Friday, August 19, 2011

Lesson #78: How to Build a Budget


Building an accurate budget is one of the hardest things to do for a startup, as you have very limited historical information to forecast with.  But, following the below road map should help you create a budget that should get you pretty close.

Sales/marketing drives revenues.  For me, the entire budgeting process starts with sales and marketing expenses, since those areas will be the key drivers of revenues for your startup.  So, please re-read Lesson #21 on How to Set a Sales & Marketing Plan for Your Startup.  As a recap, your business will either be sales driven (like most B2B companies), and you will need a certain number of sales people calling on new clients to drive revenues.  Or, your business will be marketing driven (like most B2C companies), and you need to think through what media buys or viral marketing initiatives will be most optimal for your business.

For sales driven businesses, assume each salesperson can close a certain percentage of the calls they make.  My rule of thumb is: it typically takes 100 calls, to close 5 transactions.  And, a good salesperson can be making 100 calls a month (about 5 each business day).   So, you would multiply these 5 transactions times the average selling price of your product or service, to forecast revenues each month.  But, you need to build in a monthly ramp-up period before your sales person is fully productive (e.g., 3 months for lower priced products, up to 2 years for million dollar products).

For marketing driven business, you need to identify what your target demographic is and identify channels where your prospective customers may be looking.  And, remember, viral marketing through social media (please re-read Lesson #52), is going to be the cheapest cost of marketing, followed by other online marketing activities (like search marketing in Lesson #53, email marketing in Lesson #77 and mobile marketing in Lesson #68).  Offline marketing activities like direct mail, print buys, television and radio are typically better vehicles for more established companies with larger budgets, that can afford the branding advantages of vehicles like these

Once you decide what budgets/vehicles you want to market with, you add up the total costs of such marketing activities, and then determine what your cost of customer acquisition will end up being.  Your cost of acquisition can vary significantly based on your price points, products, demographics, etc.  So, before building your final budget, make sure you have tested a couple of your primary marketing initiatives, to determine how much spend it will take to drive one customer.  Then, run that cost of acquisition through your going forward revenue forecast.  So, as an example, if you spend $100,000 at a $100 cost of acquisition, that would drive 1,000 transactions, which you would then multiply times your average transaction price point to forecast your revenues.

Expenses.  Expenses are a lot easier to forecast than revenues, since they are largely in your control.  You decide how many people you need to hire, what technology you need to buy, what back office expenses you will have, etc.  So, provided you don't spend more than you have budgeted, your actual expenses should come pretty close to your budget.  In addition to the sales and marketing expenses discussed above, the key expense categories you should include are: (i) payroll (including payroll taxes and employee benefits); (ii) technology (e.g., development, design, support, administration, connectivity, hosting); (iii) home office (e.g., rent, utilities, phone, cleaning, supplies); (iv) insurance (e.g., general liability, E&O, D&O); (v) professional services (e.g., lawyers, accountants, recruiters); and (vi) other admistrative expensives (e.g., travel, entertainment, meals).

Payroll is typically the hardest to forecast, as you do your best to match your budgets with the requirements of the best candidates for the job.  And, you need to make some smart assumptions on how much salary will actually be required to find good talent for each position.  So, ask around to determine market rates by role for your market, prior to building your budget.

Capital expenditures.  Capital expenditures for most startups typically revolve around technology (e.g, servers, software) and assets needed for your home office (e.g., furniture, equipment).  So, budget accordingly based on your tech build out needs and the forecasted number of employees in your office.  Depreciation expenses over a 3 to 10 year life, depending on the nature of the asset, will then run through your income statement from there.

Interest.  If you have any debt, you need to pay interest expense.  And, if you have a big cash balance, you will earn interest income.  Make sure you pick these up in your forecast, as well.

Taxes.  If you are running a profitable company, you will also have to budget for annual corporate income taxes at the levels appropriate for your city and state.  Understanding, you may have net operating loss carryforwards from prior years' losses, to offset your early profits.

Validate with historical/industry numbers.  Where you can, validate all assumptions made with historical data you have from past experience from your business, and then increase such levels for around 3% annual inflation.  If there is no historical data from within your business, reach out to similar sized businesses in your industry, or other mentors/advisors, to learn what they are paying for key things.  So, at least you will have a relevant industry benchmark to reference to help validate your assumptions.

Sanity check.  At the end of the day, does your forecast pass the "sniff test".  If you are only spending $500K in marketing, is it reasonable to build a $100MM revenue business?  Probably not.  If your industry is only $100MM in size, and you are building a $50MM business, is it reasonable to acheive 50% market share in your first year (or ever, for that matter)?  Probably not.  So, just make sure your forecast is credible in light of your sales/marketing budget and industry size.

Build a cushion.  Startups should always build a cushion into their forecast, as things are most definitely not going to go 100% as planned.  Please re-read Lesson #28 on Expecting the Unexpected.

Once you have taken into account all of the above, you should be in a very good position to finish your budget and forecast the cash needs of your business.  So, make sure you raise enough capital to cover at least 12-18 months of your going forward operations.  Otherwise, you will constantly be in fund-raising mode, and not focused on building out your business.

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