The Best Financial Advice VCs Give Startups | Startup Finance Basics w/ Kruze's Scott Orn

Kruze COO, Scott Orn, joins Jason (0s)

• Venture Capitalists (VCs) provide valuable financial advice to startups, offering insights gained from their experience working with multiple companies. (3s)
• From their side of the table, VCs see things that founders may not, as founders typically work on one startup every 5-10 years, while VCs work with multiple startups every month. (9s)
• At their firm, they invest in 100 companies, giving them a broad perspective on startup finance and allowing them to share expertise with founders. (19s)

The best financial advice VCs give startups, managing cash flow, and the risks of over-fundraising (21s)

• Venture capitalists often advise startups to ensure they have a cash runway that can support or overlay their milestones, as VCs have a good sense of what it takes to get the next round done (38s).
• Startups should ask their investors what it will take to raise the next round, as this is probably the most helpful advice they can receive (1m9s).
• A simple yet crucial piece of advice is to never run out of money, and startups should always have six to nine months of cash at all times, planning ahead and cutting expenses when necessary (1m17s).
• VCs have a great feel for the market and what is happening at the moment, which is why their advice is valuable (1m39s).
• When planning, startups should not cut it close and should have a little extra, just like when going on a camping trip or driving a car, to account for unexpected events (2m1s).
• Conversely, some founders are too good at fundraising, which can be a dangerous superpower, as it can lead to raising too much money and flying too close to the Sun (2m26s).
• Raising too much money can lead to a higher hurdle to get the next round, and founders may find themselves always one round ahead, with a convincing pitch that raises their series A before they have product-market fit (2m37s).
• This can lead to issues when getting to series B, as investors will expect to see growth rates and revenue that the startup may not have achieved yet (3m3s).
• Venture capitalists are human beings and can be competitive, which can lead to them winning deals with high valuations that may not be sustainable (3m26s).
• Founders should be aware of this and not try to play VCs off each other to drive up valuations, as this can ultimately lead to problems down the line (3m33s).
• Raising too much money at a high valuation can put a startup in a suboptimal position, making it difficult to secure another round of funding if the company doesn't meet expectations, and may lead to investors seeking to "return the favor" in future negotiations (3m49s).
• Startups should be thoughtful about their fundraising strategy and consider the potential consequences of raising a large amount of money at a high valuation, as it may limit their ability to raise additional funds in the future (4m15s).
• When evaluating a startup's growth potential, a 20% year-over-year growth rate may not be sufficient, especially if the company has a long runway and is burning a relatively small amount of money (4m25s).
• Startups are meant to grow quickly, and a growth rate of under 100% year-over-year may not be competitive, especially in the early stages of a company's development (4m51s).
• Companies like Uber, Google, and Apple, which are now multi-decade old, were growing at much higher rates in their early years, and startups should strive to achieve similar growth rates in order to be competitive (5m0s).
• As companies mature, their growth rates often slow, and they may transition from being a startup to a growth stock, and eventually to a blue-chip company with a more stable but slower growth rate (5m13s).

Growth strategies for early-stage startups and accounting methods (5m19s)

• Early-stage startups should focus on growth strategies and consider accelerating their progress, similar to arriving at Grandma's house before dinner, as this allows for more effective planning and decision-making (5m20s).
• Regular communication with venture capitalists is crucial, and startups should consider sending update emails every month and having board meetings every two to three months to keep them informed and gather their opinions (5m30s).
• Using the BCC feature when sending update emails to multiple venture capitalists is recommended to avoid cluttered inboxes and encourage individual responses (5m46s).
• Venture capitalists appreciate being asked for their opinions and are good at providing valuable insights, which can help startups make informed decisions (5m48s).
• Accrual accounting is preferred over cash accounting for startups, as it provides a more accurate representation of the business by spreading revenue and expenses over the relevant time periods (5m57s).
• Cash accounting books revenue or expenses as soon as they are received or paid, whereas accrual accounting recognizes revenue and expenses when they are earned or incurred, regardless of when the payment is made (6m17s).
• Accrual accounting helps to smooth out revenue and expenses, making it easier to track trends and make informed decisions, and is the preferred method of accounting bodies (7m52s).
• Using accrual accounting can help startups avoid suspicious or irregular financial patterns, which can be misleading and make it difficult to calculate burn rates and runway (7m39s).
• The primary job of a founder or CEO is to keep the company running and avoid running out of money, which requires effective financial management and planning (8m11s).

Legal aspects of financial representation and maintaining credibility with VCs (8m28s)

• When making representations in a document during fundraising, it's crucial to ensure the information is accurate, as selling securities with inaccurate information can be considered securities fraud, and the CEO is ultimately responsible for the accuracy of the numbers (8m29s).
• As an investor, it's essential to be able to trust the entrepreneurs, and if someone provides misleading information, it can be challenging to trust them again in the future (9m28s).
• Early-stage entrepreneurs often make the mistake of using cash accounting and including unpaid invoices in their revenue, which can be misleading and damage their credibility with investors (9m52s).
• Venture capitalists (VCs) are astute finance individuals who focus on portfolio construction and placing investments, and they expect the numbers to add up; if the math doesn't work, credibility is lost (10m43s).
• When presenting numbers to VCs, it's essential to ensure that the inputs are accurate and the math works, as discrepancies can damage credibility (11m13s).
• Using misleading language, such as referring to users on free trials as "customers," can also damage credibility and make it challenging for investors to trust the entrepreneur (11m37s).
• Presenting a pipeline as a client list can also be misleading and damage credibility, as it implies a level of commitment or revenue that may not exist (11m49s).
• Understanding the importance of credibility and accuracy in financial representations is crucial when investing in companies, and due diligence processes, such as reviewing P&Ls and books, are essential to verifying the accuracy of the information provided (12m13s).
• Startups should own the nature of their business, including churn and pricing problems, as these issues are opportunities for investors to invest in the company at a lower valuation, under a billion dollars, before the problems are fixed (12m26s).
• Booking free customers as revenue is considered fraud and should never be done, as it misrepresents the company's income statement (13m5s).
• Startups should not extrapolate pilot or test revenue into annual recurring revenue, as this is a one-time thing, and instead, present recurring revenue and pilot revenue as separate line items on the P&L (13m23s).
• Investors understand the different buckets of revenue, including free trials, paid trials, and subscription revenue, and different founders have different philosophies on these, but having a plan is essential (14m2s).
• Founders should be prepared to present their plan, as investors like Doug Leone expect a clear plan and will challenge it to help the entrepreneur improve (14m37s).
• Having a plan is crucial, and entrepreneurs should be prepared to work on it and improve it based on feedback from investors and others, as it can help them become better entrepreneurs (14m51s).

Building an effective financial plan for your startup (15m0s)

• A financial plan for a startup should be workable and not overly complex, as venture capitalists (VCs) like Doug Leone are looking for something that provides a clear direction and enough resources to achieve goals (15m1s).
• The plan should include variables such as revenue, number of customers, average selling price, cost of goods sold, and operating expenses (16m3s).
• Startups can begin by calculating revenue or number of customers times average selling price, then work downwards to determine cost of goods sold, gross margin, and operating expenses (15m59s).
• Gross margin is a key metric that VCs look at, which is calculated by subtracting cost of goods sold from revenue (16m31s).
• Operating expenses should include headcount costs for teams such as marketing, engineering, and operations (16m41s).
• A simple financial model with 10 line items can be effective if it is accurate and easy to understand, and the entrepreneur can explain every line item (16m54s).
• It is essential for entrepreneurs to understand the fundamentals of their business and be able to explain how different variables affect their financials (17m26s).
• Entrepreneurs should create a simple financial model themselves before seeking help from others, as this will help them internalize the key drivers of their business (17m36s).

Historical perspectives on funding and the importance of regulatory considerations (17m47s)

• Historical examples of funding and partnerships can be seen in the story of Queen Isabella and Christopher Columbus, where the queen eventually funded Columbus's voyage after he pitched his plan, despite his initial thesis being wrong (17m48s).
• The partnership between the funder and the entrepreneur is crucial, and being able to discuss the details of the plan, such as construction, crew size, and potential rewards, is essential in building credibility and securing funding (18m45s).
• The ability to have tough conversations and answer questions about the business plan is vital in establishing credibility with potential funders, such as venture capitalists (VCs), who will be working with the entrepreneur for an extended period (19m38s).
• Regulatory considerations are a critical aspect of any business, and entrepreneurs must be prepared to address questions about how they will deal with regulators and ensure their business is operating legally (19m58s).
• Examples of companies that have faced regulatory challenges include Airbnb, Uber, and SpaceX, which have had to navigate complex regulatory environments in various cities, including New York and Las Vegas (19m53s).
• It is essential for entrepreneurs to be thoughtful and prepared when operating in certain markets, particularly those with unique regulatory environments or motivations (20m30s).
• Scott Orn, a consultant with Kruze Consulting, is recommended as a resource for entrepreneurs who need help navigating these challenges and building credibility with potential funders (20m47s).