Beware the hockey stick in your budget

(Editor’s note: Brad Feld is an early stage investor and co-founder of Foundry Group. This story originally appeared on his blog.)

Odds are, by now, you have your company’s 2010 Budget set – or at least the “2010 Draft Budget” or “2010 Budget – Draft”. (This is also known as “the joy of cramming a spreadsheet into a PowerPoint presentation.”)

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And, if your budget is at all like the ones I generally see, it fits into one of the following five categories.

1. Pre-Revenue: We are pre-revenue and won’t generate revenue in 2010.

2. First Year of Revenue: We are pre-revenue but will generate our first revenue in 2010.

3. Growing Revenue: We are on a revenue growth curve in 2010 but will lose money every month.

4. Becoming Profitable: We are currently losing money but will become profitable in 2010.

5. Profitable: We are profitable every month this year.

It’s worth noting that “profitable” is often used to mean either EBITDA positive, net income positive or cash flow positive.  These are three totally different things and you aren’t really in a happy profitable place until all three are true.

Of the five types of budget categories above, three (numbers 2, 3 and 4) typically have “hockey stick problems.”  Specifically, the revenue curve in the budget model looks like a hockey stick throughout the year with steep revenue growth in Q3 and Q4.

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The hockey stick revenue helps justify additional head count and an overall ramp in expenses.  If the revenue plan is correct, this is fine.  But the revenue plan is rarely correct, especially in Q3 and Q4.

As a result, the expense base in the budget is much too high – and one of two things will happen: The budget breaks (and gets ignored) or the company continues to operate on the expense budget (or some approximation of it), resulting in a much bigger loss and cash spend than forecasted at the beginning of the year.

There’s another issue – hiring is often front end loaded and the timing is somewhat unpredictable.  It’s also hard to “unhire” a month after you’ve brought someone on board because you are below budget.  While some people talk about people as a “variable cost”, it’s a tough variable cost to immediately turn to zero shortly after you’ve hired someone.

Each case is a little different; so let me spend some time on how I think about each one.

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First Year of Revenue (#2): The problem in this case is that the company will burn through its capital faster than expected.  You can solve for this by forcing the expense budget to look like a pre-revenue budget (e.g. assume no revenue).  When revenue starts to ramp, then you rebudget, even if it’s mid-year.  Basically, discount all revenue to zero until you start generating it.

Growing Revenue (#3): This is the trickiest of the three cases.  You have revenue.  You want to spend more money to grow revenue (this is rational).  You expect revenue will grow nicely (maybe, maybe not).  In this case, I suggest you build the budget and then shift your expense plan forward by one quarter.  This delays the spending ramp by 90 days, which enables you to see if you are ramping revenue as expected. I’ve rarely seen this slow down the revenue growth and, when it’s clear that revenue is ramping ahead of plan, you can always layer in some expenses explicitly ahead of plan.

Become Profitable (#4): Similar to #3, you start by lagging your expense ramp by a quarter.  Equally important, you should manage to a net cash number (cash + borrowing capacity – debt) and make sure you never fall below a threshold that is set as part of the budget process.  Once you start generating positive cash flow, you can rebudget, just like case #2.

I find that Pre-Revenue and Profitable companies typically don’t have the hockey stick problem in the budgets.  (Pre-Revenues don’t by definition since they have no revenue.)  Profitable companies have usually been through the cycle so many times that (a) they understand how to be realistic about revenue growth and (b) they are so happy to be profitable and self-sufficient that they err on the side of under-budgeting revenue and then expanding their expense base as they exceed plan.

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Be smart – avoid the hockey stick.  Even when you are playing hockey!  It hurts when it hits you in unexpected places.

Photo by Mykl Roventine via Flickr.