MENLO PARK, CA – July 16, 2018 – Experienced software executives know the question is coming whenever an investor-type is in the room – “What’s your margin on this?” Whether on a product, a contract, or an entire business, we all wish there were a single right answer. Regardless of your audit expense, depth in finance, or the discipline of your operational controls, the fact is that representing your costs will never be completely uncontroversial. Just as you can do better, your investors had better be ready to help.
Balance the message
Management teams hurt their credibility every day with aspirational financial models made with the best of intentions. Do I think your highly-configurable, real-time, Big Data, IoT, SaaS, Cyber, AI platform can ever generate 98% contribution margins? Probably not. Will I believe you miraculously managed your professional services organization to exactly breakeven for the three years you’ve been growing in a brand new international market? Unlikely.
Savvy CFOs and investors know it’s a constant balancing act: an overly rosy picture risks incredulity, while excessive sobriety jeopardizes a call back to your fundraising team. Data should help guide your course:
Comparables: Imitation is the sincerest form of flattery. There’s an entire market of companies, investment banks and investors with data on what margins “should be” and “can be” depending on business maturity. Look close to home: what do your peers think makes sense for margin targets? A strong investor helps you leverage their portfolio of experience and assets.
Consistency: Change is good, but make sure you connect the dots between your new metrics and historical results. How can you and your investors assess trends comparing proverbial apples and oranges? Be prepared to explain when and why things changed, not just to your auditors, but to the business users of your financial statements. A strong investor keeps you honest, and drives the conversation away from window-dressing and towards fundamental performance.
Analyze the data
Most CEOs I’ve met at pre-cash flow businesses can quote monthly gross and net burn in their sleep. The geography question, though – where those costs appear on the P&L – is typically when the CFO needs to parachute in.
Cost allocation is notoriously hard, but it’s nearly impossible without quality data. Even when you have too few years for statistical significance and neither the time nor an idea of how to deal with the output, applying elbow grease early will make your life significantly easier later on. Preparing for scale means learning practices when a startup that need to be muscle memory when mature. Try adding the following capabilities to your arsenal:
Tools: As venerable a tool as is it is, QuickBooks alone may not cut it. Spending on scalable corporate infrastructure is better done proactively than reactively, and a strong investor realizes the protective value of operational best practices and comes prepared with ideas for high ROI, growth-supporting tools.
Time tracking: What is the number one expense at all software companies? If your answer is anything other than people, check again. If you don’t know how your people spend their time, how can you possibly allocate salaries to the right spots? A strong investor thinks laterally with you, empowering your people to defend their time through data.
Your costs are too high
In Silcon Valley we’ve all (hopefully) come to the conclusion that a diminishingly small proportion of hockey stick forecasts ever come true – even with the small denominator effect – and fat profit margins are more often a product of operational maturity than exponential growth. It doesn’t take an economics degree to appreciate the benefits of economies of scale!
While cost optimization can feel less “growthy” than hiring new salespeople and building new product, recognize that negative contribution margin growth is almost universally unsustainable and every dollar saved on non-people expenses represents an option for talent: more people, or a longer runway with your current people. That means bigger and better products, and more time to try new approaches.
Sometimes, more is more: Getting non-linear productivity from your people means breaking down tasks and matching resources. Seeking more accurate allocations may force operational optimization. Case in point: if your developers (operating expenses) are getting dragged away from R&D and into tech support (cost of sales), you’re losing both capacity for new product in addition to muddying the truth of your financial reporting. You know that you can’t manage what you can’t measure, and a strong investor asks for information that helps you measure.
There’s more to engineering than just Research: If you aren’t allocating time to refactoring, you’re leaving money on the table. Insufficient QA and incomplete testing might not cause you to stumble on this release, but technical debt festers and forces expensive reactive measures. “Chewing the cud” is critical to seeing real, sustainable margin expansion. Whether it’s as simple as shutting down demo instances and forgotten processes, or as complex as supporting whole new operational functions, a strong investor helps assess what is creative destruction and what is pound foolish thrift.
Your investors should be helping hands, not a frustration
Margins will never capture the richness of running a company, but they are important portholes through which outsiders observe the performance of your business. Great backers for your company should understand just how hard it can be to make the output unambiguous, and should use their own quest for clarity to help refine your capability to succeed.
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Jonathan Busch is a Vice President of HighBar Partners, a private investment firm focused on enterprise and infrastructure software companies undergoing change or transition.