Investors expect their portfolio companies to carefully manage capital. This is easier said than done for entrepreneurs with limited financial management experience. And it’s for this reasons that entrepreneurs need to survive three important tests.
The Daylight Test
The first is the daylight test. This is the ‘is it appropriate to spend this money on this item’ test. When expenses see ‘daylight’ they are often being interrogated by co-founders, accountants and investors.
This can be straightforward or be confronting. And it’s often the latter because how much to spend on any item is surprisingly subjective and based on experience.
This is compounded by the unspoken expectation when founders and first hires come together that there is some intuitive, pre-existing benchmark for spending.
It’s a mistake to assume a benchmark is understood or even exists.
Serial entrepreneurs understand frugality. They have developed a habit for processing the financial trade-offs that come with battling ever shortening runways. For them, every dollar counts.
Those who join or form their first startup from a corporate or government career have different experiences and context.
The money they spend is often regulated through their procurement department. These people source the best deals with preferred suppliers that are appropriate for the business. Although this helps staff get on with their day job, these procured standards create expectations about the ‘reasonableness’ of expenses. And in some cases, it even desensitises people to the actual cost of goods because the expense isn’t hitting their pocket.
This might be ok for that business but there’s a good chance it won’t work in a startup.
Hotel accommodation seems to be the best item to help level set teams about expenses.
I’m not sure why, but setting the upper limit for accommodation (say $150 per room per night) seems to quickly align teams on the general standards for spending company cash. But it shouldn’t stop there.
While teams should develop habits for acting (and spending) like an owner, they shouldn’t be left to work it out on their own. Take the time to set expectations on can be reasonably spent and what thresholds trigger a conversation with managers or founders.
The Trade-off Test
The second is the tradeoff test. This is the more straightforward of the two tests and I use (and have for some time) engineering hours as my tradeoff value.
In other words, I think about the opportunity cost in terms of how many engineering hours I will forfeit if I invest in something else.
It is not a perfect measure and it does reinforce my belief that the ability to scale is reliant on robust products. The point is that engineering hours provides me with a useful yardstick to help me determine trade-offs.
The Core Metric Growth Test
Every venture has a core growth metric which is the linchpin for its business model. It’s not a suite of measures or a vanity metric like the number of users (or any other chart that easily climbs upwards from left to right over time).
The metric is often revenue growth.
And this test focuses on whether or not spend by the venture is focused on increasing the core metric.
A ‘fail’ for this test occurs when direct or indirect paths to revenue growth are not clear to investors.