June 10, 2018

Financial Reporting in Early Stage Companies

Financial Reporting in Early-Stage Companies

If you don’t know where you’re going, you might end up someplace else (Yogi Berra).  If you don’t know where you are, well, you really don’t stand a chance of succeeding.  Trying to run your company without proper reporting and metrics is normally disastrous.  Yet many (actually most) entrepreneurs do not have the proper reporting mechanisms in place to help guide them along the journey.  Most of the time this is due to inexperience and lack of knowledge of critical financial reporting standards.  It might work when you re building your product, but it does not work when you are building your company.

So, this is especially important if you are seeking investment or have received investment and now have a board to deal with.  Board members are normally financially literate and expect CEOs to be able to properly report on the status of the business. When they can’t or don’t, it immediately results in severe tension.  Investors are the same way.  If you show that you don’t quantitatively understand your own business, there is zero chance that the investor is going to invest.  Zero!!!

It is important to note that accounting and financial reporting are related but different functions.  Accounting feeds financial reporting but is not the only source.  So, saying that you have someone who does your books is not a great excuse.  It shows that you don’t really understand the process.  Plus, there is much to be gained from actually touching the numbers.  Therefore, CEOs can gain a better understanding of their business by being hands-on with the numbers across marketing, sales and finance.  After the business matures a little, you certainly want to bring on a CFO.  That person will take over this critical function and can provide the right level of reporting and sensitivity analysis to your process.  But until then, it’s all you.

Financial reporting means reaching into all areas of the company and collecting and tying together meaningful numerical information that provides an accurate picture of where the business is, where the problems and opportunities are and what the future plans for the organization are.

There are a series of related reports that can help the entrepreneur and are requirements once the entrepreneur seeks funding (for due diligence purposes) and once the entrepreneur has a board of directors (for board reporting purposes).

There are several critical questions that any entrepreneur should want to know the answers to and all board members will demand the answers to.  These questions are:

  • What drives our shareholder value and what are we doing to improve those factors?
  • What is our financial plan for the year?
  • How are we doing against that plan on all critical aspects of revenue, expenses, profit, headcount, and cash?
  • What is our revised financial forecast for the P&L, contracts, and cash as the year unfolds?
  • What is the current sales forecast, by opportunity, sales person and month and what stage is the opportunity in?
  • What is the status of the key accounts on the sales forecast?
  • How does the sales forecast tie to the budget and the current forecast?
  • What is our headcount plan by month, what will that cost us and what will that provide us?
  • How many months of cash do we have left?
  • When (what month) would we run out of cash?
  • What if we miss our sales forecast by 20%? What happens to cash?
  • What high level details can you provide about the major forecasted sales over the next 3 months (status, stage, next steps, competition, risks)?
  • What are our forecasted account renewals (if any) and which might be at risk?
  • What is our lead generation plan and forecast over the next 6 months?
  • What is our average sales conversion rate and time frame by deal stage?

Problems that are common in financial reporting

  • The information is all historical. There is no forecast
  • There is no budget in sufficient detail for meaningful comparisons
  • There are not actual to budget comparisons for current month and year-to-date for categories of contract sales (bookings), revenue, expense, earnings and cash
  • Sales forecast does not tie to the financial forecast
  • Financial forecast is inconsistent between accrual and cash basis
  • The cash forecast is off due to timing, collections….
  • MRR and ARR are not reported
  • The lead generation plan does not tie to the sales forecast or financial plan
  • There is no reconciliation of renewals or no renewal schedule
  • There is a constant monthly drop-off on sales numbers in the financial forecast without explanation
  • Revenue categories are not reported in insufficient detail
  • Hires are forecasted, but on-boarding time is not accounted for

There are standard quantitative reports that will help answer these questions and discipline is required to prepare these reports monthly and go over them monthly.  Most often, these reports do not come standard out of your general ledger or your CRM and need to be manually prepared, cross-referenced and analyzed.  This is problematic for lazy or inexperienced entrepreneurs.  There is no out-of-the-box solution.  It, like everything else in the world, takes work.  Sorry.

But the art and science of preparing these reports can be the difference between life and death in a company of any stage?  But, too often, entrepreneurs do not have the discipline to prepare this analysis in this level of detail and are, therefore, caught off guard to issues to do anything about them.  The other excuse is that they are too busy running the business to do this reporting.  This is like saying: “I am too busy driving the car to pay attention to the dashboard (speed, gas level and map)”.  It’s pure craziness.  Other times, entrepreneurs imply do not have the expertise to know how to prepare and analyze these reports.  This could indicate that they are not well-equipped to be the CEO of the company.

The first rule of reporting is to keep the level of detail consistent from the original budget to the actuals out of the general ledger to the current forecast report.  This is especially true for categories of revenue (subscriptions and services).  Sometimes, organizations will break out new revenue from renewals. Or, organizations may break out new product revenue from existing product revenue if a new product is being introduced that has game-changing implications for the business.  On the expense side, employee costs are probably the most critical item and this is driven by number and type of employee.  Also, marketing expenses, and categories are critical since this dictate where leads are coming from.

The next issue is to understand that the budget, the actuals and the current forecast may all use different methodologies.  The budget can be model-based where numbers are calculated based all on assumptions.  The actuals are actuals.  There are no calculations.  The results are what the general ledger say they are.  The current forecast (for revenues) are actuals for the months that have closed, the sales forecast for the next 3 rolling months and then whatever you believe to be what will happen for the remaining months of the year for both income and expense items.  You can revert back to model assumptions for this last part, or your better judgment or whatever you are comfortable with.  Many entrepreneurs tend to try to use the original budget-only for the current forecast.  This is a huge, huge mistake since things have changed since the original budget was developed (often in the prior year).

The sales forecast is the next critical report.  Properly tracking and formatting this report is essential.  The best way to do this is to track the opportunity by forecasted month of close, sales person, and showing the probability of close and breaking out services from subscription revenue.    The probability should be based solely on what stage the opportunity is in and not by guessing.  To do this, you should be tracking what percent of deals that reach that stage actually close and then use that percentage (not make it up).  It is also critical to understand how long, on average, an opportunity takes to close once it is in that stage.  Too often, companies over-forecast both the probability of a deal and the time frame of a deal leading to poor sales forecasting.  Accurate sales forecasting is the life blood of your company. Next, companies need to multiply the probability of the deal times both the services and subscription amounts to calculate the probability adjusted numbers for the month.  These numbers should then be used for the next 3 months in the current forecast report for sales.

Critical reports:

  • Annual Budget (monthly for all categories of revenue and renewals and sufficient detail in expenses as well as forecasted cash balance)
  • P&L Actual to Budget Report Monthly (Current Month and Year-To-Date)
  • P&L Forecast for the remaining months of the year or even out through the end of the following year with cash balance and headcount information
  • Sales forecast for the next 3-6 months based on sales activity broken out by software and services and then probability adjusted based on deal stage
  • Key account report (a more-detailed write-up of your top 5 forecasted sales
  • Renewal report (a simple report with your current customers listed down the page and months across the page where the renewal amount is in the intersection of customer name and month)
  • Headcount report showing historical and forecasted headcount by position by month
  • Waterfall table (a key metrics report showing the original budget and then actuals and forecast for each key metric)
  • Lead generation forecast by category (a report that forecasts where leads will come from by lead categories (like webinars, conferences, email marketing) by month). This must also include attrition by step and average time to close for historical information

A word about the Key Account Report.  Since you are relying so heavily on the major accounts in your sales forecast, it is good practice to write-up an analysis of the top 5 accounts on your sales forecast including the pain or problem the account has, the current status of the account, the key decision maker, the next step in the sales process, what it will take to close the business, the competition and the risks associated with the account. If you don’t know these things, the account does not belong on your sales forecast.

For examples of each of these reports, write to arbordakota@me.com.

People always ask: “Do I need them all?”  Well, the answer is: “Only if you want total visibility into your business and completely understand what you need to do to succeed.”  Other than that, “no”.

In addition, you should always be asking:

  • What are we doing to increase the number of opportunities that we are competing for?
  • What are we doing to increase the win rate?
  • What are we doing to increase the average deal size?
  • What are we doing to shorten the sales cycle?
  • What are we doing to minimize customer attrition?

The reports are valuable in explaining how you are doing and point out potential areas of improvement, but you need to determine what to do about the issues.

Benefits to Better Financial Reporting:

  • Helps you set a realistic plan to follow
  • Helps you to know your numbers
  • Understand your business
  • Better able to justify investment
  • Help you achieve succeed
  • Understand where your issues are
  • Helps with accountability (for both you and your team)

Financial reporting discipline is required in companies of ALL size. The best way to improve success and get investor traction is to set realistic but stretch financial goals, manage to those goals, track your progress and then achieve them.  The only way to do this is to know and use the proper discipline and the proper detail in financial reporting.