Financial Planning and Analysis for Startups

Financial planning and analysis, also known as FP&A, combines financial analysis, planning, and reporting to support decision-making and drive financial success. It provides organizations with the necessary financial insights to optimize resource allocation, manage risks, and achieve their strategic objectives.

Although FP&A is the responsibility of the finance team at larger organizations and often relies on sophisticated financial models and techniques, basic financial planning and analysis skills are also very important for smaller startups and their founders. After all, according to CNBC, a majority of startups die due to a lack of financing and cash shortfalls. 

In fact, effectively managing a startup’s cash burn and planning for its future financial needs can be considered an FP&A exercise, albeit a very different looking process than what you would see at a mature corporation.

Below, we will take a closer look at FP&A as it relates to cash management and why it is so important for startups.

Budgeting and Forecasting

According to CNBC, in 2022 47% of startup failures were due to lack of financing and, closely related, another 44% to running out of cash. Clearly, a central focus of startups should be financing and cash management. Because financing needs will largely depend on cash management, this article will emphasize the importance of FP&A as it relates to startup cash management.

Effectively managing cash needs often rely on several skills and assumptions, including:

• Proper financial data collection, including bookkeeping and accounting records
• Alternative data synthesis and collection, including funnel, customer, and usage data
• Revenue forecasting and planning
• Expense forecasting and planning, including headcount modeling, product road mapping, and system development plans
• Assumptions related to working capital management (e.g., inventory, receivables, payables)
• Effective capital allocation strategy
• Budgeting and accountability frameworks
• Risk assessment and scenario planning
• Financing arrangements
• Properly calculating and interpreting key financial metrics and unit economics
• Use of various analytical tools, especially Microsoft Excel, accounting software, and other forecasting and visualization platforms
• Effective communication with stakeholders, including the team, investors, bankers, and, in some instances, certain customers

Financial Data

FP&A heavily relies on the interpretation of financial data. At the most basic level, FP&A reviews historical financial data (e.g., revenue, expenses) for insights and extrapolates it forward for an understanding of the future. Consequently, without good data to use as inputs for planning and analysis, results will be subpar.

As a startup matures, this means that it is important to have transactions properly accounted for. The profit and loss is the financial statement that founders will be most comfortable with. However, the profit and loss alone will not be sufficient for FP&A purposes as the business grows.

And although cash accounting may be used early in a startup’s life, GAAP accounting will become necessary as the startup progresses through the early revenue stage. You can read more about forming the finance function here.

Alternative Data

Non-accounting data can also be very valuable while trying to develop a comprehensive financial plan. This is especially useful for revenue forecasting. For instance, a bottom-up revenue forecast for a SaaS business often relies on segmented new user trends and accompanying unit economics (e.g., conversion rates, retention rates, ARPU).

Various user and product data and processing tools can be used to capture and digest these alternative data types. Because this data will likely also guide product development and growth efforts, the collection of this data is often a distinct responsibility that sits outside of the finance function. For maturing data-rich businesses, there may be an analytics and business intelligence department, whereas smaller startups may make this the responsibility of the product team, marketing/growth team, technology team, or some combination of each.

Revenue Forecasting and Planning

For all companies, especially growing startups, revenue (and billing) forecasting is central to cash management. Startups will likely forecast revenue using one of three approaches: a bottom-up analysis, top-down analysis, or some combination of the two (a hybrid approach). 

As previously mentioned, a bottom-up approach begins with a high level of granularity and is internally focused. To estimate revenue growth, it is common to begin at the top of the growth funnel and make assumptions about new user impressions/engagement, conversions, and resulting new paying customers. Using unit economics such as average revenue per customer, retention or repurchase rates, per user virality, and more, revenue from existing and new users can be forecasted. 

Other popular bottom-up revenue forecasting methods may estimate the growth in the number of salespeople (and each salesperson’s sales success) or stores (and each new store’s contribution to new revenue) to imply changes in revenue. 

A top-down approach is a less granular, external forecasting framework that relies on a review of market tailwinds and headwinds, growth rates, and industry changes to estimate a business’s future revenue, many times as a factor of the industry’s trending growth rate.

A version of the top-down approach is often used in startup pitch decks, where the startup optimistically defines the startup’s total addressable market (TAM), serviceable addressable market (SAM), and then the serviceable obtainable market (SOM). Growth is then figured as increasing percentages of the total SOM.

The best approach is often a blend of a bottom-up and top-down approach. This helps one approach check the other and can prevent unrealistic forecasts from developing. Whereas early-stage startups will likely use spreadsheets to forecast revenue, more sophisticated businesses often build complex data models—commonly with the help of expensive software packages—to process huge amounts of diverse data to project revenue.

Expense Forecasting and Planning

For obvious reasons, effective cash management also requires a dependable expense forecast. However, many founders do not spend enough time thinking about expenses and, thus, poorly understand their startup’s true cash runway. The lack of emphasis on expenses and cash outlays is due to several factors, including:

• Revenue forecasting is inherently more exciting than expense forecasting.
• Investors reward growth – This is not as true in times of economic uncertainty, but many founders have been trained to believe that if a startup is growing fast enough, the expenses do not matter.
• Because over a longer period expenses often scale up and down in response to revenue changes, effective cash management can be more dependent on the achievement of revenue goals than expense goals.

For most digital businesses, team, web tool/system, and marketing costs are the three largest expense categories. In such cases, these costs are often forecasted in integration with the revenue forecast. It is important to realize that revenue can be a function of product development and marketing, while other team (e.g., customer service) and system costs (e.g., servers) may be a function of active users/revenue. 

While the relationship between expenses and revenue can be extremely circular for quickly growing digital businesses, other businesses (e.g., manufacturing or services) may have a greater portion of expenses that are variably bound to revenue assumptions (e.g., cost of goods or services provided). This can make the decision of how to forecast expenses for these types of businesses simpler.

Working Capital Assumptions

If following GAAP accounting, projecting out the profit and loss of a business will not be directly tied to the cash forecast. This is because GAAP is based on accrual accounting, meaning revenue and expenses are recognized when they are earned and incurred, not necessarily when the cash comes in or goes out of the bank account.

These mismatches between cash flows and revenue and expenses result in something called working capital. Most simply, working capital is the difference between current operating assets and current operating liabilities. To forecast cash flows, changes in net working capital need to be forecasted. An increase in net working capital results in a cash outflow and a decrease results in a cash inflow.

We will explain how working capital works with an example. Typically, one major component of working capital is deferred revenue, a current liability. Deferred revenue increases when a business collects cash payment for a product or service that has not been fully delivered to a customer, thus, it becomes a temporary obligation (liability) on the business’s balance sheet. Once the obligation is fulfilled, this revenue will be recognized on the profit and loss statement, even though cash was already collected.

So, for a quickly growing subscription business with annual or multi-year billing frequencies, the revenue forecast will be understated in the coming months when compared to the cash forecast. The upfront cash payment from these customers is essentially a form of financing that can be used by the startup to fund its operations, even before it entirely provides its service. This is part of the beauty of multi-period upfront billing.

For very young startups and smaller businesses, the profit and loss statement is recorded on a cash basis, meaning that working capital is not a concern for cash forecasting. Furthermore, many early-stage businesses, even those following GAAP, will neglect to create a GAAP forecast, but will instead develop a cash forecast that relies on cash inflows (incorrectly thought of as “revenues”) and cash outflows (incorrectly thought of as “expenses”). 

This approach can work for a while but can cause various problems and confusion as a business grows and gains sophistication. Working capital is a particularly important consideration for businesses selling tangible goods, as significant inventory investment is required to support growth.

Capital Allocation Strategy

Capital allocation is the process of deploying capital within the business to certain opportunities and business activities. This requires a deep understanding of the organization’s financial position, growth opportunities, risk appetite, and long-term objectives. It involves balancing short-term financial needs with long-term growth strategies and involves collaboration between decision-makers within the organization.

For startups, capital is usually the most constrained resource. Consequently, running a startup can somewhat accurately be thought of as a vehicle to effectively allocate capital (as is true of other profit-seeking businesses).

As it relates to cash management, growing businesses often make large capital investments in their futures, whether that be in new manufacturing equipment, product development, or something else. Outside of depreciation, the cash outflows resulting from these investments may not be obvious on the profit and loss statement and must be carefully considered and planned for.

In the earliest stages, it will be the role of the founder(s) to form a roadmap of major capital expenditures while understanding what these investments will cost and when they will be necessary relative to other key milestones, such as revenue marks and funding events. Misjudging the timing or magnitude of key investments is frequently the final blow for an already-cash-strapped startup.

As a business grows, capital allocation strategies take a new form, relying on additional cross-functional collaboration as well as more formal financial methodologies to analyze and compare investment opportunities and their returns.

Budgeting and Accountability

Cash management and forecasting are meaningless if there is no mechanism to keep operating team members accountable to revenue goals and spending limits. That’s the purpose of budgeting.

A budget is very similar to a forecast, except it differs in that it:

• Master budgets are typically created and approved quarterly, semi-annually, or annually, while forecasts tend to be rolling and dynamic from month-to-month.
• A budget is used primarily internally as a tool to control spending and evaluate performance against targets (and the achievement of the short-term capital allocation strategy), whereas a forecast is used by a broader set of stakeholders to understand the business’s financial outlook. For accountability purposes, the budget is compared against actual results in a process called variance analysis.
• Detailed budgets often extend just a year, while forecasts may show longer periods to provide a better planning tool to strategic decision-makers who are focused on longer-term objectives and capital allocation than the operating team.

Early in the life of a business, the budgeting and forecasting processes will usually be blended into one. Even as a business grows, it is not uncommon to see the budget used as the basis for a base case forecast. This forecast is then regularly updated as real-time performance and macroeconomic data result in adjustments to forecast assumptions.

Risk Assessment and Scenario Planning

Businesses need to be agile, especially startups that are planning to disrupt a market. Effective financial planning requires the consideration of a diverse set of internal and macroeconomic scenarios, and assessing key business risks in a noisy and changing environment. 

Strategic decision-makers should prepare for and understand how various scenarios, even black and gray swan events, may affect the business and its cash runway. Some key scenarios to think about while forecasting include the effects of a recession, large revenue misses (or beats), key person departures, funding difficulties, input price increases, regulatory and geopolitical changes, natural disasters, major technological disruptions (e.g., ChatGPT), and cybersecurity breaches.

To help the business be prepared for these disruptive scenarios, multiple versions of a forecast are often created to address some of the key scenarios. This will significantly increase the likelihood of survival.

Financing Arrangements

A lot of startups take outside capital to fund product development and ambitious growth goals. At times, this can be necessary. Other times, when markets appear frothy and a “growth at all costs” mindset trumps capital efficiency (like it did in 2020-2022), taking outside capital may be more discretionary in nature, as a means to accelerate ambitions and growth. It is important to remember that taking venture money or adding leverage always has consequences, some good and some bad. 

Even though many startups raise external funds, it is worth pointing out that a large majority of businesses never fundraise and are self-funded (bootstrapped). These businesses often have a higher emphasis on controlled growth and capital efficiency.

No matter what a business’s cap table debt financing arrangements look like, it is important for founders to fully integrate their financial planning efforts with their fundraising and financing strategy. The two rely on each other. A range of financing arrangements should also be considered and available to address key scenarios (good and bad) evaluated throughout the financial planning process. Having such optionality is valuable to businesses, especially to startups with a larger distribution of outcomes.

Fundraising and a vast array of financing arrangements will be the topic of a future blog article.

Key Financial Metrics

This is another topic that deserves attention in another blog article. As a business reviews its historical financial data and reports, many financial metrics can be helpful to determine key operating trends while providing indications of what’s to come or what needs to change in the future.

Some top financial metrics may include gross margin, net margin, burn multiple, debt coverage, and net dollar retention. It is common practice for FP&A professionals to analyze key metrics and financial lines items as percent changes from period to period (horizontally) and as a percentage of a same-period base unit, such as the review of expense line items as a percentage of net revenue (vertically).

Financial metrics uncover important insights about the business and its financial operations while also providing useful benchmarks and KPIs to ensure the team is moving in the right direction.

Using Tools for Better FP&A

There are countless tools that can make FP&A easier and more effective for businesses, Microsoft Excel is the most obvious one (and the most important and widely used tool in all things related to finance). For those less familiar with Excel, a mini online Excel course will be valuable for better financial planning.

Understanding how to get the most out of the business’s accounting software or ERP solution is also beneficial. Many popular software packages such as QuickBooks and NetSuite offer add-ons and apps to assist with forecasting and planning efforts.

For companies with more sophistication, data visualization and business intelligence tools such as Tableau and Power BI will help analyze and present data for additional insight.

Cross-Functional Collaboration

As previously pointed out, the forecasting process requires strong communication across the entire organization, however big or small the organization is. For early-stage startups with small teams, the entire team may have a role in the conversation. For example, the technical cofounder will help with understanding development costs, and the one-person marketing/growth team will help share expectations for user growth.

As the company grows, continued cross-functional collaboration will be necessary to make sure financial plans are based on realistic assumptions and grounded in the insights and experience of the operating teams. A lot of the cross-functional partnership required for effective planning will be initiated at periodic strategic meetings (e.g., quarterly refresh, annual strategic planning meetings) and carried out in several ancillary, topic-focused discussions between whoever is leading FP&A efforts and key persons held accountable for key assumptions that must be made.

Conclusion

The FP&A process is important for companies of all sizes and stages, startups included. Early in a business’s life, it is especially important to adopt an approach to financial planning and analysis that provides insights for proactive management of the cash runway in a manner that promotes long-term business objectives. This strategic process must be carefully integrated with the operating team and its leaders as well as key external stakeholders, such as external investors and creditors.