How to Recession Proof Your Annual Budget
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Today's volatile and unpredictable business climate has left many founders needing a clearer understanding of weathering the storm. And those the current macro-environment has not impacted will need to prepare for this eventuality. Proactively reexamining your budget is one fundamental way founders can adequately prepare themselves during this time. So, we've put together four considerations for founders who want to reevaluate their budgets during an economic downturn.
Step One: Re-examine Your Key Business Drivers
The first step to recession-proofing your budget is to look at your business's key drivers. These metrics tell you whether or not your company is successful and how well it's doing. Depending on what industry you're in, these could include:
- Revenue growth
- Customer retention rate (CRR)
- Average order value (AOV)
At Pilot, the first thing we want to do with a founder is to discuss what leading indicators and key drivers we want to watch to determine the magnitude of the effect of an economic downshift on the business. But what is a driver? Every line item in your model has a driver, e.g., customer growth and price drive your revenue, while growth and headcount are drivers for payroll cost.
We're currently working with a company that has been watching:
- Sales Cycle Length (if longer, it means customers are more concerned about spending)
- Churn (up)
- Average Deal Size (down)
We recommend companies start tracking KPIs specific to their industry so that they can sharpen their pencils on a month-over-month (MoM) basis based on how these KPIs are changing in response to the downturn. The benefit of re-examining your key business drivers is greater financial visibility. That often looks like tracking:
- Burn Rate,
- Cash Runway,
- Customer Acquisition Cost,
- Customer Lifetime Value,
- MoM Growth Rates on Revenue, and
- Profitability Margins.
When growth slows, ask yourself: Do I understand what's hampering growth right now? And do I have alternative strategies for driving incremental growth and preserving cash burn?
If you are early in your growth cycle, monitoring a few metrics is fine, but when raising a larger round or trying to get to a Series A and hit the next milestone, these are the relevant questions you'll want to ask.
Step Two: Plan for Multiple Scenarios
Now that you've determined your key business drivers, it's time to plan for multiple scenarios. We want to take those indicators and KPIs and build a financial model that gives us a bear, base, and bull case. In scenario planning, you develop new assumptions for your drivers based on each scenario and understand the interplay of all of these drivers to determine where you think the business will go over the next 12-24 months.
Suppose your business will be affected by a recession if the unemployment rate increases by 2% and sales fall by 10%. In this case, you should examine how much each of these factors could impact the viability of your company. You can do this by calculating their potential impact on key metrics like sales volume or margin percentage (this is where understanding financial ratios come in handy).
Once those calculations are complete, identify which scenario best represents an ideal outcome and then plan accordingly by re-calculating cash burn rate—the amount of money needed each month to sustain operations until you reach profitability—and extending runway length based on how much runway would be required under each scenario.
You can construct a series of outcomes to show your team what the effect on, for example, your P&L and Balance Sheet, and specifically, cash, would occur if these were to happen. Start by asking yourself these questions:
- What will revenue look like if churn increases by 20, 30, or 50 percent?
- What if sales grow, hold steady, decrease slightly, or plummet?
- How will headcount and payroll change in response to these changes?
- Will utilities, leases, and other operational expenses change for better or worse?
Step Three: Recalculate Your Cash Burn Rate
Once you know your burn rate, it's time to figure out how much runway you have. To do this, use the following formula:
Cash Burn Rate + Cash Inflows = Current Balance
Suppose you have a $1 million cash balance. If the business is burning through $10k per month and has no other sources of income besides loans or investments, then their current balance would be $1 million - ($10k x 12) = $880k. They have about 880 days' worth of runway left before they run out of money.
You'll want to know how much runway you will have in a moderate, medium, or serious downturn — and the reality is, we don't yet know which one we're in right now. In an ideal scenario, your budget is dynamic enough such that, for example, if your churn is 20% higher, ideally, that flows through the model and will impact your cash burn.
You can play around with different drivers to see their potential impact on the cash runway over time and then plan for those scenarios affecting your cash runway. Ask yourself:
- How will your cash burn rate increase or decrease in each scenario?
- When will your business fume date (zero cash date) be in each?
- What does this mean for future fundraising plans? Do you need to find money fast, or can you delay the need for investment by reducing your cash burn rate?
Step Four: Extend Your Runway & Adjust Growth Plans
Extend your runway by analyzing costs, understanding your financial profile, reducing your burn rate, and adjusting your growth plans accordingly. Scrutinize your company and identify unavoidable costs, e.g., current employees, compensation, facilities cost, utilities, etc.
Then, look at non-labor costs and ask: Do I need this? How much can I defer? What is the business impact if we cut this out entirely or by 50%? When you save costs in one area, can you re-allocate them to help sales navigate the downturn and shift the revenue into marketing?
The rules of the game are:
- Analyze costs. The first step to extending your runway is to analyze the cost of everything that goes into running your business. Examine every expense line item and consider if you can reduce or eliminate it altogether or if there are other ways to reduce the cost of those items without sacrificing quality or service. For example, if you're paying for office space but only using half of it on average, it might make sense to downsize into smaller quarters. You could save money by sharing resources with another startup needing office space.
- Understand your financial profile: Determine what is a nice to have vs. a need to have. Understand the business impact of not having it all (classic examples of cost-cutting include cutting out unnecessary travel, meals & entertainment, cutting back on office supplies, reevaluating software subscriptions, and identifying those that aren't critical for the delivery of your service).
- Don't increase your burn rate: If you are developing a new product or service or line of business that you haven't done before, what's the impact of waiting six months to a year? Do you need a full-time hire, or can you outsource part-time?
- Adjust growth plans accordingly: If a recession hits soon after launching an MVP (minimum viable product), it will likely adversely affect your business. Chances are, no matter how well-crafted your pre-launch marketing strategy was—and how much money you committed to building out features post-launch—you might struggle to raise additional funds. Investors are wary of lackluster sales numbers coming out of early adopters who signed up during this period when everyone else was struggling financially themselves.
Bonus: A Note on Fundraising
Many founders we work with are either considering fundraising or preparing to fundraise. From our experience, investors run a much more thorough due diligence process today than they were even a year ago, so when you raise capital, make sure you know your story well.
We recommend that founders ponder the following questions:
- What did you accomplish with cash when you took in the last investment?
- Did you come up with a new version of the product? Did you expand your number of customers?
- What did you raise the cash for, and did you accomplish what you set out to do?
When you go back to investors, you want to be in a position to say, "I took X from you, and I did 14 out of the 16 things we discussed. So let's talk about raising the next round!"
Generally speaking, for an investment to make sense, your investor needs conviction on specific questions based on what stage you're at:
- Pre-seed to Seed: Is there significant potential? How big could it be if it worked? Is this a team well-suited to solving this problem? Why now?
- Seed to Series A: Is there a product-market fit? Is the business growing well?
- Series A-B: Will you be the market winner? Is your growth efficient and sustainable?
- Series C-D: Are your unit economics compelling? Will this business continue to compound and grow?
The truth is, fundraising is a demoralizing process - it's not going to feel good, so let's normalize the experience. If you're feeling burnt out, know you're not alone. However, we've found that it helps to adopt a current market focus on profitability and profitable outcomes.
Based on our analysis, there is a reason to be optimistic despite the current market conditions. Of course, this kind of downturn happens, and we are in such a cycle now. However, while the data indicates a lot of headline risk, there's also reason to be optimistic. There's still capital to be deployed, so the more prepared you can be, the better off you will be.
In the meantime, we hope this article, taken from our recent Four Ways to Recession-Proof Your Annual Budget webinar has given you a better understanding of how to recession-proof your budget and ensure it stays secure during tough times. Remember, the key is to remain flexible and plan to adapt when things change quickly.
If you need advice on preparing for the uncertainty of 2023, book a 1:1 CFO Office Hours session where you can connect with a CFO to ask questions about the current macroeconomic conditions, your company's operating strategy, and more.
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