Mastering The Balance Sheet Can Make Or Break A Startup

Mar 27 2014, 10:18am CDT | by

Mastering The Balance Sheet Can Make Or Break A Startup
Photo Credit: Forbes Business

When I see something happen again and again in Silicon Valley, I use the phrase “Prevailing Pattern of Practice in the Valley” to describe it. When things work well here, they get copied broadly.

Over the last twenty years, recruiters and VCs have actively turned to VPs of Marketing and VP/GMs in large public technology companies to find CEOs for new startups. I know many people who have made that transition (as I did) and my recruiter friends tell me they have seen it hundreds of times.

It’s easy to imagine why this particular prevailing pattern of practice works well. First of all, competition for promotion in startups is pretty tough. Many smart people flock here from all over the world, and many develop their careers in these multi-national technology firms. This means personnel winners have already been vetted in terms of their ability to develop products and services which win in the market. Additionally, since these large firms serve global markets, these winners have international experience. Finally, because these companies tend to be well run financially, these people understand the importance of high gross margins and rapid revenue growth to the financial community.

If a VC is really fortunate, the recruited person picked for a startup even has experience in speaking to financial analysts and investment conferences. The new startup leader has been well coached in the types of phrases to avoid and the importance of certain key financial metrics to the banking community.

This all sounds like those cake mixes which became popular when I was young.  “Just pour the mix into a bowl, stir in a beaten egg, add a cup of water, spoon it into a pan, and bake for 30 minutes.”  The result is a “home baked cake made from scratch.”

Is it really that easy?

Unfortunately, it isn’t. In the case of bringing a first-time startup CEO up to speed on the financial responsibilities of a nascent company, one absolutely essential ingredient has been left out of the winner’s experience in a large multi-national company (MNC): That key ingredient is managing the balance sheet.

Why is the balance sheet important, and why don’t these winners have the necessary exposure to manage it? To answer those questions, let me refresh everyone on what’s on the balance sheet.

The balance sheet lists the various and sundry assets of a company and pairs them off against the sum of its liabilities plus its stockholders equity. When I say “pairs off” what I really mean is the cardinal rule of accounting in a balance sheet: assets must equal the sum of liabilities and stockholders’ equity. They must balance, hence the name balance sheet.

In a business generating positive free cash flow as well as operating income, as most large multi-national technology firms do, current assets will exceed current liabilities since cash balances and other assets will be increasing in size from increased profitable sales and collections. When that happens, stockholders equity rises to fill the gap between assets and liabilities and balance sheet management gets reduced to investing ever-increasing loads of cash. The emphasis of the equity markets shifts to the income statement when the far more sexy metrics of revenue growth and gross margin percentages live.

The reason why these winners don’t have balance sheet management skills is that in MNCs, balance sheet management occurs in the treasury department of the company’s finance function. The role of the marketing or GM exec in these firms is to sell more product and drive up gross margins. These are measured in the income statement; not the balance sheet. As a VP/GM at two different Fortune 500 companies, I never recall my CFO wanting to speak to me about the balance sheet. They were eager to talk about metrics from the income statement at least monthly and often weekly.

So why is the forgotten financial statement in large MNCs so important for startups? Because they are not generating profits and free cash flow in their early days.  They’re burning through cash and accumulating losses (negative shareholder equity) in their early days as they seek Product Market Fit, increasing sales, and cash-flow breakeven.

Even if gross margins are high, it is the very rare startup which generates enough gross margin dollars to cover the entire startup’s operating expenses. That may because there is some development time needed to get to Minimum Viable Product, it may be because the startup has not yet achieved Product Market Fit, or it may be because the particular product or service doesn’t immediately generate collectable sales.  Companies which go to market with a Freemium model or where the customer purchasing cycle requires a trial period might well have this problem.

Moreover, the two techniques to improve financial results that these winners know from their large public company experience will not work in most startups.  The two classic techniques are increasing gross margins and increasing sales and channel coverage to increase the sales growth rate. Given that most startups are software based today, gross margins are already high and don’t have much room to grow.  And since adding sales people increases costs ahead of increased revenue and gross margin, that won’t help slow down cash burn in the short term. If the startup doesn’t have Product Market Fit, it won’t even help in the long term.

So what should a first time startup CEO do to meet this challenge? The obvious first step is to admit that there is an important gap within the startup’s most important financial metric, how long the current cash will last, and his experience. The second step is to get experienced guidance on how to plan this. Often times I recommend supplementing the skills of the person doing the books with someone who either has done a CFO job or is has a lot of experience working with startups over the early course. In most cases, this can be a half a day a week sort of engagement.  There are plenty of regional accounting firms who provide these services.  They are not inexpensive because these people deliver real value, but then you do not need them for that much time per week.

The good news is that help is available. For the startup CEO who appreciates the importance of cash management and the balance sheet, it is all good news. However, many first time CEOs do not have an appreciation of this problem because they have no prior experience. Not jumping on this skill gap right away will likely lead to bad news in the form of needing to raise additional equity before you’ve proven your company. That is never pleasant. It’s also avoidable if the startup CEO makes this an early, important priority./>/>

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Source: Forbes Business

 
 

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