5-4-3-2-1 Countdown for Entrepreneurs (1/11/23)
5
Myths that divert startup CEOs from the path to profitability
#1 “When fundraising is necessary, the wants and needs of investors are most important.”
The key word is “most.” Investor needs are indeed important, but trouble looms when startup CEOs put investor needs ahead of all other things, including prudent financial decisions that could most effectively put the venture on the path to being profitable.
Why would an investor want that? After all, they don’t want to undermine the venture. They just might have different motivations and a different timeframe for when they want to see a return on their investment. There are legitimate reasons why they might not match a CEO’s determination to achieve profitability in the shortest period of time.
The myth is that you need to focus on investor needs above all else, when the reality is that you can do two things at once: pursue a cash-centric, mature approach that gives you the greatest chance of success and find investors who want to go along on the ride and will accept your terms for investing in your startup.
#2 “As I raise larger sums of money, I don't need to scrutinize our expenditures as much.”
I call this the “Funny Money Fallacy”: If the amount of money you've raised is large, then every one of your costs is less significant and requires less of your time and attention. It’s as if the big sum you raised doesn't feel all that real or tangible anymore, so it makes your decision-making less cash-conscious.
You figure, “I've got bigger problems to deal with than this minor expense. I'm not going to waste time on whether it's the right price, whether I can get a better deal, whether we're spending too much. It's such a small proportion of the money we raised; it really doesn't matter.”
But that rationalization is contagious. It can quickly roll up and leave you looking back with painful regret at recent expenditures, wondering where the money has gone.
#3 “We can solve sales problems by cutting our price.”
It’s a typical scenario -- a startup CEO is reviewing recent sales numbers, either because they're trying to project for the future or maybe they're getting ready to pitch to an investor. And when they look at the sales count, they're underwhelmed and want to improve it. Their solution is often to adjust the price.
Well, that seems logical. It's simple economics -- supply and demand -- drop the price and, all else being equal, you will increase the number of sales. For an established company — for a scaling venture — that works nicely. Imagine competing in a crowded space. You bring down your price. You're able to get more market share. You're able to attack more of the market...It works.
The myth is that the same rules apply for an early-stage venture. But the rules don't apply -- because what your early-stage venture is trying to do in this uncertain environment is to create value that is somewhat new and different for a well-defined market. So, when you adjust your price down, you are admitting that this value is not fair — it doesn’t warrant its price. And I'd argue it's usually too early to be doing that.
What is more likely is that you've got either a product problem or a market problem, or a combination of the two. From a product perspective, it could be the case that — even though you have the vision and opportunity to create real value for a customer — the way you have structured your product or service is not quite right. Maybe it's missing a feature or a function or some other element, and if you go back to the drawing board and solve for it, maybe you can not only maintain the price, but even increase it. The last thing you want to do in that case is reduce it.
The other issue might be that your product or service is delivering the value, but you’re targeting the wrong audience. Maybe you've missed the mark, or maybe you're being a little too broad and could narrow to a subset of your market that’s truly enthusiastic about what you're delivering. They may be willing to pay more. So, if you were to focus on product and market — instead of price — and reject the myth that price is always the best way to improve sales, you'd put your venture on a more successful path to profitability.
#4 “Cashflow and profitability are issues for my CFO, my accountant, or financial advisors. They'll let me know if there's an issue.”
This attitude is common because startup CEOs are advised to focus on selling, raising money, creating a vision, and building culture, not to analyze financial statements. So, they're motivated to delegate this kind of stuff as soon as they can -- the faster they can hire a CFO, the better. But I think that’s a big mistake. If cash is king, then why isn't being cash-centric a chief focus for CEO decision making? After all, a startup CEO makes decisions every day that shape the business, and those decisions are inextricably tied to, and hugely affect, cashflow and profitability.
So, the idea that startup CEOs should focus on the financial effects of their decision-making only after someone else pulls together information for them is short-sighted and risky. Cash and profitability need to come to the forefront, and it must stay that way until a startup has truly graduated to a much more established level.
#5 “If profitability is a long way away, I don't need to worry about it today.”
It is true that for many startups, profitability is a longer-term prospect. They've got to engage with a market, start generating some sales, find ways to build an efficient system to deliver the product in a profitable way, and then do that for long enough to cover all prior losses.
Yes, it can take a fairly long time to generate profitability, so the idea of focusing on it very early can seem like unnecessary anxiety, analysis, and distraction. But if every decision you're making in your venture, particularly in the earliest days, is critical and has a material effect on the outcome of the business, shouldn't those decisions focus on the opportunity for that company to build a more sustainable financial future?
Shouldn’t it be the primary objective in those earliest days to make sure you're getting off on the right foot, with the right actions, to ensure you're doing everything necessary to shorten the time and increase the likelihood that you achieve profitability?
Well, that takes the ability to stop and ask a simple question: Is what I'm about to choose, or what I’m about to do, going to help or hurt this venture’s ability to be profitable?
4
Reasons why successful startups focus on their assumptions, not their projections
Having observed hundreds of startups, I’ve noticed that successful CEOs focus more on their assumptions – what must prove to be true if they are to achieve their goals – than on their financial projections.
Here are four reasons why that focus on assumptions improves their odds for success. The first two reasons explain why projections are often unreliable:
1. Projections are often lagging indicators.
The traditional construction of financial projections – like revenue or total sales -- produces a lagging indicator. By the time the data is collected and presented to a CEO, if the numbers spell trouble it is often too late to make a change. All sorts of things happened that led to the top line number and, as a result, that metric lags the activities driving it. What is most vital in the functioning of a business happens prior to seeing results in the form of things like total users, units sold, or total revenue.
2. Projections can be like the tail wagging the dog.
Does this scenario sound familiar? A CEO is prepping their deck for an investor meeting, and they've gotten to the financial projections section. They are trying to determine what revenue growth might look like for the next five years. They settle on something reasonable, deliver the pitch, and it’s a good meeting...but the investor feels that the revenue projections just aren’t big enough to be a good fit for them. The investor says, “Let’s stay in touch, and if something changes, please come back.” The CEO leaves but, being ambitious, resolves not to take no for an answer. The CEO goes back to the projections and gets creative about ways to increase the pricing per unit, or ways to generate more recurring sales or renewals of the thing they're trying to get users to subscribe to, or they find another market that would be as interested as the core markets they’d identified. They are on the hunt for more revenue for more growth, and soon they “find” it. They revise their deck, return to the investor and maybe are lucky enough to get funding.
Here's the problem: That venture is now tied to a set of expectations that aren't reasonably achievable. The inflating of projections wasn’t done with bad intent. Startups are uncertain and the future is unknowable. And is the larger projection much less likely than the previous, smaller one? Not necessarily. But the problem is that this venture is then anchored to an expectation much harder to achieve. And this ratcheting up of expectations usually continues and results in unvalidated projections becoming the frame through which the venture is seen and judged by investors. The investors now have expectations that put a great deal of additional, unhelpful pressure on a startup. So, what began as an aspirational spiraling-up turns into a depressing spiraling-down: new projections turn into unachievable expectations, which turn into stressful pressures, which result in bad decisions that ultimately undermine the projections.
Just as projections can be lagging indicators, assumptions can be leading indicators – elements core to the business that reveal what’s likely to happen.
The following two reasons explain why focusing on assumptions gives a startup the advantage of reality-based insight:
3. Analyzing assumptions will uncover risks.
What elements need to be proven true for a startup to be able to achieve its goals? Generating $25 million of revenue might be considered great success, but what must happen 5-10 steps before that? What smaller, earlier assumption must be true to set in motion the next-step assumption, which in turn needs to be proven true, and so on, to fulfill that projection of $25 million in revenue?
Focusing on the assumptions that lead to success is critical for startups because of the risks they face. Given how quickly so many things can change, to focus on a result or a metric that is 10 or 20 steps down the road is foolhardy. The main focus should be figuring out the aspects of the business that are core to its operation in its earliest stages, determine what needs to be proven true, then quickly learn or experiment to determine if assumptions are valid.
For example, let’s say a projection metric is overall sales for a Software as a Service company. A sale might be to an enterprise customer that takes six to nine months to go from being introduced to a product to ultimately signing a big contract. Think about the number of steps in the process to go from initial interest to a sale. It might start with prospects seeing some content or reviewing an ad that might turn into a demo, with the demo prompting a second call, and so on. What might be early assumptions? One assumption might be that a certain percentage of a target audience that views a piece of relevant content will engage with it, and some will follow up or reach out to the SaaS. And if a meaningful proportion reach out, the company can make the case that a meaningful number will turn into a sale. So, now they’re thinking that if they can see positive early engagement, they have a good indication that it’ll turn into sales possibly a few months down the road. In that case, if they can validate the assumption that they’d get a certain percentage of the audience to engage with content, that could be a core indicator to help them determine their ability to generate sales down the line.
We can repeat that kind of analysis and reconstruct it for many types of companies at different points in their life cycles. No two companies are the same, no two metrics are the same, and no two points in those companies’ lifecycle will produce the same collection of core assumptions.
4. Testing assumptions will uncover the real opportunities.
When we focus on assumptions, we prioritize things that are essential for a startup: realistic analysis, experimentation, validation, agility, and resilience.
Considering all this, what are we supposed to do? For starters, when it's requested, go ahead and make financial projections. Stopping that work is not what I am suggesting. I'm merely urging that we see the projections for what they are: a tool that might be a minimum requirement for certain aspects of your venture – like pitching an investor, applying for a bank loan, or meeting with your leadership team to do some strategic planning – but unreliable as visions of the future.
So, we should reduce their negative effects by applying much more of our focus to testing assumptions -- what needs to be proven true today to create more opportunities tomorrow. With that focus, we will find and fulfill new opportunities. And that’s the hallmark of a successful startup.
3
Criteria that define a “scaling” venture
Generally, ventures have two phases in their lifecycle: a startup phase and scaling phase. The startup phase is filled with unknowns. Can we effectively develop and sell our product or service? Can that product or service deliver real value to a clearly defined audience? Can we remain financially afloat during all the learning and experimentation? And the entire goal of the startup stage is to get out of the startup stage -- to graduate to become a “scaling” venture.
To many, “scale” implies massive growth in an enormous market. That might be true, but it doesn't have to be true. To me, scale isn't about size; it's about certainty. Here are three criteria for an early-stage venture to be considered “scaling.”
First, a scaling venture is crystal clear about why, what, and how it does what it does -- its purpose, goals and operations are defined, realistic, and embraced.
Second, a scaling venture knows its market inside and out. It consistently delivers valuable offerings to that market, and that market consistently pays for it.
Third – and this is where I get a bit controversial -- a scaling venture has earned the opportunity to maintain or grow its current business. It is economically sustainable. The model works. The venture is profitable or at least on a proven path to profitability.
Let's have no ambiguity about that last point. A path to profitability means if a venture stays on its current course, it will achieve financial success in short order. The revenues created by selling goods and services exceed the cost to run the business. It doesn't need to close a huge new customer; it doesn't need to land another big round of funding; it doesn't need to finalize a major partnership. The business can pursue all those things, but it doesn't need to pursue any of them.
As I noted, none of my criteria cite the size of a business or the speed at which it is growing. I often see hypergrowth ventures raising many rounds of capital that I wouldn't consider scaling. And I often see smaller, younger, less funded, slower growth ventures that I would consider scaling because they've got their money model figured out. Their destiny is in their hands. They can maintain their size. They can look for opportunities to merge or get acquired. They can afford the calculated risks that come with growth.
2
Articles you might find interesting
“Reframing our understanding of remote work”
by Mike Elgan in Computerworld
“The End of the Silicon Valley Myth”
by Brian Merchant in The Atlantic
1
Piece of advice for startups: “Practice like you play”
Growing up and playing sports through college, I heard this exhortation often. To practice like you play is to treat your preparation like it's the main event. We would do that by trying to have our intensity, focus and environment while training match our intensity, focus and environment when competing. Obviously, it wasn't always possible, but we did our best.
Compare a startup CEO to an athlete in training. They both prep for the big show. Whether the goal is to win under Friday Night Lights or graduate from startup stage to scaling stage, they practice for what is to come. For most tech-centric startups, achieving profitability, or any revenue at all, takes time. It also takes money, sometimes a lot of it.
So naturally, in the early stages of a venture, most startup CEOs spend a lot of their time focused on finding and collecting the funds needed to operate the business. In my experience, this quest for capital leads to a common mistake: they don't practice like they play. They make decisions during the startup stage that they wouldn't or shouldn't make once the venture has matured.
They stray off the path to profitability, thinking they'll get back on it later. Sometimes, they even convince themselves they could find success without ever returning to it at all. They fall into bad practice when it comes to their venture’s money -- usually without even realizing it's problematic. But the reality is this: whether they are fundraising or not, profitable or not, generating revenue or not, cash is still king. It is the primary resource required to operate our ventures, no matter what circumstances we're facing. So “practice like you play” means being cash-centric in the here and now; producing value for customers in the here and now; staying focused on profitability in the here and now.
Stay safe, stay happy, stay in touch!
Adam
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