The punchline is that money needs to survive three tests when you’re an entrepreneur.
I raise this after troubling conversations this past month which left me thinking that most first-time founders don’t know how to think about money.
While the reasons vary, I think the core of this issue lies in how people have received and valued money in their lives before taking on investment.
People Invest For Different Reasons
It’s important to understand why people invest in ventures. There are three macro-level reasons.
Friends and family invest as a means of encouragement. They don’t often expect a return on their capital.
There are professional investors who make risk-adjusted commitments. They expect growth and a return.
And then there are those who invest because they like the problem and believe you’re the right person to solve it.
However, as soon as the money hits the account, regardless of investor motive, the companies commitment to its investors becomes real.
Four Post Financing Thoughts
Founders tend to have four thoughts in quick succession as soon as they close a financing round.
1. I’ve never seen that much money in an account before
Celebrate it because it was likely hard won.
2. Time to get started and I hope this capital is enough
It probably won’t be. More often than not the amount raised is less than ideal. This means that compromises have been made against original estimates and now the real work begins to make each dollar stretch three times as far.
3. I’m going to keep my investors informed, I owe that to them
I want to point out that this is the wrong way to think about investors.
‘Keeping investors informed’ suggests the development of a monologue between entrepreneur and investor. In doing so, entrepreneurs cut themselves off from the non-cash value that investors bring to the table.
Notwithstanding their motive, investors engage to increase the likelihood of your venture succeeding. They expect to be informed but the best investors also want to contribute experience and expertise to help solve problems and remove roadblocks.
They can end up being a secret weapon and that’s why maintaining a dialogue with investors is vital.
4. I guess I can’t do what I like anymore
This can be a jarring realisation. The capital was committed to deliver on the plan and team subscribed to by investors. And some founders can think this means they have to strictly adhere to their plan.
The reality is that (most) investors are firm on the mission but flexible on how to achieve it. That’s why they back the entrepreneur. They expect them to have a better ‘on the ground’ perspective and an experimentation-led approach to learning as quickly as possible to drive growth and momentum.
Does this mean you can’t take gambles with product and marketing initiatives?
No, but it means you’ll need to make sure it tracks towards the mission and that the decision can be explained.
Three Money Management Tests
Investors expect their portfolio companies to carefully manage capital. This is easier said than done for entrepreneurs with limited financial management experience. And it’s for this reasons that entrepreneurs need to survive three important tests.
The Daylight Test
The first is the daylight test. This is the ‘is it appropriate to spend this money on this item’ test. When expenses see ‘daylight’ they are often being interrogated by co-founders, accountants and investors.
This can be straightforward or be confronting. And it’s often the latter because how much to spend on any item is surprisingly subjective and based on experience.
This is compounded by the unspoken expectation when founders and first hires come together that there is some intuitive, pre-existing benchmark for spending.
It’s a mistake to assume a benchmark is understood or even exists.
Serial entrepreneurs understand frugality. They have developed a habit for processing the financial trade-offs that come with battling ever shortening runways. For them, every dollar counts.
Those who join or form their first startup from a corporate or government career have different experiences and context.
The money they spend is often regulated through their procurement department. These people source the best deals with preferred suppliers that are appropriate for the business. Although this helps staff get on with their day job, these procured standards create expectations about the ‘reasonableness’ of expenses. And in some cases, it even desensitises people to the actual cost of goods because the expense isn’t hitting their pocket.
This might be ok for that business but there’s a good chance it won’t work in a startup.
Hotel accommodation seems to be the best item to help level set teams about expenses.
I’m not sure why, but setting the upper limit for accommodation (say $150 per room per night) seems to quickly align teams on the general standards for spending company cash. But it shouldn’t stop there.
While teams should develop habits for acting (and spending) like an owner, they shouldn’t be left to work it out on their own. Take the time to set expectations on can be reasonably spent and what thresholds trigger a conversation with managers or founders.
The Trade-off Test
The second is the tradeoff test. This is the more straightforward of the three tests and I use (and have for some time) engineering hours as my tradeoff value.
In other words, I think about the opportunity cost in terms of how many engineering hours I will forfeit if I invest in something else.
It is not a perfect measure and it does reinforce my belief that the ability to scale is reliant on robust products. The point is that engineering hours provides me with a useful yardstick to help me determine trade-offs.
The Core Metric Growth Test
Every venture has a core growth metric which is the linchpin for its business model. It’s not a suite of measures or a vanity metric like the number of users (or any other chart that easily climbs upwards from left to right over time).
The metric is often revenue growth.
And this test focuses on whether or not spend by the venture is focused on increasing the core metric.
A ‘fail’ for this test occurs when direct or indirect paths to revenue growth are not clear to investors.
One last thing …
I remember seeing the balance of the company bank account after the seed round closed at our previous company. It had been an arduous effort and while we were exhausted we still marvelled at the balance.
After that we made sure our capital survived all three tests and today, we do the same at inkl.
If your venture has just raised money and never talked about how to spend it, have that conversation and go one step further, ask each team member to come up with their own trade-off test.
Finally, provide each team member with permission to ask ‘how will this increase our [insert core growth metric]?’ when the team is exploring a new initiative or assessing an existing one.
It will save a lot of time and potential angst in the future.