Thursday, March 30, 2006

Build Before You Burn

Avoid the trap of burning through all your capital before proving the business model

This is a repost of an article I was asked to write for IBDNetworks:

Starting a company demands blind enthusiasm and an ability to ignore the laws of “physics” lest you be daunted by the obstacles of reality. Being a start-up CEO requires an almost impossible balance of irrational exuberance needed to overcome obstacles coupled with fiscal conservatism.

While optimism and persistence are necessary to grow the company, you have to remain anchored to the realities of company progress and the market. Lose this balance and you will find yourself wandering in the wilderness trying to figure out whether the lack of revenue growth is a result of product or market issues. Underperforming against sales objectives inevitably leads to the company burning through hard raised capital sooner than expected, annoyed investors and the never exciting prospect of a down round.

So, how do you avoid this dilemma and maintain the balance?

Companies that succeed start with a thoughtful business plan that includes business metrics and establishes milestones that are proof points for growing the business. This is the best place for you to start. Organize the metrics and milestones around major risk areas of the business; aim to prove out the key questions about the market, technology and development.

Typical milestones and metrics include technology proof of concepts, product release dates, bug rates, customer acquisition rates and costs, as well as average order size and revenue growth. Organize your operating plan and budget so that you can see how much cash is required to reach each key milestone that proves out the business.

Now comes the tricky part, you need to suspend your optimism. In the real world things never happen as quickly as desired or planned. Most operating plans are based on perfect execution with only modest contingency. Plans assume technology will get developed on budget, products released on schedule, fast market adoption and sales grow as forecast. In a mature company and market this can be true, but in a start-up it rarely happens.

If you make these assumptions and ramp spending ahead of hitting milestones, you may get lucky, but more likely you will miss milestones and burn through cash faster than expected… we’ve seen this movie before and the ending isn’t pleasant.

Take the typical example of a product taking longer to develop than planned. This leads to a delayed product launch and lower sales revenue than planned. If you ramped the sales and marketing expenses in anticipation of product shipment, you are left with lower revenues and higher expenses. You have a team of highly compensated sales and support staff on payroll without the planned revenue to offset expense. You are digging an expensive hole in the ground that will be difficult to fill. The company is now significantly off budget on both top and bottom line.

A better alternative is to line up growth in expenses with the achievement of milestones. You should plan expense ramps so they are gated by milestone achievement. In the above example, you would not significantly ramp your sales force until you delivered the product and proven market acceptance by sales into several key customers at the anticipated price point. If you are late on product delivery, you will still miss the top line, but your bottom line won’t look nearly as bad, in effect buying yourself more time to make progress.

If by a stroke of skill, luck and good fortune you find yourself making the milestones, it’s always easier to accelerate expenses than it is to cut them back

You shouldn’t make these decisions in a vacuum. This is a perfect opportunity to engage the experience and objectivity of your Board of Directors and Advisors. You should carefully construct both groups so that each individual brings unique operating insights that strengthen your company. The right people will be able to provide good feedback on the appropriate milestones and help calibrate expectations on how the company will achieve them and how long it will take.

Remember to build and prove those milestones before you ramp your burn… the movie will have a happier ending!

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