How to Properly Handle Startup Expenses | Chartered Financial Analyst Nathan Beckford

So we— I just walked you through a very quick and dirty revenue buildup for 2 types of businesses. Once we've built that, now we really focus on cost of goods sold, or once we've built that, we focus on expenses. We usually start off with cost of goods sold, and the way we think about cost of goods sold is for every incremental user or customer, what are the expenses associated with that? So it's a per-unit thing. You want to be thinking in per-unit expenses. If you're making a water bottle, every per sale is the plastic, cost of the plastic and the cost of the water, right? That's a per unit type of assumption. For something like an online video site, every user would drive X amount of traffic, And you have to pay for that bandwidth. So that's the per unit metric there. Step number 2 is build your hiring plan. We talked about that a little bit. Who do you need to support this business as you grow? Engineers, marketing, start to layer on management at some point, kind of a layer of management. And then build the marketing and sales budgets, pretty straightforward. I encourage startups to really— I think this is part of your class at some point, but really spending the time to develop a good marketing plan and how that would change over time. And then any other OpEx and CapEx. So you have to be inclusive here so you don't miss expenses. It's better to include more expenses than you think than to miss expenses, because if you didn't include expenses, later on you get tripped up when you run out of money. Yes, ma'am.

Can you please tell us what is more about OpEx and CapEx and the differences between them?

Sure. So, like I mentioned, cost of goods sold is usually a per-unit thing. What happens every time a new customer or a new product is sold. OpEx and CapEx are more fixed costs or costs that aren't driven by a per-unit thing. So, for example, your monthly rent. You've got, you know, $2,000 rent whether you sell 1 unit or 1,000 units. You can't change that. That's an example of an operating expense. Or, you know, maybe you're paying an attorney $2,000 a month. That's a little bit easier to adjust, but it's still, it's kind of a fixed stream of cost. CapEx typically refers to physical goods like machinery or even For an internet startup, you would treat your computers and monitors and all that stuff, or even furniture, as CapEx. And so not to get too caught up in accounting, but CapEx, you would plug it into the model when you spend $10,000 on a bunch of laptops, and then you depreciate it. But we don't want to get too down into that.

So we haven't thought about the money that you have to pay to the venture capitalists and other people, which basically will take away 90% of—

Have you ever had an even bigger exit than that? Yeah. No, I— you wouldn't necessarily model that so much because if you're raising venture capital, they'll typically get paid back when you exit, like when you hire Kelly Porter and you sell your company, they'll get paid back then. If you're doing a debt deal, like you're taking a loan from Silicon Valley Bank and you have to pay, you know, make repayments every month, you would definitely model that in. So, the money you pay back to VCs, not so much. A loan or other debt, definitely. Yeah. Any other questions on this topic? Okay, so we've done a revenue buildup, we've done an expense buildup. I like this quote. These guys are VCs with a firm called Foundry Group in Boulder. They've done a lot of really interesting deals. Smart, smart guys, great blog. I think they have a book out too called Venture Deals. But I like this quote. You can't predict your revenue with any kind of precision, but you should be able to predict your cost structure pretty well, especially over the next 1 to 2 years. And going into an investor and saying, we expect to spend $1 million and here's how we're going to spend it and here's where it will get us, is a really strong foothold to go into an investor versus, we have a vision, we need money to do it. And in many cases, we'll even start by building a budget or expense worksheet before doing the whole model, not to throw you a curveball there, but— Understanding your expenses is important because again running out of money is the number one cause of startups going bust. So we built our revenue buildup, our forecast, we've built the accompanying costs. Now what do we do? We take this all and turn it into proper P&L, proper income statement. I'll show you an example in just a minute. But basically we start by summarizing the monthly income and expenses and roll that up into quarterly and then we roll that up into annual summaries so we can show this nice P&L of where this business is going to go over the next couple of years. We make some adjustments to get to cash flow and again I don't want to bore you with the accounting details, but for example, there's a difference between depreciation and there's some ways we treat different things like—

Property taxes.

computer equipment, we'd capitalize it and depreciate it over time, but you really want to focus on cash flow, what actually comes in and out of the business. And then we tie it all together and look at this model and say, does this look right? Does this feel right? Do the growth rates, the margins, the headcount seem reasonable? Again, you're applying kind of a sanity check. And then finally, to the extent we can, we want to break these things into per-user economics. This is really great when you're going to talk to investors too. If you can talk about your big picture vision, where this goes over 5 years, how much you need to get there, but then you can also talk about a per-user economic basis. Every— Zynga is great at this, right? Every member is spending X amount on virtual goods and it's costing us Y to service that person. Are you guys familiar with kind of per unit economics? Should I cover this a little bit?

Medium?

You got it pretty good?

Cover it.

Oh, cover it, okay, sorry. Again, just almost think of like in a very explicit way, what does one customer or one unit of product, if you're selling a product, generate in revenue and what does it generate in costs? And we think about it in terms of revenue per sale, cost of goods per sale, marketing cost of sale, and shipping cost per sale. If you're Zappos, you have a pretty clear visibility into what it costs when you sell a $60 pair of shoes and you probably also know they're breaking it down to what it costs to, on average, to support that one person in terms of support costs, in terms of shipping. And then also you want to think about what it costs to acquire that one customer, right? So you've spent $2 to drive someone to your website, shipping is $4, the average customer support cost is another $2 or $3. You know, you can add that up and come up with what your your cost per customer is and then you know your revenue. So this, we call it VC Valhalla equation, you've entered the perfect zone for raising funding if you can show an investor that your lifetime value of a customer less the cost to support that customer is greater than your cost to acquire your customer. And in simpler terms that means, It costs you a buck to acquire the customer, it costs you 50 cents to support that customer, your lifetime value of that customer is $3, essentially you're saying every dollar in generates $2 out the door, right? It's a great position to go in to go talk to investors. It's a little bit of a tough concept to get, but basically it shows every customer is profitable. Thank you. I was wondering how long the lifetime value of a customer would be. Do you take inflation into account and other different time values of money? Yeah, it's a great question and it's tricky because you can massage the numbers a little bit, right? And you don't want to get overly aggressive. Part of the equation of how long— what is the timeline on a lifetime value of a customer, is a function of your churn rate. If you're getting customers in the door and they're sticking around for a long time, if you're losing— if you're losing 50% of your customers every 6 months, you have a pretty short timeframe. If you're keeping them around for a couple of years, your lifetime value would obviously be greater. When you're in the early days of a startup, that doesn't help, right, because you're maybe got 3 months of data, so you don't know how long people are sticking around. But you would probably then look at other comps, right? If you're in the retail business, how long can Zappos keep them around, stuff like that. But yeah, the short answer to your question is the time duration is inversely correlated with your churn rate. Does that make sense?

Yeah. Yes, sir.

I might have missed it. Can you go over what the equation means, the acronyms or whatever? The lifetime value of a customer less the cost to support the customer, when it's greater than your cost to acquire the customer, you're on fire. And this is why startups will raise these massive rounds, because they've shown that $1 in, you know, in terms of investment can produce $2 in in value basically. There's some great blogs on this because it's somewhat of a technical concept. In this tool I'm going to show you, Founder Suite, we have a calculator that you can play around with and get familiar with lifetime value customer. And then there's also some good blog posts from Andrew Chen on this topic too. So for further reading. Thanks, Tim.