Every startup founder needs a basic understanding of startup financials to be successful.
Like a car, your startup won’t go without gas in the tank.
The destination is far. If you don’t use a map, watch your gauges, refuel, and change the oil, you’ll break down.
Nine out of ten startups fail, and 82% of those failures are from cash flow mismanagement.
So it’s time to take the initiative and do the math because you can’t afford to wing it, especially with a recession ahead.
You might already have investors and staff depending on you. Or maybe you’re still on your own with personal savings and/or debt on the line. Either way, you owe it to someone to do your due diligence when it comes to managing your startup’s finances.
Use this comprehensive guide to take control. We’ll help you brush up on startup finance fundamentals, bookmark key metrics, anticipate challenges, follow best practices, and prepare for harsh economic conditions.
Startup Finance Fundamentals
Startup finance is a far cry from finance at an established business.
Most startups take three seed rounds and almost two years to establish a product, user base, consistent KPIs, and revenue.
However, even in the early stages, having a firm grasp on startup finance fundamentals is vital. Key startup accounting records like income statements (income and expenses) and financial projections can be essential in securing funding that might ultimately make or break your startup. Here are a few of the fundamentals.
Basic Startup Accounting
Getting started is simple. Regardless what phase your startup is in, you need a basic income statement that allows you to manage revenue, operating expenses, and net income. Simply track revenue and costs in a spreadsheet, and subtract expenses from income to get net income.
As part of the accounting process, you must meticulously account for every cost. This should include easy to overlook costs like shipping, taxes, insurance, payment processing fees, and utilities.
Later, use the net income figure to create a cash flow statement. Your cash flow statement will yield a cash balance to feed into a balance sheet tracking finances and retained earnings over time. Ultimately this will enable you to create a solid financial model and forecasts.
Looking Ahead
Financial projections are vital to the fundraising process because they’re essential to prove yourself to potential investors. You’ll need to demonstrate possible, solid ROI with stats when the time comes.
Here are a few positive signs investors like to see in financial projections:
- Prepare to break even by year two or three.
- The stats should support 50%+ margins and revenue expectations of $20 million to $100 million by year five.
- Revenues at a minimum doubling each year demonstrate viability and confidence.
- Predict a likely growth rate given the necessary business operations. In other words, don’t expect to make $100 million in sales in the first year.
- Aim for 10%-50% penetration of your target market segment over five years.
- Request investments in segments alongside milestones.
- In your investor fund usage plan, prioritize business scaling requirements like marketing, inventory building, and staffing in detail.
- Lay out an exit strategy (IPO or acquisition) with a valuation five times your projected revenue.
- Have a simple financial model anticipating market shifts, slowing growth, and cost increases.
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Key Financial Metrics for Startups
So, how do you get from the most basic income statement to a concrete financial model with detailed and logical projections?
Track and interpret key metrics:
Revenue: How much money a startup makes
The starting point of your income statement, revenue, is the sum you generate through sales. Revenue doesn’t say much about financial health, but it’s vital to other equations.
Expenses: How much money a startup spends
Expenses are the costs you deduct from total revenue in an income statement to see whether you’re profitable.
Net Income: The ‘bottom line’ on a startup’s income statement
Net income = Revenue – Expenses
Subtract expenses from your revenue to determine net profit in an income statement. Expenses include operating expenses, cost of goods sold, depreciation, interest, taxes, and allowable deductions. Then, plug net profit into your cash flow statement to track cash movement and find the cash balance.
To increase net income, a.k.a., the bottom line, watch your:
- Customer acquisition cost
- Churn rate
- Customer retention
- Cash flow
- Customer lifetime value
- ROI
- Burn rate
Net Profit: Profitability over a specific period
Net profit = Total revenue – Total expenses
This is similar to net income, but net profit computes profitability and tax liability. It’s total revenue minus total expenses calculated in stages to establish profitability for each expense type.
Gross Margin: Preliminary measure of profitability before overhead
Gross margin = 100 x ([Revenue – Cost of goods and services] / Revenue)
This is an early indicator of profitability. Deduct all overhead and operating expenses to get your operating margin, a.k.a. EBIT (earnings before interest and taxes).
An investor usually looks for a 70% to 90% gross margin for a SaaS business.
There’s sometimes room to bet, and founders have successfully used negative gross margins to test product functionality, pricing, and the possibility of reinventing a whole market. But this gamble only works for those who know what they’re doing and raise enough money.
Amazon, Uber, Lyft, and Postmates started with negative gross margins, but they pulled it off with massive market disruption.
Burn Rate: How quickly a startup spends cash reserves
How fast does your startup spend capital to fuel operations? Burn rate gives startups a timeline for how long cash reserves will last. There’s gross burn rate, total spending, and net burn rate.
Net burn rate = (Beginning cash balance – Ending cash balance) / Measurement period such as months
Runway: How long a startup has before it runs out of cash
Runway = Cash in hand / Projected burn rate
That timeline for how long the cash reserves will last at the current burn rate is called the runway. It’s how long your startup has before it has to ‘take off’ with profits.
Take the amount of cash remaining and divide it by the projected burn rate. For example, if your burn rate is $10,000/month, and you have $100,000 COH to spend, you have a 10-month cash runway.
Customer Lifetime Value: Cumulative revenue a customer generates
LTV = (Average purchase value x Purchase frequency) x Average period of customer retention in months or years
Customer lifetime value (LTV) is how much revenue you expect a customer to generate cumulatively. This number can help you decide how much money is worth investing to win each new customer.
Customer Acquisition Cost: Money spent on converting a new customer
Customer acquisition cost (CAC) is the sum of all sales, marketing, and distribution expenditures to get a new customer. It tends to be high initially, decreasing as you narrow down ideal customers and marketing channels and earn referrals.
Churn Rate: Percentage of customers you lose
Churn rate = (Customers at the beginning of period – Customers at the end of period) – Customers at the beginning of the period
Customer churn is the percentage of paying customers you lose in a window of time, contributing to revenue churn. Ideally, you want to keep customer and revenue churn as low as possible. To ensure financial health, investigate any high or persistent customer churn, and try to correct it.
Customer Retention: Percentage of customers staying
Customer retention = (Customers at the beginning of period – New customers gained over the period) / Customers at the beginning of period)
The inverse of customer churn rate, customer retention measures how many customers you keep over a given time. This metric can help quantify customer satisfaction.
Return On Investment
ROI = Investment net profit / Investment cost orROI = (Value – Project cost) / Project cost
These formulas reveals the degree of an investment’s success. It’s also an excellent way to test the accuracy of your projections for a specific project or initiative.
Five Common Financial Challenges For Startups
Even when startup founders have a thorough grasp of finance fundamentals, there are a number of challenges that can impact a startup’s financial performance. So let’s discuss the most common startup finance pitfalls and what to do about them:
Limited access to funding and capital
Overwhelmingly, startups fail because they run out of money.
This can be devastating since 77% of small business owners and startups depend on personal assets like savings, home equity, and loans for funding.
VC firms can get over 1,000 proposals a year. Startups must cut through the noise and make an impression that warrants a $250,000+ investment.
So, in addition to managing finances to appeal to angel investors and venture capitalists down the line, weigh all your funding options from the beginning:
- Bootstrapping- side gigs, pooling with co-founders
- Loans
- Pitch competitions
- Startup incubators- government and private
- Grants- SBIR, 4pt0, etc.
- P2P lending
- Crowdfunding
- Corporate seed funds in return for equity or future partnership
- Accelerators- guidance and financing in return for fees or equity
Insufficient data/records
Potential investors need accurate, hard data from financial statements to assess risk and pricing. Produce monthly financials and show a history of recurring revenue so they can make their projections.
Excel and Google Sheets may suffice at the start. But look into industry-standard accounting software like QuickBooks to organize data and streamline transaction verification/reconciliation.
High costs and risks of product development and market entry
When estimating the time and cost of getting something done in a startup, experts say you should usually double whatever figure you come up with.
That’s why founders usually look for ways to cut costs. This includes paying themselves a fraction of the standard market salary and outsourcing work to firms and contractors to conserve funds and stay flexible.
Additionally, don’t compartmentalize financing and product development too much. Stay involved in the finances and the product itself to know when a calculated risk or expense is worth it.
Intense competition and uncertainty in the market
One of the biggest fatal startup mistakes is blundering product-market fit. In perpetually competitive and evolving markets, take these steps as early as possible:
Research the market and direct competition exhaustively.
Fully validate the target market needs what you have.
Rapid growth and changing business needs
You can’t be too eager to spend money, but don’t be too scared to spend, either. Staying on top of financials puts you one step ahead of worst-case and best-case scenarios.
Have the financial knowledge and resources, so you don’t miss the wave. Say you’re onto something, and your target market responds enthusiastically to the product. Be ready to hire the right amount of the right sales staff on time to sustain trending sales growth.
Six Best Practices For Managing Startup Financials
Let’s summarize startup finance best practices to follow going forward:
Develop a comprehensive financial plan and budget for your startup
Using the cash flow statement, profit and loss (P&L), and balance sheet, your financial plan charts the path for revenue, goals, predictions, strategy, hiring, and more. It details:
- Fixed/variable expenses
- Revenue
- Gross/operating margins
- Profit potential/durability
- Break-even point
- Cash balance
- Cash flow changes
The ideal software can help you develop a financial plan by linking financial statements to formulas generating performance forecasts.
Track financial performance and metrics regularly
Make the metrics readily accessible for weekly or daily review. Diligent tracking helps you identify, leverage, and update KPIs to harness opportunities and mitigate problems.
Be flexible and adaptable to changing business conditions
Make an educated guess and try something. Watch the data to see if it works, and take the outcomes in stride.
Here’s the philosophy of Eric Ries’s The Lean Startup. In a startup, you know nothing, and your only tool is trial-and-error. Experiment cheaply to adapt as much as you need to without diminishing funds too fast.
Communicate openly and transparently with investors, employees, and stakeholders
In the era of Theranos and FTX, always be transparent. Instead of fearing accountability, welcome it. Trust and visibility bring investors, employees, and customers; and startup accounting prowess brings results.
Connect with other startup founders to learn and build relationships
Immerse yourself in a community of startup founders who understand all the struggles, questions, and answers. Build relationships with people who offer fresh perspectives and share success through mentorship, resources, referrals, leverage, and opportunities.
How the Looming Recession May Impact the Startup Scene
It’s hard to know what to expect with an oncoming recession, like which industries it will affect and how. For now, here are some recession predictions and survival tips:
- Funding decrease: Scale back non-essential expenses, communicate with investors, and secure as much cash as possible to extend your runway.
- Consumer spending slowdown: Anticipate current and prospective customers trimming the fat. Take the chance to focus on your best customers with a personal approach. If you’re not already, get used to spending time selling directly.
- Intensifying job competition: Your workforce might worry about security. Do what it takes to hold on to top talent.
Although a recession causes many problems, problems are opportunities to innovate.
FAQs About Startup Financials
Why do startups have a hard time forecasting financial results?
Financial forecasts use existing data, and startups have minimal data to pull from.
How to maximize cash flow for your startup?
To maximize cash flow, incentivize early payment, optimize inventory, use electronic payment, negotiate with suppliers, and have high-yield savings accounts.
How much equity should a CFO get in a startup?
An early-stage CFO may get 1-5% equity vested over time.
What is the most important financial statement for startups?
Income statements are the most important startup financial statements.
How to present financials in a startup with no revenue?
If you can’t show revenue in your pitch deck’s financials slide, expect questions and criticism, and at least present customer acquisition costs, profit margins, growth rates, and ROI potential.
What do most startup founders get wrong about financial projections?
Too many startup founders cherry-pick what they want to happen in the next 12-18 months. Instead, observe what the data of the last four months predicts.
How often do you work on your startup’s financial model?
Work on your startup’s financial model as often as necessary. If things don’t play out the way you modeled, react to the information immediately and pivot your model.
What are your startup financial goals?
Are you ready to approach angel investors and VCs yet? Is your startup still in its infancy? Either way, these fundamentals, metrics, solutions, and best practices are just as relevant for your startup’s future.
Whether in year one or approaching profitability in year five or six, take action now to solidify your startup financials for the long road ahead.
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