Ask your CEO where they stand on financial engineering. If they wince — send them this.
How great leaders create value outside of their function
My specialty is helping startups navigate transformative change on the path from $10M to $100M in ARR. Over the course of this quarter, I’m exploring a question that’s been bugging me for years: Why aren’t we hiring leaders based on their ability to build teams of lieutenants?
Today, I want to layout one of the reasons why the best founders understand the strategic value that hiring a great CFO can bring.
No, this is not an article about how to define ARR vs. GAAP Revenue.
I want to talk about the key difference between good CFOs and great startup CFOs: the ability to present the financials in a clear, succinct, (and compliant) way that not only supports, but enhances the forward-looking narrative of the company in the context of a fundraise.
In an ideal world, finance is an objective function accurately representing reality through a set of standardized reports that can be easily compared across time and companies. That’s why we have GAAP financials — 90% of the time accounting is there to serve your investors, not to support the decision making of the company.
But the path from $10M to $100M in ARR is messy. Along the way, startups get funded based on the strength of the forward-looking narrative, not their previous three years of profitability.
Today’s cover image is Ivan Albright’s Picture of Dorian Gray. Every successful startup has warts and needs some make up (storytelling and financial engineering) from time to time.
GAAP financials often fail to capture the growth potential and future efficiencies of scale. And most CFOs know this — after all, they would be the first to admit that accounting and financial planning are two very different capabilities with different goals.
But Accounting vs. FP&A mindset isn’t the real division here. I’ve seen not just accounting-focused CFOs but even the best VPs of FP&A make the mistake below. In fact, most CEOs — even those who’ve raised multiple successful rounds — miss this.
Here’s the fundraising mistake:
For 95% of finance leaders and 90% of startups CEOs that I’ve met, when they believe that the current financials don’t accurately represent the future of the company the response is two-fold:
(1) Prep a giant data room with a detailed view of every metric they can think of: customer cohorts, renewal rates, product usage data, detailed cost breakdown by vendor, performance by AE etc.
(2) Build a very detailed bottoms-up model with 1000s of rows and hundreds of untraceable assumptions — and then devote a third of the fundraising deck to laying out the forecast drivers.
The problem is that by the point anyone is looking at this data the emotional part of the investment decision has already been made.
The detailed metrics, models, and cohorts aren’t there to convince someone to invest, they’re there to make sure they don’t decide not to invest.
What this means is that, before anyone looks at the detailed metrics, you need to convince them emotionally to be excited about the future potential.
Specifically, by the end of the very first pitch meeting, investors must want to believe:
That your software is solving a valuable problem
That your unit economics are sustainable
That future growth is just a matter of executing against the plan
That you know how to manage all this responsibly
But startups are messy, growth comes with mistakes and trade-offs, efficiencies of scale take years to ramp into. By design (and rightfully so) all these warts show up in your GAAP financials.
A great CFO needs to understand the business (to the point of knowing what each individual team does day-to-day) and determine how to best represent that using both GAAP, non-GAAP, and SaaS metrics.
So what do you do in the initial fundraise meeting, when you need to look your best? Here’s how to solve for the most common “warts” in your P&L that I tend to see.
For some of these, it is key to start managing for the “wart” metric up to 12 months before the next raise.
Showing that your software is solving a valuable problem
Potential Wart #1. A significant chunk of your revenue is services. Most of your customers think of your startup as a service provider, not a platform. Your software isn’t usable without the services attached.
Possible solution: can you position your services as recurring or, at minimum, as re occurring? Take credit for the services revenue as part of your ARR. Then make the case that you have a viable path and a plan to productize them over time and shift those $ to software revenues.
Potential Wart #2. your churn is high with many customers dropping off during the implementation phase or shortly thereafter.
Possible solution: consider treating customers as trials or pilots when they first sign; do not include them in your customer count until after they launch (you may still be able to include it in cARR if you walk a fine line in your story). Measure churn only off of the customer base that has launched and/or graduated from the trial/pilot period.
Showing that your unit economics are sustainable
Potential Wart #3. You’re losing money on services / implementation and it’s dragging down your GM.
Possible solution: consider breaking out software vs. services gross margin; if the picture is particularly unattractive consider not taking credit for any services revenue (this trades-off with wart #1) or even showing your services cost on a net basis in the management (non-GAAP) view of the financials.
Potential Wart #4. You are selling a highly technical product where customers needs a lot of support. These costs are dragging down your overall gross margin.
Possible solution: you need to start allocating your CS/CSM costs across your GAAP P&L line items. Carve out a portion that corresponds to supporting renewals and move it to Sales & Marketing. Make the case that some of the work is reusable (e.g. automating standard tasks) and move it to R&D. Of course, continue to make the case how over time you’re going to productize this more, help the customers to be more self-sufficient, and get more efficient.
Potential Wart #5. Your cloud costs are high and are dragging down your gross margin.
Possible solution: negotiate an EDP agreement with AWS/GCP if you don’t already have on i.e. commit to a certain amount of $ spend over X years in return for discounts and credit. Pay particular attention to how those discounts and credits are structured — in my experience the teams at GCP/AWS are more than happy to work with you to help get the desired accounting treatment.
Showing that future growth is just a matter of executing against the plan
Potential Wart #6. You are spending more than you should on sales or marketing — as a result, your sales efficiency is way off benchmark and has never even come close.
Possible solution: this is one area where using GAAP may actually help you instead of hurt. Most rapidly-growing startups’ P&Ls benefit from ASC 606 when sales commission is capitalized. In other words, your GAAP Sales Costs are often going to be lower than actual cash outlay in a given year (it catches up as growth slows down).
Potential Wart #7. Your growth is slowing down right as you need to go raise another round.
Possible solution: it might be time for you to start thinking about a price increase. If a significant chunk of your revenue is month-to-month (MRR) and/or self-serve you may be able to execute on this within months. A well-timed price increase lifts a lot of metrics in the short-term: you get a rapid inflow of new bookings and NDR, your gross margin goes up because you’re booking more revenue for the same costs, your sales efficiency looks great for a quarter.
The dirty secret (one of many) of pricing is that most price increases provide a pretty immediate and tangible bump, while the risk and downside associated with them stretches out over time.
Showing that you know how to manage all this responsibly
Potential Wart #8. You are simply burning too much.
Possible solution: can you allocate more of your costs towards R&D? That’s one area where investors have more tolerance for excess burn relative to benchmarks. Many teams can often sit in either R&D or other line items on your GAAP P&L. For example, you can justify classifying your Data/BI teams as R&D vs. G&A; you can consider allocating the IT team’s costs across line items; you can even mess with how aggressively you capitalize your R&D costs.
Potential Wart #9. You have debt on the books and are burning cash on interest payments.
Possible solution: consider leading with EBITDA instead of burn metrics. EBITDA is Earnings before Interest (and Taxes, Depreciation, Amortization) and can sometimes look much better than your actual cash burn. In parallel, make sure you position the debt as either an insurance policy to extend the runway or to offset timing of customer cash collections. At all costs, avoid implying that the debt is being used to pay for the ongoing operating expenses of the business.
Some other tricks of the trade
Lead with your new bookings instead of revenue growth
For example, $60M → $70M → $84M in ARR look quite weak even if the YoY growth is accelerating, while $10M → $14M in new bookings clearly shows that acceleration and can help you anchor your visuals in the deck at +40%.Sometimes it’s better to not do the analysis at all so you can truthfully say “we don’t think about it this way” if you know ahead of time the answer won’t be attractive (this should inform how you segment the business for management reporting purposes).
Obligatory reminder:
The line between creative accounting and financial engineering is easy to cross if you're not a professional. Creative accounting represents a willful disregard of the rules, while financial engineering is the art of figuring out how to apply the right combination of rules to get the desired outcome.
Remember that just because two things sound the same in plain English, it does not mean they are on the same sides of the legal line.
By the way: I partnered with Operator’s Guild to launch a master class and diagnostic focused on leveraging the CRO/CFO Partnership to drive the entire company forward.
Our inaugural class is 280% over-subscribed.
If you’re an OG member this class is free as part of your membership.
If you’re not an OG member, feel free to grab time below to learn more about OG in general or about the master class more specifically.