Starting up: 3 metrics entrepreneurial CFOs need to watch

Tom Eisenmann, Harvard Business School professor and author of The Fail-Safe Startup, says only 10% of high-tech, high-potential startups are successful. In that success, the CFO has a critical role that includes managing cash and working out when to raise more and monitoring key metrics. He warns the new entrepreneur against rushing in without proper customer research and product evaluation and explains why "trusting your gut" can lead to flawed decisions.

What you'll learn from this episode:

• When the CFO's role becomes a critical one.
• The need to consider both early adopters and mainstream customers.
• When's the right time to scale the business.
• The top three metrics that startup CFOs need to watch.
• How to avoid "false starts".

Play the episode below or read the edited transcript:

To comment on this podcast episode or to suggest an idea for another episode, contact Oliver Rowe, an FM magazine senior editor, at Oliver.Rowe@aicpa-cima.com.

Transcript:

Oliver Rowe: Welcome, Tom.

Tom Eisenmann: Well, it's great to be here. Thank you for hosting.

Rowe: It's estimated that only around 10 percent of startups succeed. Is that a global picture, or are companies in some parts of the world more successful?

Eisenmann: It does depend on your definition of startup and success. If success is making money for investors, then I suspect if you look at high potential startups anywhere in the world — Asia, Europe, North America — it's going to be the same kind of number. Only something like 10% of venture capital-backed startups are going to make real money for the investors.

Of course, it does depend on your definition of startup. Entrepreneurship ranges from the entrepreneurship of necessity with people in poverty to traditional businesses like restaurants and all the way on up to high-tech startups. Most of what I'll be talking about is the last — the high-potential ventures.

Rowe: Thank you. What's the role of the CFO in these startups in determining whether an enterprise can survive and then thrive?

Eisenmann: Crucial, after a point. In the very early days, most startups won't have a CFO. The founders will perform those functions. But when you get to, I would say 30, 50 employees, that's a point where you may have a bookkeeper at that point, somebody literally keeping track of the cash in and outs, monitoring the expense accounts.

Beyond that stage, a CFO is crucial because startups, almost by definition, are cash constrained and even more so than the traditional enterprise. You need a CFO to monitor the cash situation, figure out whether and when it's time to raise more money, and crucially figure out if the business is actually making money.

Rowe: Thank you. Why is it important to focus on mainstream customers rather than early adopters?

Eisenmann: A failure pattern is focusing too much on early adopters. Of course, every startup needs early adopters to get going. Those first customers that embrace your product, they are quite crucial. It's natural for the entrepreneur to feel tremendous loyalty to them, gratitude to them, go out of their way to satisfy them because their word-of-mouth referrals are going to be essential to the success of the business.

But it is true that you can get — if we think of COVID testing false positives — false positives from the early adopters. You can, as an entrepreneur, think that your business is in better shape than it really is if you focus too much on the early adopters.

Their enthusiasm may not be shared by the mainstream. Any business that's going to grow to any kind of scale needs the mainstream customers to come on board. It's also true that sometimes the mainstream customers have different needs, often less sophisticated needs, than the early adopters. Early adopters have been foaming at the mouth, waiting for someone like you to come along and meet their special needs.

A good example would be Dropbox. I'm sure a lot of listeners are familiar with the product. When Drew Houston launched that business, his early adopters were software engineers. It was very sophisticated needs for file management.

They had multiple computers, big files, collaborating with a lot of other engineers, but Drew knew that he wanted to build a big business, actually in his application to an accelerator spoke about creating a product that was so simple to use that his mother could use it to store her recipes.

He had the discipline to not build the product that the early adopters, the software engineers, were asking for. He bet correctly that what he built would be good enough for them and very good for the mainstream.

It's tricky, that's not always the right answer. Sometimes you do need to build a product exactly for the early adopters and hide features, a pro version and a basic version. There are many different ways to handle this issue, but the key point for an entrepreneur is just to be aware and to truly understand how the needs of mainstream customers and early adopters may differ.

Rowe: You've talked about growing customers. What makes a scalable business?

Eisenmann: An entrepreneur shouldn't scale, try to aggressively expand the customer base, until they have what we call product-market fit. Fancy term for, really just what it sounds like, a product that fits the needs of the market and more importantly, does so in a way that you have clear sight to profitability, at least over the medium or longer term.

Most startups aren't profitable early on, but you need to have some confidence that with scale, often they're scale economies, you can get to profitability. It's not just product-market fit, we actually use a framework and call it RAWI, the initials stand for ready, able, willing, and impelled, and each of the words is fuzzy enough that they require just a bit of definition.

Ready means you have product-market fit. That actually you can continue to grow in ways that will be profitable. Again, it's sometimes the case that your first customers will be profitable, but almost by definition, as you grow, you're moving further and further away from that bullseye.

The next wave of customers may be less interested in what you're doing. It'll take a price cut to attract them or lots of marketing. Over time, it's often the case that the next wave and the next wave of customers become less profitable, so you need assurance that you'll continue to attract customers profitably.

Able talks about access to both the manpower, the team, resources, and the money that you need to expand. Expansion will typically require capital, and there's no assurance that you can bring on board and coordinate the activity of all the people that you need to actually build a business.

Willing is, for the entrepreneur, an issue of do they really want to go fast and get big? The way it works in most startups is each round of investment, if you're raising from venture capital investors, puts a new lead investor on the board, you add a board seat.

At some point in time, the outside investors will outnumber management on the board. Of course, the main job of the board of directors, as in any corporation, is to hire and fire the CEO. If the CEO is a founder and they're outnumbered by investors and they're wobbling, then you can get actually thrown out of the business that you're building.

You have to decide as an entrepreneur whether you're willing to take that risk and also suffer the personal consequences. Growing fast usually brings all sorts of challenges and problems. You'll be working very hard and sacrificing family and relationships with friends and so forth.

Impelled, it's to the issue of, are there structural attributes to your business that just force you to go fast? Some businesses enjoy what we call network effects. If we think of Skype, one Skype user is useless, two are useful, 200 million are very, very useful.

Some products become more valuable as they have more adopters. If you're in a business like that, there's tremendous pressure to grow fast. Likewise, if there are high switching costs to switch from one vendor to another. If switching costs are high, there is going to be a race to lock in customers before somebody else gets them for the first time. Ready, able, willing, impelled. If the answer is yes to all of them, then step on the gas, scale up.

Rowe: In your book, The Fail-Safe Startup, you talk about how late-stage startups can lose the "cascading miracles gamble". What exactly did you mean by that?

Eisenmann: There's some startups that are just audaciously bold in their ambition. They're trying something fundamentally new, breakthrough, and by its nature there may be a lot of science and engineering work to do. A long product development cycle is often a regulatory or legislative gray area, so it's unclear how the government will respond. You sometimes need the cooperation of incumbents who've benefited from the status quo.

There are many uncertainties, including a fundamental uncertainty about whether customers will adopt some new behaviour. The example in the book is Better Place, which is set out to build a network of charging stations for electric vehicles all over the world.

This is in 2008, before we had very many electric vehicles, and this was going to include stations where you drive in, a robot would pull out your depleted battery and pop in a new one, all in five minutes, a time that it takes to refill at a petrol station, and they raised $900 million and some of the bets went right.

So cascading miracles, if you think about a mathematical equation, where you're going to multiply a bunch of things together. If any of those things is zero, if the probability goes bad, then the whole expression goes to zero in math.

Same thing with cascading miracles, there's all of these uncertainties, and if any one of them doesn't go your way, if you haven't had that miracle, then the business can be doomed. Sometimes it works.

If you look at SpaceX or Tesla, these are businesses that really enjoyed cascading miracles, but more typically when you try something this bold, the outcome is less good, as it was for Better Place. They raised $900 million and lost it all.

Rowe: What would be the top three measures? The top three metrics for measuring a startup's economic viability?

Eisenmann: Now this is where the role of the CFO comes back into play. I would say there are three things that the financial management team in a startup has to focus on. One is probably of less concern in established companies.

A lot of entrepreneurs will focus on the ratio of long-term value of a customer to customer acquisition cost. The shorthand in startup-land is LTV, long-term value of a typical customer, and LTV to CAC, customer acquisition cost.

LTV, of course, looks at the lifetime value of a customer. You'd need to know how long the customer is going to stay around. If it's a subscription business, will they keep resubscribing? If it's a repurchase business, how frequently will they do that? How much will they spend? So you need to understand unit economics, or how much are you making per transaction, and then you need to know how long those transactions are going to keep going.

That'll give you a sense for the value of the customer. Of course, you want to discount those cash flows. And then customer acquisition cost is whatever you're spending on paid marketing, essentially divided by the number of customers acquired in that time period, and you have a lot of trouble if that number is below one, that ratio is below one.

What's not covered there are all the overheads of the business, and so you actually need a number greater than one if you're ever going to make money over the longer term. A lot of software-based startups will target an LTV:CAC ratio of three.

The second thing you want to look at as a startup CFO is the burn rate and the fume date. Burn rate is just what it sounds like it. How much cash are you consuming per period, and then if you know your cash in the bank, that will tell you your fume date, when the current cash balance runs to zero, and boy, entrepreneurs really need to focus on those two numbers, hawk-like, in ways that the treasurer, or CFO in an established company, is probably less worried about running out of money completely.

Then the third set of metrics that entrepreneurs should look at closely are all the inputs to what's called cohort analysis. So startups will acquire a set of customers through a given customer acquisition channel, a marketing approach, say, here is the group that we acquired through Instagram ads in the month of March, or any type of measure: customer retention, customer satisfaction, spending. We want to do cohort analysis to see how that cohort ages over time, and then, let's say when they hit the six-month point, the people we acquired in March, here we are in August. Let's see if the cohort in August at the six-month point is doing better or worse.

It's a way to measure the health of your customer acquisition, and essentially whether you're reaching too far for customers. At a point if customers start to be unprofitable, that shows up quickly in the cohort analysis.

Rowe: Thank you. Finally, Tom, what would be your top three pieces of advice for the new entrepreneur?

Eisenmann: So, a first-time entrepreneur, I would say the number-one killer of early-stage startups is what I call a false start. The entrepreneur is jumping in, rushing to build and sell the product, and does so with zeal, assuming they found the right problem and solution pair.

Entrepreneurs are confident, they think they can see around corners, and these entrepreneurs have skipped a wave of upfront research that you want to do before you start the engineering work, to really understand customers, their unmet needs, and test multiple solutions, as a designer would do.

You want to explore multiple solutions to make sure you've found, both through the upfront research, customer interviewing, and so forth, do you really have a strong unmet need? And of the many solutions that might be available to meet that need, is yours the best?

That's not a lot of work, it might take four weeks to do all that. And these entrepreneurs rush in, build, and sell the thing. They might spend four months building, selling, figuring out it's not working, and then figuring out what to do next, and so in order to get going they've wasted four months on a flawed first version of the product in order to not invest that four weeks. It's a bad trade.

So the advice to the first-time founder would be watch out for the false start, watch out for the false positives that I spoke about earlier. Make sure you understand the difference between your early adopters and your mainstream customers.

A third, and I'll give you a fourth, I'm afraid. Can't resist. A third piece of advice would be to understand whether your industry is one where industry expertise is absolutely crucial. It turns out there are many startups where you don't need, as an entrepreneur, to have worked in that industry prior to launching a venture.

But if you launch a startup in food and beverage, or in fashion —one of the examples in the book focusses on an apparel company — there are all these specialised tasks and you need to know how to do them, how to make them fit together.

In a food and beverage company, how to work with a co-packer who will actually manufacture your product, or how to get packaging to make things jump off the shelf. When to expand from local distribution to national distribution and on, and on, and on, when to pay slotting allowances to the retailers to get your product featured. And if you lack the industry expertise, you're much more likely to make crucial mistakes on this front.

Last piece of advice is slow down as an entrepreneur. You're going to get a lot of advice to trust your instinct, and there are many decisions where trusting your gut is going to run the risk of a flawed decision.

Your gut will be racked by strong emotions, you won't think clearly, and so sometimes you do need to slow down, sleep on it, sleep two nights. List out the pros and cons. Show those to people who know you, your temperament, and your business, and don't be so quick to trust your gut. Some analysis is the right way to go.

Rowe: Tom, thank you.

Eisenmann: Pleasure, Oliver. Thank you very much for hosting.