Q: When performing diligence on a new investment I will dig through management’s projections. Even though I am a finance guy I try to understand the costs associated with the software development.  Probably needless to say, I have been burned by cost overruns quite a few times.  The Companies burn through our cash on development and don’t have enough left over to actually run the business.  Do you have any suggestions (for both managements and investors) on how to better budget for these costs.

A: (Brad) I’m going to assume you are talking about an early stage company (pre-product, pre-revenue.)  As someone who has been involved in creating a number of software products, they always take longer and cost more than budgeted.  In addition, the revenue ramp almost always starts later than planned and isn’t as steep as expected.

I have come to simply not believe any early stage projections.  Rather than worry about financial model, I use a zero-revenue based budgeting approach to figure out the appropriate staffing level / burn rate for a company at different phases of development.  Early on, I encourage the entrepreneur to manage his spending so that he has enough time to get to the next “value point” in the business (whatever “value point” means – it’s different from company to company – but it usually means the next time at which you can logically raise more money.)

At some point revenue starts to happen.  Or a bigger financing is raised.  In either case, spending can be increased, but in a measured way to get to the next value point. 

The biggest mistake I see is adhering to the entire budget assuming a revenue ramp.  Early stage companies have complete control over their spending; they have very little control over their revenue.  Most companies I’ve worked with have no trouble making their expense plan.  These same companies almost never make their revenue plan in the early days of a company.  So – manage the expense / cash side of the equation and lag your increase in spending behind the actual revenue generated.

Don’t forget to focus on gross margin.  If you have a pure software product, $1 of revenue is almost $1 of incremental cash you have to spend.  However, if your real gross margin is only 50% (because of services, cost of sales, equipment, installation, hosting), you only have an incremental $0.50 to spend for each $1m of revenue.