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

0:02the best financial advice that VCs give startups. Let's go over this because we see things from our side of the table that maybe founders don't see because they're doing one startup startup. five or ten years, we're doing, you know, five or ten startups every month at our firm. We invest in a hundred companies. So let's talk, let's unpack it, Scott. What's the advice you hear most often from venture capitalists like myself giving to startups and why do we give that advice? Yeah, the simplest advice and probably the best advice is always make sure you have a cash runway that can support or overlay your milestones.

0:41VCs are really, because you're exactly right, Jason, you're doing this all day long too. You're seeing companies come in, ask for funding, and you know what's kind of attainable. And you also have a good sense of what it's going to take to get that next round done. So launch, seed investor, pre-seed investor, you guys have a really good eye for what a series A needs to look like to get in. And what I mean by that is like, how much ARR or how many customers, how many users, whatever it is, right? And so asking your investors what it's going to take to raise that next round is probably the most helpful advice.

1:14And then the second advice is kind of the simplest, which is don't run out of money, dummy, right? Like always have six months of cash, maybe nine months of cash at all times and make sure that you're planning ahead. And sometimes you got to cut some expenses, even though it's painful. Sometimes you're feeling really good and you're getting inbound term sheets. Maybe you can delay that a little bit and hit the accelerator a little bit more. So VCs have just such a great feel for the market and what is happening at the moment. It's so true. And if you were going on a camping trip for the weekend, you wouldn't bring exactly the amount of food and water you need.

1:53You bring a couple of extra power bars. You bring a couple of extra bottles of water. You don't cut it close. Why? Hey, what if there's a mudslide or inclement weather and you can't get out? you need to have a little bit of an extra uh and you don't have like a charge on your car if you're using an electric one if you're going to grandma's house and it's 100 miles away you don't leave the house with 100 miles you leave the house with 200 miles you don't want to have any agita that's runway we see it all the time conversely you're right scott sometimes i see a founder they're really good at fundraising some of them it's a superpower and that's a dangerous superpower to have because you can fly too close to the sun you raise too much money and you just think well i can just keep doing this.

2:35And then at some point, the hurdle to get the next round becomes greater, and you are now always one round ahead. So you've got such a convincing pitch that you raise your series A before you have product market fit. I see it happen sometimes, people get excited, or you raise your seed on a blank piece of paper. And so you're ahead by a year or two in the funding cycle. And then you get to series B, and those investors are like, okay, let's talk about the growth rate? What's your month over month growth rate? Tell me about your churn. And you're like, we're still figuring out product market fit.

3:09Or we just got to 100K in ARR. And they're like, okay, come back when you're at 10 million, because this is a series B. We want to see 5, 10 million for the series B, not 500K. You should be going for your series A. And you're like, I spent my series A already. Ouch. And a lot of times that's the founder has triggered that because venture capitalists are human beings too. They're very competitive people. And so they want to win the deal, right? And as you, as a founder, you think it's smart to play VCs off each other and drive the valuation up. And they know in the back of their head, the valuation is probably getting a little too high, but they're competitive.

3:44They go for it. They win. And so everyone's kind of ended up in this suboptimal position where not enough product market fit. The liquidation preferences are too high. If you don't just thread the needle perfectly, it's going to be really hard to get another round. And by the way, who are you going to go back to for more money? You're going to go back to those investors who you just drove the price up on and maybe were a little rude because you were feeling pretty good about things. Well, guess what? Now it's their turn to return the favor. Yeah. So just be careful. Be super thoughtful about it.

4:18I've also had people who, you know, they, they raised this 5 million or$10 million round, uh, and And they're going for break even. And I'm like, but we're only growing 20 % year over year. And we've got 5 million in the bank. And we're only burning, you know, 500k a year, we've got 10 years of runway. And we're growing 20%. Can we have five years of runway and grow 50 %? Can we have two years of runway and grow 100 % year over year? startups are meant to grow they're meant to go fast if you're growing under 100 year over year you kind of take yourself out of the venture olympics at this early stage i'm talking first five years of a company you look at uber you look at google apple some of these multi-decade old companies or a decade old companies they're growing at 30 20 a year if you're a startup and you're growing at 20 or 30 you've become a growth star and then you become like a blue chip when you start growing at 10 % a year.

5:18So be careful. Yeah. And to use your grandma's house analogy, like it doesn't do you any good to get there after dinner, right? You got to get there before dinner. So like hit that accelerator a little bit. And that's, again, just to bring it back, ask your venture capitalists. Like you should be having a board meeting every two, three months, something like that. You should be sending them an update email every single month. And so it's perfectly fine to ask them how they feel in that update email. Just say, hey, please don't reply at all or definitely be using the BCC thing, but just get their opinion.

5:50They appreciate it. And this is something they're very good at. People like to do things they're good at. And very basic blocking and tackling. We like accrual accounting, not cash accounting. Explain it for the 700th time this month, Scott. Accrual versus cash. I know we're here at Startup Basics. You can point people to this timestamp and you wouldn't have to do it a 787th time. You just point them here. Yeah. Well, cash accounting is literally booking revenue or expenses the moment it comes in or leaves your bank account. It's like such a literal thing, right? So you get a check from a customer for$100 ,000, but that covers 12 months.

6:33That doesn't mean you book a cash accounting, you book it$100 ,000 in one month. Accrual accounting means spreading that$100 ,000 over 12 months, the life of the contract, the life of the time you're providing service under the deal and recognizing my mask can be a little bad here, but$8 ,000,$8 ,500 per month in revenue. The rest goes into deferred revenue. Same thing on the expense side. Say you have someone building your website for three months and they send you a bill for$50 ,000. bucks. Well, you're going to actually accrue those expenses over the whole time period, the three months the developer was working on the website.

7:11Don't just plop it into one month and call it a day, right? And where this gets really important is when you're sitting up there at your board meeting, showing the financials and you see the VC squinting and trying to figure out what the heck's going on. And it's because you've been doing cash accounting and your expenses and your burn rate and your revenue are all over the place. And they don't even know how many months of runway you have because they can't calculate an average burn rate, right? So you need... It also just makes people, for lack of a better word, makes them suspicious that you're doing something incorrect or maybe against the law because things are bouncing around so much.

7:49So you really just want to normalize all this stuff. Just accrual kind of just means normalizing, smoothing the spend or revenue out so that it's a trend you can actually follow. And by the way, it's more accurate. That's really the reason to do it. And it's why the accounting bodies all want to be on accrual. And we want to understand the nature of the business clearly so we can give the best advice, we can fund properly, we can staff properly. And the number one job of a founder is, of a CEO? Keep the plane going. Do not crash. yes don't run out of money you you run out of jet fuel game over you're fired right and i'll give you another one we don't like to get into this too much because now we're dipping into becky wilson's and zini's uh category but if you make representations in a document during a fundraising you are selling securities and there's a special word that the government likes to use for selling securities with inaccurate information it's called securities fraud you have a high high high benchmark when you say buy equity in my company those numbers have to be right and there is no saying i made a mistake you know uh ftx and sam bankman freed elizabeth holmes they claim they made mistakes they claimed other people signed off on it does not matter the buck stops at the CEO's desk, you got to get that right.

9:21Correct? I totally agree. Even if it's short of fraud, but it's just like you, Jason, as an investor need to be able to trust the entrepreneurs. And if someone sends you an email, I remember you said you get like 20 ,000 submissions a year, some huge number. And they say, yeah, I'm doing$100 ,000 in MRR, right? And so, the monthly recurring revenue, the natural thing for you to do is 12X that for the year and be like, oh, this company is doing pretty well,$1.2 million in annual revenue. What a lot of times, and this is usually a mistake that early first-time entrepreneurs make, they've done that cash accounting, they plopped that$100 ,000 invoice into this month's revenue.

10:03And they're kind of like, maybe not totally intentionally misleading you, but they're taking some liberties. And I think, you know, once you get on, I'm speaking for you, I don't know your opinion, But I know for me, like once I get on a call and I see the person's doing this, it's really hard to trust them again. Six months later, when there's some other issue, can I really trust you? Should I really be investing in your company? Yeah, we have a credibility building exercise at our accelerator. You can go to launch.co and see the accelerator where we tell people, hey, when you're pitching, I perceive your credibility going up.

10:40I perceive your credibility going down. And when you do numbers with VCs, the majority of those VCs are very, very astute finance individuals. In fact, some of them come from finance backgrounds and venture is a finance based business. You're doing portfolio construction, you're placing these investments, aka bets, and you are always thinking about the odds in which they turn out. you do numbers vcs do math you do numbers and the inputs don't math if the math don't math credibility goes down so you say we have a thousand customers and in the previous slide you said it's 99 a month we're saying okay you got 1.2 million in revenue a year you say okay so you're at 1.2 million in revenue a year and you said you were spending 1.2 million so you're at break even they say oh yeah no we're losing a million a year and say okay wait a second the math done math here you say oh well 800 of our customers are on free trials okay well you use the word customers you didn't say users on free trials you know and another very one i see all the time is here's our customers and pipeline and it's one slide and you're like whoa ibm and ge and you know sony pictures and wow what a great client list is like yeah we have meetings with them coming up we you know they they added us on linkedin you're like wait a second it's a client list it's like yeah well those two that you haven't heard over the clients the other nine are in the pipeline those are two different slides credibility going down let's make credibility go up and you must understand when we're investing in companies and you know this full well scott because you're asked to you know do the pnls and the books and those are part of the due diligence process it will come out anyway so own the nascent nature of startups if your startup was churning and cooking like netflix or uber or airbnb it would be a public company so therefore don't be embarrassed you got a churn problem you got a pricing problem you're losing money you know that's the opportunity for us to invest in your company at under a billion dollars because you haven't fixed those things yet.

12:56I totally agree. And just to go back to one thing you said, which just like made my head explode because I've seen this before, the booking free customers, I've actually seen startups say like, well, hypothetically, we would have charged them$100 a month. So therefore, we're going to put this in the income statement. And that is fraud. That is something you should never, ever, ever do. So just all those things you rattled off are such great examples. Also, one other little thing is don't book like your pilot or test revenue and extrapolate that into annual recurring revenue. That is a one-time thing.

13:35Super simple way to do this on the P &L. Present your reoccurring revenue stream, one line item, one line item below that. Just put your pilot revenue. People like seeing pilot revenue because that means the dogs are eating the dog food. People are trying out your service. they can extrapolate forward on that don't try to get cute and mix that in and try to get that benefit on the multiple because we've seen this movie before totally totally we we understand free trials paid trials uh subscription revenue we understand there's different buckets here we understand different founders have different philosophies of it if you're a raul from super human there's no free trial you give me your credit card you use the product this is you know like going to the amon hotel it's luxury software you don't get to try the amon hotel for free for a night that's not how this works you pay other people might be like sure stay at my airbnb for free for a night if you like it pay for the second and third now having a plan that's something we can all agree on and you know i had doug leone tell me at some point when he asked me my plans you know uh jason hope is not a plan let's make a plan and i said yes sir mr leone i will get to work it was 20 years ago and i built a plan and then he banged on the plan ruloff banged on the plan i became a better entrepreneur make a plan what should be in the plan scott if you were asked to come in and help with the plan people get intimidated maybe you're creative, you're a product person, you're a designer, you never built a model, you never built a plan, demystify it.

15:15What are the variables that you need, the inputs, the answers to those variables that you need to make a good plan? Yeah, well, first of all, no one wants you to be the Goldman Sachs analyst. No one expects you to be that person, right? In fact, those people make terrible entrepreneurs. So really, people like you, people like Doug Leone, they are looking for something that's workable and they're going to give you a lot of kind of creative, like they're going to give you some room, right? So leeway is the exact word I was looking for. They're not going to scrutinize every single crazy line item.

15:50What they want, they treat it, I think, like a treasure map almost. They want you to, they want to be able to look at it and see where you're going and make sure you have enough fuel to get there, right? So very simple. You can just start with something as simple as revenue, or if you want to get a little fancier, maybe your number of customers times the average selling price, something very, very simple. Just work downwards. Then you're going to go to cost of goods sold. How much does it cost? How much is your web hosting or your compute costs every month? How much does it cost if you're a biotech company to run some of the basic experiments that you need to get your products out there?

16:28Whatever that is, that's going to be your cost of goods sold. And below that, you take the revenue minus cost of goods sold. You've got your gross margin. That's one of the first things that VCs are going to look at. And then you just kind of load in your operating expenses. And a lot of that's going to be head count. So think your marketing team, think your engineering team, think the operations team. And once you get that, you now got your operating expenses and you've got your operating income. It can really be that simple. I've seen great models that have 10 line items. and what made them great was they were accurate and they were very simple and easy to understand.

17:04And the cherry on top was the entrepreneur could talk to every single line item and explain what was happening. The worst scenario is that you pay someone to build some crazy fancy model that you don't know how to use and that it gets totally screwed up. And then you find yourself in a VC pitch and you can't explain what is happening because you've never really internalized the fundamentals, the gears in your business. You need to understand if you pull over here, this is going to happen. If you pull over here, that's going to happen. Super important to kind of... I actually recommend people do a real simple one themselves.

17:41And then as they get more advanced, we'll build it for them. We'll build something that they can use though. That's a really key point. You only need to look back to a bit of history, as I'll tell some founders like Queen Isabella, back to christopher columbus to go to the new world not to find north america it wasn't a new world voyage it was hey if we go that way we can get to india and this the spice is quicker he had a thesis the thesis happened to be wrong it's a big land match you're not getting to india going across the atlantic it was better off going the other way however after pitching and pitching she gave in supposedly she sold and pawned her jewelry uh in order to back him and you know it took time but there was a plan and then there were you know rewards for hitting that plan rewards included like spreading christianity and getting the bounty and making spain a very powerful trading country so you know you had these two people in this dance of hey should we make should we take this voyage look at it that way and if you say here's the number of miles here's the construction of the ship here's the size of the crew here's what we could get here's the range of what we could get all of a sudden the person who's got to fund that journey starts to feel safe now you're going to go on the journey and listen it's not life or death but it's years of your life and we all die so you should look at it like that they're going to back you you're going to go on the journey it's a partnership so be able to discuss you know how the ship is constructed how many people on the ship how many limes and lemons you're going to bring so you don't get scurvy these are important discussions to have and if you can't have them credibility goes down funding does not arrive.

19:24You must build your credibility. And they also just make you a better entrepreneur. Like you talked about Doug and Roloff banging on the model, banging on the business plan. You probably learned 10 things in those conversations that made the company so much better. So don't get all bent out of shape when the VCs are asking you tough questions. Sometimes they're just asking you tough questions to see how you react because they're going to be kind of be married to you for five to 10 years, right? Like they're going to be sitting in board meetings every two or three months listening to you talk and they want to make sure you take some criticism.

19:55Airbnb, Uber, SpaceX, top questions. How are you going to deal with regulators? Is this legal? How are you going to convince them to not kick you out of Las Vegas or New York? And you know what? Airbnb got kicked out of New York. Uber, the last city to fall was Vegas, right? We knew Vegas would be the last city to fall because there's certain people there who run that town in a certain way that let's just say you want to be doing things the right way and not the wrong way because you could get a visit from a couple of guys. So be thoughtful is what we're saying here. Totally agree. Totally agree.

20:35We don't have a startup basics around operating in certain markets with people who might have different ways of motivating you to operate your business. So with that, go to cruiseconsulting.com. Email Scott at cruiseconsulting.com. He's a mensch. He does the right thing. He works with our tiniest companies. He works with the biggest ones and everybody in between. If things are broke, he fixes them. So he's my fixer. Scottcruiseconsulting.com. We'll see you all next time. Thanks, Scott. Thanks, Jason. Appreciate it.