How should a growth company manage its budget? Does an annual budget approval process even make sense in a fast-moving firm?
My friends who are executives at large, established companies complain about how fixed budgets lead to gamesmanship. An executive who wastefully spends down their travel and expense budget at year-end to justify an equal or larger budget next year may also fail to take advantage of a great marketing opportunity with a December 31 deadline — because they spent their budget on T&E.
However, in a startup, the most common scenario is that projections get missed. Paul Bianco, CEO of Graphite Financial*, says “entrepreneurs are characteristically optimistic by nature and often present their board best-case-scenario budgets and projections. Inevitably, things cost more and take longer than expected. I encourage entrepreneurs to correct course with a re-forecast early and often. The worst thing you can do is dig in your heels and hope things will miraculously get better. Being transparent enough to say ‘look, we expected X to happen, but now we expect Y to happen, this is why, and this is what we’re doing about it’ is an admirable trait.”
Here’s the solution I have recommended to some of my portfolio companies: “agile budgeting,” i.e., monitoring a few key variables, while giving managers significant flexibility. Entrepreneur Jeff Magnusson provides a sample agile budgeting workbook. Sean Colrock, Director of Client Partnerships at Wiss & Company, suggests at a minimum you track: cash on hand; fume date, and burn rate. The next most important set of metrics are sales by category; working capital (cash and other current assets, less current liabilities); EBITA and gross margin. Ben Horowitz writes that you can ruin your company with a bad budgeting process and recommends a similar approach.
Regardless of whether you take a traditional or agile budgeting approach, Robert A. Howell, Professor of Business Administration at Tuck, writes that you should turn your budgeting process upside down by “reformat[ting] planning and budgeting templates to highlight cash rather than accounting net income.”
This agile approach is not restricted to small startups. In Stop Budgeting, Start Improving, Brad Power writes:
“Consider ThedaCare, a healthcare system in Wisconsin, which eliminated its budgeting process in 2010. According to ThedaCare’s chief financial officer, Tim Olson, top management viewed it as a significant waste of time. With four hospitals, 22 physician locations, and over 5,000 employees, ThedaCare managers spent 10,000 hours a year to build their budget, and another 10,000 hours to explain, manage, and argue about it.
The organization replaced the budget with a quarterly forecasting and planning process… The new plan includes a rolling look-back at the last eight quarters and a look-forward at the next six. Managers look at numbers at a higher level than before. For example, they’re monitoring cost per unit of service (not just cost by department) to be sure that they offset cost increases (e.g., due to inflation, salary increases) to maintain margin in an environment of downward pressure on prices. When managers see problems ahead, they launch a process improvement initiative — not budget cuts — to close the gaps. ThedaCare also introduced a daily financial management tool for department managers.
Group Health Cooperative, a nonprofit health care system in Seattle with 10,000 employees, has also thrown out its budgeting process. In 2009 the organization moved to a run-rate methodology, which monitors spending quarter-over-quarter. That reduced the administrative burden of budgeting, and freed up managers to improve processes.“
Andreas Rothe, CFO, Fragomen, observed, “one of the reasons for a budget is to align the various resources of the firm to projected revenues from clients and company objectives. In larger, more complex organizations, it is difficult to make such alignment on the fly, hence the reason many of them keep an annual budget. Still, especially in today’s quickly changing environment, such alignment needs to be done more quickly.”
Jeff Burkland, an experienced Silicon Valley CFO, says, “when you consider that most startups change so much and so frequently, trying to build a budget for a year and stick to it is useless. Instead, managing to a rolling forecast/budget is much better. The trick is to make sure the forecast/budget watches cash. That’s the critical item for startups! At Segment, I still only do monthly rolling forecasts and then I compare actuals to that in order to provide evidence that helps tweak the model. And, every change I look at cash, including cash out.”
“Forecasting is exceptionally challenging in practice, especially as end users drive an era of distributed spending,” says Peter Nesbitt, VP of Finance at Teampay. “Purchases are often made without the company’s knowledge and only seen after employees submit expense reports, by which time even more money has been spent. Finance teams need real-time visibility into spend, so they can course correct immediately rather than waiting until after month-end close. Successful agile budgeting requires modern technology. Without systems in place to manage distributed spending, finance teams will leave money on the table.”
John Evans, CEO of DecisionCFO, says, “for an agile start-up cash is critical. Specifically, we deploy a 13-week rolling forecast for all our companies, with updates twice a month. This gives our companies maximum granularity in understanding how cash moves through the business. Further, we support this with weekly flash reports that focus on key operating metrics of the company.”
*Disclosure: Graphite is a spinoff of ff Venture Capital, where I was formerly a Partner.