Understanding Basic Finance

The fundamentals of finance are this simple – we record every income item (what we sold) on one side and then record every cost on the other side. We subtract the income from the costs – and voila! – profit (or a loss. In the early days it’s usually a loss.)

There’s no special black magic to recording income and expenses.

We’ve probably seen complicated spreadsheets or financial software that looks harder than figuring out the cockpit to a 747. At some level that amount of complexity is important. When we’re just launching a startup, we want the complexity of a go-cart. Gas pedal = revenue. Brake pedal = costs. Easy.

The spreadsheet we’re going to use (it’s called an “Income Statement”) is nothing more than a place to capture all the income items on one side and the expense items on another. The spreadsheet will automatically tally all the values and tell us whether we made any cashola.

The first year of finances at a startup company is very different than any other year, so that’s why we spend a lot of time on the nuances. If we’re in our second or third year, this course will still apply because it’s really just explaining how good finance works.

If we had a finance gig at an existing company there are so many aspects to startup finance that don’t apply. At an existing company, we already know how things work. We know how much people make, how much our customers pay, what products they buy, and how our finances worked last year.

In Year 1 of a startup – we don’t know jack.

As an example of this, let’s compare how a startup business and a mature business look at forecasting.

Startup vs. Mature Business Forecasting

We have no idea if our customers will buy the product we just invented, what they’ll pay, how much it will cost to acquire them, what people we will ultimately hire, how long (if ever) we’ll earn back the money we invested, and more. It’s all questions and no answers.

Therefore, we need a model that is less about “tracking our financial transactions” and more about “how to make some wild-ass guesses about how things might go and then quickly changing everything when we find out how wrong we were.”

What’s important to understand is that startup finance is a combination of “forecasting” the future (which is very uncertain) and “accounting” for the present (what just actually happened). There is a constant back and forth between making a guess about the future and tallying up the results.

The reason there is just so much damn forecasting involved is that it takes years before all of the variables of a startup are proven out. As we discussed a moment ago when comparing a startup to a traditional business, we can’t operate with the luxury of knowing what values to use in our forecasts. We have to constantly make guesses, test our assumptions, then refine the numbers as quickly as possible to adjust our financial forecast.

At a big company, forecasting is often done on an annual basis. While those are still guesses as well, they are at least based on a lot of history and previously-proven assumptions. A big company may not know how many units of the product they will sell, but they know how much customers will pay, what the product will cost, and how many people they need to employ to run the company. We don’t know any of that.

Therefore, startup finance is heavily weighted toward tons of forecasting and tons of revision. There’s no version where we just make a single forecast for the year and let it play out. We’re going to be revising our forecasts daily which means our Income Statement (more on that later) will become our operational Bible!

There’s often a misconception that finance is the last step that happens in a startup company. The thinking often goes that marketing, sales, product, and other aspects of the business do their thing, then the bean counters in accounting show up to tell them if they made any money.

This is what we call playing “Startup Finance Defense” and it’s a lousy way to operate.

If startup finance isn’t deeply integrated into every aspect of the company, we’re essentially leaving all of the key stakeholders who contribute to the finances completely in the dark! For example, the marketing team needs to know “what is the most we can possibly spend to acquire a customer?” while the engineering team needs to know “what’s the most we can possibly spend to hire the best engineer?”

Where this breaks is when the marketing and engineering leads have no idea how their decisions impact each other. We picture this old curmudgeon finance person just saying “NO! You can’t have the money!” without really explaining how the decisions will impact other facets of the business. The startup finance person knows that one decision will take resources away from the other – but doesn’t explain that to anyone else.

This is what defense looks like. Finance is just this bizarre black box where no one really understands why things are working or why they can’t happen. For what it’s worth – this is how most companies operate – and as mentioned, it’s crappy.

Conversely, playing “Startup Finance Offense” is about letting everyone understand how their contribution to the business directly impacts everyone else’s decisions and capabilities.

What we’re going to focus on in this course is all offense. We’re going to talk about our Income Statement and forecasts as something everyone in the organization can understand very simply. For the time being, that might just be ourselves alone! That’s OK. If we understand the finances well, that means we can teach others to understand the key metrics as well.

On a personal note, as both the CEO and CFO of Startups.com, having intimate knowledge of both the operational side of the business as well as the financial side gives me unprecedented ability to make complex decisions across the organization very quickly. I know how a decision that I make with the marketing team will directly impact the efforts of the engineering team down to the dollar. Even if we don’t decide to pursue a career in finance (I was a theatre major, so...) learning the basics of finance will have a massive impact on our ability to lead a startup.

While we may not know all there is to know about our business yet, there’s still going to be some good old fashioned accounting to do. So let’s break out those green visors and adding machines – it’s time to learn WTF accounting is!

At its core, in order to be an accountant we need to be able to collect all the sources of income and expenses and translate those into a spreadsheet. When the numbers are small, this is so easy to do we’ll wonder why people get paid to do it. When they get large, we’ll wonder why anyone is willing to do this for any amount of money ever!

Here’s an example of how startup accounting would work:

That’s it. That’s literally how startup accounting works. If we can put numbers into a field in a spreadsheet (especially one set up to do some math for us – like what we provide) then holy cow– we’re now a startup accountant!

Does startup finance get more complicated later? Yes. A bunch of complicated accounting may eventually come upon us – probably a year or two from now. We’ll start dealing with far more complicated versions of taxes, health insurance, receivables, and cash flow. For now, we don’t have to worry about any of that so we’re going to start with an accounting system that’s very easy to understand and manage.

Finance is a big topic, so it’s safe to say we can’t cover every possible facet of it. That said, there are a few areas of finance that we may require a bit more support. Let’s talk about what they are and where to seek out good guidance.

• Payroll. There’s very little upside in trying to figure out payroll on our own. Instead, for less than $50 per month, we can outsource all the complexity to an online provider like Gusto.com (that’s who we use). Dealing with withholding taxes, employer payroll taxes, creating W2s and other issues is a huge waste of time. Whether we’re paying 1099 or W2, absolutely outsource this.
• Taxes. A startup tends to have very simple taxes. So long as we’re doing a good job of tracking all of our income and expenses, handing our Income Statement over to a qualified accountant should make handling our taxes easy. The cost of a tax accountant goes up exponentially when clients show up and say “I have no idea what my income and expenses were – please figure that out.” If we show up with a pretty clean income statement, our cost goes way down.
• CPA Review. No matter how good we feel about learning finance, there’s almost always this voice in the back of our minds that is saying “Oh man I probably messed something up!” That’s OK. If we do most of the heavy lifting on our own, such as collecting all of our revenue and expense items and then doing our best to categorize them, that’s most of what would cost us a fortune with an outside CPA. If we want, we can have a CPA review what we have done – likely on a quarterly or annual basis – to simply do a spot check on our work and make sure we didn’t miss anything. In some cases, this may sync with the same person who does our taxes. So don’t worry about getting an extra pair of eyes on this!

What’s nice about what we’re about to go through is that once we understand the basics of startup finance, our reliance on 3^rd parties drops drastically. The reason for this is that like anything else in life, once someone demystifies the work for us (like we’re hoping to do here), none of it really seems that complicated.

And just like that, we now have a crash course understanding of the basics of startup finance!

So what have we learned?

Well, we learned that we basically don’t know squat and that that’s a perfectly normal situation to be in as Founder of an early-stage startup.

If we’re plunging headfirst into Year 1, it’s entirely reasonable going into this not knowing things like how much our customers will pay for our product, how much we need to spend to acquire them, or what our net margins are. How could we?

What we do know, is that early startup finance is all about building wild guesses around these amorphous costs and values, using those assumptions to forecast for the future, and constantly iterating until we get close to something right.

If that sounds tremendously vague and scary, never fear. Here’s the thing: everyone who’s ever put an ounce of effort into startup finance begins here. But unlike everyone else who’s had to go it alone, we’re going to walk through the process every step of the way.

With that, let’s get to guessing!