The Annual Plan
Revisit the Vision and Prioritize Initiatives before building a Financial Model.
(This post is a follow-on to the thoughts expressed in An Improved Strategic Planning Process, which I wrote in late October 2020.)
Each year, from mid-Q4 through the end of January of the following year, business leaders are involved with building and securing Board of Directors approval for the 2021 budget.
As I publish this post, many companies are just finalizing their 2021 budgets and writing up presentations for budget approval at the upcoming Board meeting.
I have seen countless budgeting exercises and want to offer a few thoughts based on my experiences.
Finance Should Follow not Lead.
Frequently, the CEO requests that the Finance leader create a “first cut” of the annual plan.
This first cut is often based on high-level financial goals. These “goals” are either communicated by the investor representatives on the Board to the CEO or based on the CEO’s expectations of what investors would like to see. Usually, these financial goals involve two components – a minimum hurdle and a constraint.
1. The Minimum Hurdle: Revenue growth (year over year) is the minimum hurdle. Quite often the expectation is for 100%+ growth or at least >50% growth.
2. The Constraint: Burn Rate (or negative free cash flow). The expectation is that the business “burns” less than $X00,000 per month (on average across the year). Or, if the cash balance is low, the mandate is to ensure that the current cash balance lasts for at least Y additional months.
This first cut request is viewed as way to shorten the planning process and avoid spending days in meetings. I am a huge fan of limiting meeting lengths or avoiding them altogether whenever possible. One exception to that rule is during the annual planning process.
Taking a short-cut in annual planning by having the finance team create a plan without a strategic priority discussion and shared buy-in from all functional leaders is a big mistake.
Annual Plans Should Reflect the Vision not Financial Goals.
The perils of the Finance team leading the planning process driven by financial goals are numerous including:
1. Lack of Ownership: When things don’t go according to plan (as is the norm in innovative, fast-growing businesses), the other functional leaders will often claim (not surprisingly) that they did not create nor buy-into the budget created by Finance.
2. “Lies, Damn Lies and Statistics”: This saying acknowledges that numbers can be massaged (by a capable finance leader) to say almost anything. A plan built upon financial constraints requires the finance team to force fit assumptions to create desired outcomes, and then make a case for why this plan represents a believable and likely future outcome.
3. No Framework for Making Decisions when Prioritization is Necessary: Target financial goals don’t offer any shared heuristic for making decisions when it is necessary to choose between different two initiatives or in selecting the optimal path (including trade-offs) to achieve a specific outcome.
4. A Destination rather than a Map for the Journey: Financial metrics or goals (such as revenue growth and free cash flow) are output metrics. They let you know the destination a business wishes to reach (in the next 12 months). They are markers to gauge when you have reached the destination. Financial goals offer no guidance on how to get there.
5. Gaming the Outcome: Researchers have noted a phenomenon that is generalized as Goodhart’s law: “When a measure becomes a target, it ceases to be a good measure.” An oft-cited example is the negative impact of focusing on test scores as a proxy for the quality of education in schools. When this happens, teachers teach to the test rather than focusing on actual education. The primacy of “financial goals” in business is subject to the same “gaming.”
An Alternate Path Forward.
If you are asked by the CEO to choreograph the annual planning process (as many finance leaders are), I would suggest the following.
As a kick-off to the planning meetings, ask the CEO to present to and discuss with the Leadership team the following:
1. The Vision for the Business. Where do they want the company to be in three to five years? The CEO often believes that everyone knows the vision and that a discussion might be a waste of time. CEOs need to remember that they live and breathe the vision while almost no one else does, not even other C-Level leaders. Starting by reiterating the vision is a great use of time in the planning process.
2. Learnings from the Past Year. Provide anecdotal and quantitative feedback from prospects, customers, competitors, and investors. Have the CEO discuss elements of the feedback that have further strengthened their belief in the vision. Ask the CEO to highlight items that have led to modifying parts of the vision. In business as in life there is no shame in modifying a vision and learning from “failure”. I like John Wooden’s quote: “Failure isn’t fatal, but failure to change might be.”
3. A North Star Metric. Have the CEO lead a discussion on the North Start metric. Popularized by the growth hacking movement at highly successful B2C tech companies (e.g., Facebook, Uber, Airbnb etc.), a North Star metric is a single metric that best reflects how value is experienced by customers. It is almost always an engagement metric and is a leading indicator which can be directly influenced. Optimizing for the North Star metric should lead to increased customer satisfaction and financial business success.
This entire first phase of a planning process ought to focus on customers, their problems, and potential solutions. It should steer clear of expected company financial performance.
Next Turn to Prioritization.
The “vision” for a rapidly growing business is bold. Or as Jim Collins said in Built to Last, realizing the vision necessitates a BHAG (“Big Hairy Audacious Goal”.)
BHAGs may take years to realize. Thus, prioritization is critical. Before building an excel model, the Leadership Team needs to agree on the priorities for the coming year as well as the sequence in which things must be done.
There are two categories of priorities:
1. New Initiatives: Things not done before such as entering new markets (geographies), launching new channels, or introducing new products.
2. Supercharging Existing Initiatives: This encompasses planning for “more of” and/or “more efficiently doing” things that have been done before.
Being focused on choosing priorities is challenging. It requires the admission that the business cannot do everything it would like to in the next year.
Do not take on too many priorities. Focus instead on the big ones that will really matter to customers or substantially expand your addressable market.
I find Steve Jobs statement at the 1997 Apple Worldwide Developers Conference, worthy of repeating here: “Focusing is about saying ‘no’. You’ve got to say ‘no, no and no’ and when you say ‘no’ you piss off people.”
Priorities will inform the revenue projections for the coming year.
The role of the Finance leader in the prioritization phase is to ensure that everyone has reached agreement and is committed to the priorities that have been agreed on. Most CEOs will push for more priorities to be adopted or more to be accomplished in a year. The Finance leader needs to ensure that commitments agreed in this phase are achievable whilst skewing towards being a tad aggressive.
Only Now Begin Modelling.
1. Provide Some Guidance to Functional Leaders. My experience with asking department heads to specify “what they need” leads to an inefficient process with a highly bloated expense envelope in v1 of the plan. Instead, offer some general guidance, based on the strategic priorities previously agreed along with targets for spending increases or decreases in certain areas.
2. Start with Last Year’s Spend. Assuming actual data exists from the prior year, start by presenting the data for the prior year for each department to the respective functional leader. Let them know to present justification if they anticipate diverging materially in the coming year from the existing spend envelope.
3. Focus on the big things. Pay attention to the most important expense categories. Small changes in these areas will have a much greater impact than any change in a small category.
4. Use the Same Expense Format for Each Function. Categorize expenses in the same manner for each function, to make reporting and categorization in the financial system as easy as possible. Clearly some functions may have additional items in their budgets such as program spend for Marketing or corporate insurance spend in Finance.
5. Have a “Cushion” in the Budget. Every budget I have been responsible for has omitted certain future spend by mistake. That mistake will likely plague all budgets. Most finance leaders want to have a “cushion” in their forecast to cover both “forgotten” or “unbudgeted” expenses as well as to offset revenue shortfalls. My preference is to have specific target assumption driving all department spend, and then separately budgeting the “cushion” (e.g., a % of revenue or of spend) within the Finance or Executive team budget.
6. Benchmark your Forecast. When presenting the forecast internally (and particularly for Board approval) know how your business forecast metrics for the coming year compare against the median and top quartile companies with similar business models and ideally at a similar stage or scale. Benchmarks will help inform you when model outputs are risky or unlikely to be realized.
Looking back to 12 months ago, none of us could have imagined how things have unfolded with the COVID pandemic. Anticipate that the future will be quite different from your expectations, and actual performance may not meet the plan. However, paraphrasing both Churchill and Eisenhower, I strong believe that while “Plans are useless. Planning is essential.”
A thoughtful annual planning process which progresses from VISION to PRIORITIES to BUDGET MODEL can ensure the business is better prepared to meet the challenges of the coming year.