that you record every transaction that has occurred and categorize them in terms of the type of income or expense along with a short description of what the transaction was made for. This may seem like an unnecessarily over-ornate, boring task but it saves a lot of time in cleaning up your accounts later when you need them.

Besides helping maintain a clean book, undertaking the role of managing your own finances will also help you develop a better understanding about financial concepts that are important and relevant to your startup. If you’re working with a team, you might want to assign responsibility to a person who will undertake this task. However, make sure that the person you’re assigning is sufficiently capable and committed to handling this task.

Regularity in maintaining your accounts is key to being able to respond to changes. I strongly recommend that you look at your accounts at least every week. Not quarter, not month. Keep an eye on your numbers every single week. Anytime, anywhere someone asks about your numbers, you should know it.

Underestimating expenses

Earlier, when finding our default alive state, we assumed that the expenses remain constant. However, this is rarely the case in an actual scenario. There are three common ways we undervalue our expenses:

Undervaluing your own time

Hiring people doesn’t just cost their salary

Assuming paid acquisition remains constant

In the early days of a startup, you are likely to be acquiring new customers in a way that does not scale well. You are dedicating your own time and resources to basic tasks that help you get new users for your product. You need to keep in mind that this method of customer acquisition is temporary and only appears to have a lower cost of acquisition because you do not account for the time and resources you personally spend on it.

As you begin hiring new employees, you start paying them a salary. What most people fail to understand is that the additional overhead cost of hiring someone is worth consideration. Depending on your startup, a new employee usually needs equipment and supplies to work. A good rule of thumb is to estimate the cost of hiring someone as 25%-50% more than what their actual salary costs.

Lastly, we might falsely presume that the cost of acquisition will only get lower as the startup grows. In reality, this is usually not the case. Your early users or early adopters are usually the customers with the highest need for the solution you’re building. The mainstream customers will require more persuasion to buy your product. So, keep this in mind when you are making any assumptions on your customer acquisition cost.

Outsourcing Financial Responsibility

Outsourcing the responsibility of managing the company’s finances is a completely normal thing to do. However, knowing when to outsource responsibility and how to do it is critical. Unfortunately, there isn’t a single condition that fits all when it comes to answering these questions. Typically, startups invest in third-party bookkeepers when their company begins growing, they have a lot of employees or when they recently secured their first round of investment. In such conditions, it isn’t the best use of the CEO’s time to look after the books while he/she could be spending their time on more valuable activities.

What most startups fail to do when they outsource responsibility is that they stop looking at their own books in the assumption that it is now the responsibility of someone else. This misinterpretation of outsourcing financial responsibility can cause accidental startup failures. The CEO along with all members of the startup must acknowledge that they all are responsible for the finances of their company. The external bookkeepers and accountants wouldn't know what to make of the data and how to response in the way that you'd know. They can’t reason with why the numbers behave the way they do. Only you and your team can relate the numbers to what’s going on within the business. That's why it is crucially important that even when you outsource the financial responsibility, you and your team must continue to assume the responsibility of your own numbers.

Assuming Growth is Always Good

CEO and founders of startups are usually inclined towards an obsession for growth. Investors, media and other founders further fuel this obsession as founders develop an intuition relating growth to success. This misinterpretation of growth has caused several startups to fail. Growth isn’t a goal. It isn’t something to aim for. Growth is a result of building the right product for the right group of people. Growth occurs naturally when the demand for your product rises.

The misinterpretation of growth with success and scale has had many startups hire employees too quickly. Having more employees does not necessarily mean you’re more successful. This flawed thinking causes startups to burn money faster and die faster. The key to hiring new employees in a startup is thinking in terms of the Return on Investment of the employee. This can be really difficult in some situation, but you can find techniques to measure this number. A good ratio to determine the value of employees is revenue : employees ratio. Use this ratio instead of number of employees to judge your startup's performance.

One of the most difficult moment of being a founder is firing employees. If you’re in such a position, you must not hesitate to fire fast. If people aren’t pulling their weights, they need to leave. Instead of growing the size of your company, focus more on growing the culture, quality of work produced and other similar goals of the company. The best startups do more with less.

The best startups do more with less.

Like growing the size of your company, growing the size of your product portfolio quickly can also do more harm than good for your company. If your first product hasn’t yet achieved a product-market fit, then you should not be looking to expand your product portfolio. Without achieving product-market fit, your products aren't ready for growth yet. Adding new products to your portfolio when you don’t already have a product-market fit, will bring more burden to your product development team. You may end up hiring more employees to cover the work, further increasing your expenses and decreasing your runway. Despite the effort, hiring more employees rarely leads to achieving product-market fit quicker. Overall, it is best to avoid hiring new employees before you reach a product-market fit.

Raising Investment When Your Runway is Low

If you wait too long to raise funding for your startup, you will have great difficulty in raising funding later. You should assume that the previous money that you had raised is the last funding you will ever have. Imagine the money that you currently have is the only thing remaining for you to reach profitability. The seed stage money you’ve raised is the money that should get you to product-market fit. In the later stages of funding after that, the investors expect growth and continued product-market fit. It gets considerably more difficult to raise money as you go up the life cycle of your startup.

The reason why you can’t afford to let your runway get too low is because your runway gives you leverage over your investors. From a game theory perspective, your investors are better off stalling you until you completely run out of money and you have no leverage left at all. So, try to raise funding at least 6 months before you’re out of runway. If you only have 6 months or less of runway left, take action immediately to lower your spending and increase your runway. Consider that getting to 2 months or less runway is a point of no return.

TLDR

Know your cash balance and runway at all times

Understand how your expenses rise over time

Remember to make your runway look better

Be truthful to yourself and use honest numbers

Understand high revenue:employee ratio is better than number of employees

Assume you’ll never raise again, so have a plan for reaching profitability

This is all you need to know to manage you startup finances. What topic mentioned above was useful for correcting your mistakes? What problems is your startup dealing with financially?