4 Capital Allocation Mistakes Smart SaaS Founders Avoid

please help me in welcoming Kevin Houston to the stage Kevin welcome Drake great to be Founders in the audience right now put up your hand how many people looks at look at their financial statements every single month amazing I love that I love that as a Founder especially in the early stages before you hit 5 million in AR you are

the CFO so um uh my background here so I'm the the fine the first Finance hire at founder path I joined Nathan back in early 2021 it was actually two months after my first baby was born so I saw two things in the early stages thankfully they're both thriving today um and I was I I both raised capital and deploy Capital so I'm talking to

Founders every day I'm not one of the founders but I serve Founders I sometimes act as a Founder therapist and I've learned a lot of lessons by staring at financial statements talking to Founders and noticing patterns so what I want to do today is walk you through four lessons that I've learned that you can use when you're wearing that CFO hat and making critical decisions in in terms of both what you're doing on

the sales side in terms of contract structure the potential issues that you could find in your receivables a a metric that I find to be really really critical networking Capital lots of Founders look at their bank account and just and and make Runway decisions based on that and there's limitations to that which I'll sort of go through in networking capital and the last one is I'll provide a framework for both sourcing and also allocating

capital on your balance sheet as a SAS founder so let's get into that okay so lesson one the downside of the multi-year contract so uh this may resonate with some of you um the multi-year contract is basically you offer a discount for a multi-year relationship with a SAS customer collect all the cash up front uh but what it what it effectively does is it

it moves all the cash to today but your mrr may go for years so before we get into it uh a quick story so I worked with a company a few years ago and they were both hardware and SAS their customers were not used to paying for the hardware component so they baked that cost right into the SAS contract and it was generally a five-year contract that they would that they would enter into with their customers

um and in order to actually Finance the hardware they would sell these contracts to a partner and basically do the same thing that a multi-year contract would do bring all the cash to to today but the challenge with that is no cash in the future on that contract until the five-year term restarts so it was all well and good um cash was coming in the door through this financing partner based on new sales coming in and that would find their burn that would fund their Hardware expenses it

was all okay um what happens when new sales stops what happens when covet heads uh all of a sudden the cash flow stops or cash flow basically comes comes to a halt and the reserves basically came down in a hurry so it led to basically a risk that they didn't think they would ever meet and because they sold off so much future cash flow they had to deal with the consequences of a timing crunch so

let's look at some contracts so contract one here um as you can as you can see maybe it's too small the ACV on this contract is 50 Grand so over a three year period about 150 000 were the contract value imagine you went to your customer and offered a 10 discount so basically 15 grand off of the 150 to collect it all today so that's the blue bar there 135 000. the gray bar is the mrr that you'd be

collecting or accruing on your financial statements over a three year period those are accrual numbers those are not cash flow you can see that there's no other blue bars that come in the future scenario two in this scenario the ACV is still 50 000 but it steps from forty thousand to fifty thousand to sixty thousand and years one two and three so you can see the mrr bar slightly steps up in each of those years

so let's compare these two contracts side by side and look at a couple metrics so you can see as as you may recall uh contract one uh has a 10 discount on it so the year one cash flow is 135 000. your two cash flow zero dollars your three cash flow zero dollars and the MRI stays constant at 3 700. contract two forty fifty sixty three thousand four thousand five thousand so if we're looking looking at the the

contracts the cash flow on day one metric I'm sure you guys can do the math on the year one cash flow it's much higher in contract one first contract two total cash collected add up all the cash flow and you can see contract two's higher because it doesn't have that discount mrr growth you can see because of those step UPS you're benefiting from just time going on and maintaining that relationship and it translates into the next one net dollar retention so

basically of an automatic ndr metric built into your contract structure I think gross margins who who's felt the the pain of inflation over the last little bit you can actually you can actually handle an increasing cost of goods sold because you're collecting more cash over the term of those three years and you're not as susceptible to margin erosion so long story short the key takeaways here are the multi-year contract could

be incredibly helpful in the early days obviously as you're trying to find product Market fit you need cash you need to experiment you need to do a whole bunch of things but the sooner you can get into multiple uh annual paid contracts hopefully with an embedded growth mechanism uh the better you'll be and as I said it's a cheat code for ndr ndr is a big driver in value evaluation so it should be something that you should be thinking about and the third one

you were you're raising Capital to fund payroll payroll is going to happen every two weeks if you collect all the cash today and you can't rely on future cash flow you need to to either be you're taking more risk in your business so cash is King okay lesson two bad accounts receivable and what to do about it so in this scenario let's all let's all put on put on our Founders hats take off the one that

we're that you're managing right now and put on a new one let's say you want to sell this business you got 1.4 million in there are your growth rate's 53 14 cash flow margin and a rule of 40 is 67 pretty healthy business rule of 40 is the the cash flow margin plus the growth rate what kind of multiple do you think this business would sell for on micro acquire which I'm sure some of you have dabbled in maybe five maybe six x

really good metrics there's cash flow on day one maybe there's there's growth potential obviously it's growing let's take a quick look at a report that you may not look at as often your accounts receivable aging report which basically buckets the amount of overdue receivables over different time periods so as you can see from the customer names Tesla and Peloton are not willing to pay their bills

there's 205 000 in that that last bucket that's at risk of getting written off on your accounting statements which impacts Revenue it impacts everything so now let's look at your metrics again let's assume that 205 000 is annual licenses so it's going to impact your AR so let's take 200 000 off of the 1.4 million we're down to 1.2 million your growth rate drops I'm sure some of you

no none of you are doing calculations on your page the code three drops to about 30 percent your cash flow margin hits zero because the the basically the 200 000 that you see there that is basically eroded your whole cash flow margin and your rule of 40 drops to below 40 to around 30 percent all of them go down if this if this were to happen and your multiple that you're looking to

exit at probably just cut in half at least so not only is your AR part of your your valuation metric error decreased your multiple on that has also decreased so how do we prevent that your customers make sure they have the the ability to pay obviously that's that should be part of your qualifications and still a close and collect culture this was a lesson uh one of one of the

one of the founder path Founders uh basically said you we don't pay commission until cash is in the bank if they send cash to the wrong place I still don't pay their commission I want it in my bank account before you get paid so a closing collect culture on the sales team and the third one be proactive don't let it get to that 90-day bucket get on get on the phone figure out what the issue is get your bills paid

lesson three why Network capital is good for your health your balance sheet health so let's start with a story here so who here has heard of commercial paper it is a product used by public companies it's an unsecured debt product that rolls over every 30 days it's cheap it's flexible it's unsecured it's a great product

investors like it because the duration is very short what could go wrong this short-term debt product in good markets is amazing but in bad markets it basically becomes a bank run so in 2008 the commercial paper Market there's a 65 billion dollar money market fund that took a billion dollar write down on Lehman Brothers commercial paper that triggered a bank

run and because Lehman Brothers did not have time to meet the maturity that led to their eventual bankruptcy so why why do you why why did I bring up this story to a bunch of SAS people and also what is networking Capital so let's start there let's define networking Capital so it's your current assets minus your current liabilities you might remember this from your high school accounting class if you took that but I make some adjustments to it for SAS businesses

so as we learned the last lesson accounts receivable over 90 days should probably be ignored inventory it's hard to liquidate on short notice if you need to meet a payroll cycle and prepaid expenses those are things you've already paid for the cash is already gone you're just marking it because it's a future expense so on the current asset side I'd only include cash and accounts receivable on the liabilities side

payables crude expenses credit cards short-term debt deferred revenue I also ignore for high margin SAS business because the only liability portion of this is your cost of goods sold so let's say you have 80 margins you should if you want to up to you multiply your deferred revenue buy your cost of goods sold so that 20 percent and that's your actual liability component to that line item so what can you do with the networking

capital you can calculate Runway who here looks in their their bank account to determine the numerator in their Runway calculation who does that you're brave that's great thank you thanks for sharing um there there's actually there's actually a downside to purely looking at cash for your Runway and it's you're ignoring your short-term liabilities that very materially impact your

liquidity so let's look at this side by side cash was not King Network capital is if you take on a short-term debt your current liabilities go up more than your cash does so if you're looking at your bank account you think your Runway got got longer but if you're using networking Capital to calculate Runway it actually got shorter so in the other example if you take let's say a 24 month deal so half of its current half of it's long

you've created networking Capital that you can then use to extend your Runway or invest in growth okay so some key lessons here so look at both cash and networking Capital when thinking about your Runway be careful with short-term debts if you're planning to use the capital for growth because your network Capital actually goes down and spend time with your balance sheet each each month to see how your accounts are trending

okay so Lesson Four here last one we're going to do another exercise think about we're gonna we're gonna we're gonna put that cap back on let's make some Capital allocation decisions and then look at a framework that you can use to make Capital decisions in the future so here's example one your use of proceeds our marketing program with a return on ad spend of 1.5 x so that basically means you put a dollar into a

marketing channel and this month you get a dollar fifty back so this is an incredible metric you should use debt for this because it's predictable it's short term and know what use credit cards use short-term debt that's totally fine this is this is a great use of of debt uh it's predictable and if you use equity you're just making your investors rich as a Founder you should make yourself rich

use debt for for if that's your metric second one cash is tight and you're worried about next payroll I put this in the bucket of bad use of debt Equity Capital should be used if you're in a situation where you feel like you're sort of backed into a corner and you've sort of missed used capital in the past to put yourself in that position using debt should be used to feel growth

not fill gaps in your funding third one hire a sales rep with a ramp time of six months that can reliably produce 500 000 error per year that's a great hire you should be doing that as much as possible as a Founder you're you're earning a multiple on that 500k per year you want to accelerate growth you want to create Equity value hire that person and actually this is a good use of debt if you have a program where you can

reliably depend on that time but be very cautious about the type of capital you use you want the duration of your Capital to be longer than the ramp time for a higher like this so long longer term debt would be better for a sales rep with this ramp time and the last one an engineer hire to work on a new complementary product

hopefully you guys can guess you don't know the ROI on this it may take years but it could be a many multiples of of the money you invest so this could be either you just need time to discover what your return profile is on this investment and it it should really be very long-term debt convertible saves Equity or profits it you're you're investing in a complimentary product there already is a

cash flow stream and a revenue base that you can rely on ensure that you're using that ARR to invest in things like this with a portion of those those uh that that those profits that you create so this is probably the the best slide for you to take a photo of if if you're if you're interested in sort of the framework of it you can see across the top it's different Capital products that you can that you can tap into as a SAS founder

to fund your business so you'll see credit cards short-term debt long-term debt and Equity slash retained earnings the retained earnings part is profits from your current businesses and then across the bottom user proceeds marketing spend go to market and product um what this is trying to tell you is don't use credit cards to hire Engineers because you're asking for trouble and you probably don't even you don't need

Equity to invest in marketing spend try and line things up and you can also invest across your your business by raising Capital across different sources so the world is your oyster this is this is sort of the business that you're building you're going to decide how how to invest it and here's here's a good guide for you to uh for you to raise capital so you're the you're the takeaways

you're not you it's not debt or Equity it's debt and equity um manage risk cross obviously try and try not to if anything go longer duration on your capital and shorter duration on your use of proceeds not the other way around and create buffer in your plan part of the value of your business is the option set that you have if you are so constrained because you've spent all your money that you don't have

options like hiring people when others are laying off making Acquisitions when others are shutting down uh you're you're leaving Equity value on the table because that option value has value and a couple final takeaways so you're you as a Founder your top job is to mitigate risk every risk that you eliminate from your business increases the value that an investor should be willing to pay because they're taking less risk at that

point bootstrapping requires patience maybe you need to hold off on making that CFO higher if you want to go bootstrapped that's a very valid way to do things you don't need to move fast as a bootstrapper the whole point is to hold on to the whole pie and be the one at the end or or down down the line holding on to it and double down on small experiments um

capital is is is your key constraint be very be very very protective of it and um but once you see an experiment starting to pay off that's when you raise Capital that's when you double down that's where your Equity value actually accelerates um so so double down on your small experiments and that's it from me these are the four lessons

the downside of multi-year contracts keep a close eye on your receivables maybe include Network capital in one of the metrics you track and think about think about the source and uses of your Capital as your as you're allocating across your business that's it thanks so much give it up to Kevin who's leading Finance at founder path thanks Kevin