What is Annual Budgeting and Why is It Such a Pain?

The Magic Behind the Finance Org

Nov 09, 2022

We are super excited to extend our guest blog post series at Software Snack Bites featuring CJ Gustafson, CFO at PartsTech and formerly FP&A director at Snyk. This post will focus on creating annual budget models for startups, how founders can go about it, and why they’re needed. If you enjoy CJ’s writing and advice, I highly recommend you subscribe to Mostly Metrics (recently crossed 10k subscribers!! That’s 2x Software Snack Bites) where he writes about all things startup metrics and finance!

I tried to find the most generic photo of CJ possible for this post :)

Are you a founder who’s been asked by the board to pull together something called an “annual operating plan”? Are you attempting to turn that cool hockey stick graph from your pre-seed pitch deck into a useful plan of action? Did you recently realize that “Budget” is not just a rental car company?

If you answered “yes” to any of these questions, you’re in the right place. Today we’ll cover what the annual planning process is, why it’s important, and some best practices for getting it (close) to right.

Why is Annual Planning Important?

Annual planning is a forcing function to get the org “in shape” for the company’s next chapter. I’m a big boxing fan and they say the hardest part of a fight is actually the training camp leading up to it. The fight itself is really just the culmination.

Annual Planning is similar in the sense that it's a “training camp” for the company to “get in shape” for next year.

Think of your annual planning cycle as the mechanism for determining how much you expect to make vs spend next year. More specifically, you’re aligning the org across five key questions:

How fast would we like to grow our revenue next year?
How much money can we spend to get there?
How many people will we hire?
How profitable do we want to be?
How will we track our progress to know we were successful?

All of these questions are interrelated, as we’ll discuss.

Who’s Involved in Annual Planning?

The cycle usually starts with the CEO and CFO, who discuss high level revenue, productivity and profitability targets to frame up the discussion. And then it extends to leaders from the Sales, Marketing, Customer Success, Product, Engineering, Finance and People Team. And finally, it gets approved by your Board (which is probably why you are embarking on this annual planning process for the first time).

I’d say the most important input comes from those who either build or sell your product. Therefore, close alignment is required between Engineering and Product, as well as between Sales and Marketing. Your Engineering team needs to staff its headcount against the Product team’s roadmap. And the Marketing team needs to drive enough pipeline for the Sales team to knock down. And to bring it all together, your Sales and Marketing teams need to understand when they can monetize what the Engineering and Product teams have built.

Everyone else at the company is essentially there to help those groups do what they do better - recruiting is on a mission to staff the teams, finance makes sure there’s enough gas in the tank for the road trip, and customer support makes sure all the current customers stay on the bus (and maybe even get them to buy some more snacks).

How the heck do you match dollars in a model to people?

Believe it or not, 75% of costs at tech companies tend to walk on two feet.

That makes nailing your headcount forecast key to budgeting success - not only is payroll the majority of your costs; it’s also a driver for the majority of indirect costs (e.g., software licenses, office expenses, rent).

So it’s less about matching the dollars in the model to people, and more about using the people to come up with the dollars in the model. You may have an idea of where you want your spend and cash burn (or profitability) to shake out, but to validate that you have to build up from the bottom starting with employees.

From an OPEX perspective, the most crucial part of the annual planning process is coming up with “max headcount” figures by department, preferably phased by quarter. Leaders should hire throughout the year to stay within the bounds of a “total team size”. This is where annual plans either make it or break it. Full stop.

In terms of putting numbers on paper, first start with your revenue and expenses from the prior year. This is your baseline to work off of.

Now your mission is to construct two Profit and Loss forecasts. One should be organized by team and another by expense type. They should both tie out to the same amounts, but provide different views for decision making.

The most basic expense types you’ll want to budget for include:

Salaries & Benefits: For US based employees you can usually use a 20%-25% uplift off of salary as an estimate for benefits (health insurance, dental insurance, life insurance etc.). Some rules of thumbs for other countries can be found here.
Commissions: This should be reserved for the sales team and sanity checked as a % of revenue.
Contractors: Flex labor capacity for specialized or project based work, like design or copywriting.
Professional Services: Lawyers, bookkeepers, tax accountants.
Rent: You should think about allocating this out based on headcount once you surpass ~100 people.
Subscriptions: The cost for software tools like Salesforce, Adobe, Miro etc.
Travel: Useful to break this into team (internal) vs customer (external) buckets
Office Expenses: Paper, pens, coffee, food

You can budget for and embed most of these expense categories within each team, then roll them up at the company wide level to check total spend by bucket.

How to use the model to guide decision making in startup building?

If there’s one thing I know, it’s that your model and my model will both be “wrong” at the end of the year. It’s just a matter of how “wrong”. Ideally the model becomes a living, and breathing document for data based decision making.

If you’re managing your budget right, you’re working off the best information you have at the time and course correcting on a quarterly basis. A model should never be the “end all be all,” but rather a set of guardrails you set up to keep the business on track. That’s where the term “reforecast” comes from. At the end of each quarter you should check how your sales and costs are tracking against what you thought. And ideally you check this against both P&L views we discussed above.

Why is this important? Well you’ll want to know if, say, the Product team is purchasing more tools than anticipated (comes from your P&L by team). Or if my Salary & Benefits across the company are higher than expected because we’ve been hiring more senior people than we anticipated (comes from your P&L by cost type). Different questions call for different views.

Your reforecast becomes your new “baseline” to work off of. At the end of the first quarter you now have one quarter of “actuals” and three quarters of forecast. At the end of the second quarter you now have two quarters of “actuals” and two quarters of forecast. So each period you have more information “in the books”.

You’ll also want to monitor your cash runway. This is the number of months you have until cash runs out.

Burn = Revenue less Expenses

Months at Current Burn = Ending Cash / Monthly Burn

If you are doing better than you anticipated - great! You can reinvest money into additional go-to-market resources or start building a new product sooner than expected.

But if you are getting negative signals out of your model, you need to change part of the equation. When companies talk about “extending their runway” this means cutting costs, which are usually linked to headcount.

Conclusion

President and General Dwight Eisenhower once said, “In preparing for battle, I have always found that plans are useless, but planning is indispensable.”

Annual planning is similar in the sense that agreeing upon shared objectives and analyzing market opportunities is, at the end of the day, more important than the P&L that drops out.

The annual planning process forces the company to align on a set of shared priorities. Said in a less McKinsey manner - it forces people to work on the same shit as one another and to know what money will be spent on.

At startups, the scarcest resource isn’t always money - it’s mental bandwidth. People can only focus their energy on so many things. Annual planning helps you become maniacally focused on the same stuff. And it gives you an evolving baseline to go off of so you can course correct throughout the year.

Best of luck this planning cycle, and remember, if you get it wrong, just blame it on “macroeconomic conditions.” At least that’s what I always do.