Financial Models for Underachievers: Two Years of the Real Numbers of a Startup

My buddy at Redfin, Glenn Kelman, decided he wanted to bare his financial soul so that other entrepreneurs could get greater insight into the witchcraft called financial modeling. In this two-part posting, he reveals his numbers and his lessons. They are eye-opening for most entrepreneurs.

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Part I: Numbers

Startups face one primary challenge: To never run out of cash. So when projecting costs, we heeded Guy’s advice that “the three most powerful words you can utter at a board meeting are, ‘We beat projections.’” This convinced us to develop the worst possible financial model that could still be used to raise money.

We’re glad we did. True underachievers, we’ve performed at or just a bit better than this worst-possible plan almost every month, raising revenue projections only when forced to in December 2006. We’ve been able to stick to our plan mostly because absurd assumptions in opposite directions cancelled one another out. As the real estate market tanks, we may not be so lucky in the future.

When first putting together our financial model, we looked online to calibrate spending assumptions. So many people have blown venture capital, we thought, there must be a manual somewhere on how to do it, at what rate, avoiding which follies. We couldn’t find anything. So we took some wild guesses and figured we’d see how they turned out. And now two years later to the day that we built our first model, here are the projections and actual results. Hopefully, you can learn from our experiences.

Rent, Per Employee, Per Month

Redfin Model: $250. Actual Redfin Cost (Last Month): $336

Our actual costs are high because we just moved last month into an office with room to grow, which seems to happen every eighteen months. When people were sitting in hallways at the old space, we were paying about $200 per employee, per month. Class B space on well-traveled mass transit lines is roughly $20 per square foot per year in Seattle, $30 in the Bay Area. You need 165-200 square feet per person or more.

At the extremes, Adobe supposedly allocates 435 square feet per person while Yahoo! allocates 220 square feet per person. The startup cult of cramming people into small spaces is counter-productive: people are what’s really expensive, not space. The cost Redfin really didn’t anticipate was for tenant improvements which you mostly have to fund yourself when signing sub-three-year leases. In September, we spent more than $100,000 to add private offices for our engineers on the hope that our current office will last us longer. It was probably too much money.

Initial Per-Employee Equipment Cost

Redfin Model: $6,500. Actual Redfin Cost: $5,700

Computers, 20” monitors, Ikea desk, decent chair, VOIP telephone, and cell phones for field employees. Our first phone system came from Craigslist, and we had to upgrade after a year.

Monthly Benefits, Per-Employee

Redfin Model: $600. Actual Redfin Cost: $471

Redfin benefits are competitive, but many employees are Seattle-based. Costs are 10% higher in California.

Annual Payroll Tax

Redfin Model: 12.5%. Actual Cost: 8.5%

We added 4% here to our plan, just to pad per-employee costs. In ways you can’t anticipate, people cost money. Payroll taxes are the same nationwide. California’s state payroll tax is, for example, negligible.

Quarterly Bonus Payout, as a % of the Total Possible

Redfin Model: 85%. Actual Cost: ~85%

We pay quarterly bonuses, mostly based on customer satisfaction objectives. Maintaining discipline on bonus payouts has been difficult. When business booms, everyone wants to be paid for it, even if you haven’t yet turned a profit.

Annual Payroll Increase for Existing Employees

Redfin Model: 6%. Actual Cost: ——-

We can’t disclose actual costs here, but they were higher than planned. When we set the plan, many employees were being paid below-market rates, which is not uncommon for startups; as a startup raises more capital and people go into their second year of sucking it up, you have to pay the piper at the employees’ annual review.

Percentage of Candidates for Which Redfin Paid a Recruiting Fee

Redfin Model: 35%. Actual Percentage: 20%

If you can’t build an engineering team through your own network, recruiting fees can become a significant expense at an early stage. Most of the folks Redfin paid a recruiting fee to hire still came through our own employees who got a $2,000 bonus for every recruit they bring on board.

I assumed colleagues would encourage friends to apply to Redfin without a fee, but for $2,000, people start nagging their cousin’s friend’s wife to apply. We saw an immediate increase in candidates. The occasional party, done on the cheap with kegs and pizza, has also worked well for us.

For Employees Recruited for a Fee, the Recruiting Fee as Percentage of Annual Salary

Redfin Model: 20%. Actual Cost: 4.5%

Because we want top-of-the-stack candidates, we do pay 20% to professional headhunters, but most recruits only required a $2,000 employee referral bonus. We’ve also experimented with in-house recruiters working on an hourly wage, but they tend to focus on managing the hiring process rather than adding candidates to the pipeline.

What really wrecks the budget is a retained search for executives ($30,000 - $50,000), a cost we didn’t even include in our calculations above. A retained search as an agreement to work exclusively with one search firm is reasonable, but we recommend negotiating aggressively to defer most payment until placement.

Incremental Amount Paid to Contractors, as Percentage of Payroll

Redfin Model: 5%. Actual Redfin Costs: 3%

Our contractors have mostly been an in-house recruiter, a graphic designer, and a web programmer; no big-shot consultants.

Monthly Travel Costs, Per Field Employee

Redfin Model: $300. Actual Redfin Costs: $369

The $369 includes mileage for field agents who drive clients to listings as well as travel between our San Francisco and Seattle engineering offices. Your costs may be lower. Or not: on the road, some of us still stay with friends.

Monthly Telephone Costs per Field Employee

Redfin Model: $125. Actual Redfin Costs: $261

We’ve started equipping real estate agents with cellular modems, so costs are unusually high here, too.

Monthly Legal Costs

Redfin Model: $12,500. Actual Redfin Costs: $9,406

The $9,406 per month excludes legal costs for a round of financing, usually about $50,000 for company counsel and investors’ counsel (more late stage, less early stage). We have saved money by dividing the monthly work between a more-expensive tech-focused firm (Orrick, very good) for board resolutions, minutes and stock administration and a general corporate practice (Lasher, also quite good) for employment and real estate law.

We also handle on our own most of the repetitive paperwork like option grants and, perhaps unwisely, vendor contracts. We don’t spend much on patents. Incidentally, we pay a service $14,000 per year to set a quarterly price for our stock options. This is a cost that we didn’t anticipate and didn’t project as part of our legal costs.

Annual Accounting Costs

Redfin Model: $45,000. Actual Redfin Costs: $32,912

Once you’ve raised money, your investors will want a year-end audit of financial statements. This can be done for less money when the business is small and if you keep your books in good order, but we commissioned our first audit only after Redfin had generated over $1 million in revenues. Your accounting expenses will also be a bit higher (and your payroll significantly lower) if you can hire a book-keeper to come in twice a month to pay your bills, which makes sense for the first year or two until you need someone permanent.

All-Company Meeting Cost, Per-Meeting, Per-Employee

Redfin Model: $350. Actual Redfin Cost: $560

Almost half of Redfin works outside of Seattle, so our meeting costs are unusually high. But we can't avoid meeting at least once a year, which is a significant expense that we forgot to plan for in our original model.

There are of course all sorts of other costs that are unique to our business as an online real estate broker: how much we spend to attract a home-buyer to our site, for example, or what it costs to sell a listing. What you see here are just the costs common to every startup.

And now, looking this over, I worry at every turn that we've spent too much money. When I first worked at a venture-backed company, someone told me that Sequoia liked to see entrepreneurs "dive in the toilet for nickels." I'm not even sure that's true, but it was an image that always stayed with me. At the time it was actually comforting. I couldn't do anything else right but, thinking about the toilet and the nickels, I said to myself, "This, I can do."

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Part II: Lessons

Here are a few other tips for building a financial model:

1. Focus on headcount. Outside of marketing programs, the basis for all cost in Internet software is headcount. Just figure out whom you'll hire and how much you'll pay and you can't go far wrong.

2. Plan slow, run fast. The most likely scenario is that you won't be able to hire engineers fast enough, and that revenues will come more slowly too. Investors expect their money to drive artificially accelerated growth rates, but signing up for that sometimes just blows a company up before you've had a chance to figure everything out. At least in the financial model, give yourself as much time to grow as you can.

3. Run top-down sanity-checks. To estimate what a company is likely to spend each year, try doubling the average salary and multiplying it by the number of employees. A 100-person company might spend as much as $15 million per year.

4. Forget economies of scale. The biggest whopper is that a business will magically become more efficient as it grows. If you really believe this, just walk into the headquarters of Amazon or eBay. Bureaucracies grow. Salaries float away. Straining to make a model work, I always forget that per-employee costs rise every year.

5. Admit that revenues are a mystery. If you don't have any revenues yet, you can't say what they'll be. The point of a model is to prove you can make money if people buy your product, not to insist that they will. By developing different scenarios based on different levels of demand, you can later calibrate hiring and spending according to which scenario fits reality best.

6. Build from building blocks. Nearly every model is the sum of smaller units. In Redfin's case, our unit is a market like the San Diego real estate market, which we plan to grow to a certain size in a certain number of months, hopefully returning a certain amount of profit to the overall business. We can then gauge whether the model works by just looking at whether San Diego works, and then asking, "Now what if we had twenty San Diegos?" For another company, it may be a user-created website, with so many page-views and so many ads, or it may be the productivity of a single salesperson, with a million dollars in quota per year.

7. Take out "hope." Think about what is most likely to happen, so that a bookie would say you're as likely to out-perform the plan as under-perform it. Generally speaking, "hope" is not a strategy.

8. Flag your assumptions. Rather than burying your assumptions in Excel formulae, call them out in a separate tab of the workbook, so that you have a control panel for adjusting the model. This is especially important if you plan to share your model with potential investors.

9. Hit $100 million in revenues within five years. The premise of most venture investments is the possibility of generating ten-fold returns in five to seven years, which is hard to do if you spend $5 million to build a $25 million company.

10. Keep market-share under 20%. Most startups reach a jillion in projected revenues by assuming that the business grows by leaps and bounds for five years. Since there's a natural limit on growth, be ready for the question: "What would your market-share be in year five?" If it's over 20%, take the jillion-dollar projection down a notch. Even a hit like iPod doesn't have 20% market-share. You'll be lucky to come close to 20% of any market.

So these are our costs, and that's our advice. What's your take? We'd love to see how our costs compare to other startups'; please leave a comment and let us know where your numbers differ from ours, especially in markets outside the U.S. We could also post a sanitized version of our financial model, if enough people ask for it to make it worth the trouble.

(Thanks to Redfin's Chris Roske, Chris Neitzert, Matt Goyer and Angela Cough for their help with the numbers in this post.)

Comments

[Bas Brouwer]

Dear Glen,

What you did today is amazing.

This is what business students and upcoming entrepreneurs all over the world are craving for: REAL numbers, examples, practical stuff.

If you could go through the trouble and post the financial model, I'll be a very (!) happy student.

- Bas

[Brian Brady]

I'm pleasantly shocked, Glenn. Yesterday, a request for advice from Greg Swann, today a transparent plea for advice.

Here's my take. Stop thinking of revenue as an unknown. once you've established a pricing plan that can realistically be profitable, offer your services to HR departments of corporations as an employee benefit. Gather their databases and start mining them.

Gary Keller taught us that a database of "mets", meaning people with whom you have SOME relationship, can produce one transaction for every 12 people. You can get those "mets" from the employee rosters from the companies with whom you have a relationship.

Hire a "sales person" (I know that sound ugly to you but try it) to establish those corporate accounts (call him/her an account executive if you must).

You'll get more transactions from serving a wide audience of "mets" rather than trolling for hits on a website. It's time to go beyond 2.0 strategies and incorporate traditional marketing into your mix.

Reference:
http://www.bloodhoundrealty.com/BloodhoundBlog/?p=1896

[Darren Herman]

This is a fantastic transparent post. Not many companies reveal their information, so it's great to have a benchmark.

[Chris G]

The hardest part of modeling is always (at least for me) calibrating the assumptions. It was very useful to see these benchmarks, as well as you discussion as how they compared to initial estimates.

Please add me to the list of people interested in seeing the sanitized full model.

[Glenn Kelman]

Dear Troll,

You're right that it's hard to be realistic and still generate the kinds of returns venture capitalists' expect for their best investments. For Redfin, the "worst possible financial model that we could use to raise money" was one that:
1. Could reach break-even before we exhausted the current round of capital.
2. Could scale to more than $100 million in revenues four - five years from now, so that the company could reach a size where a public offering would be worthwhile. An acquisition is also possible, but unlikely and probably unwelcome in Redfin's case, and certainly not within our control.
3. Could over time generate a healthy operating margin, so that the price of Redfin stock on a public market would be a healthy multiple of revenues.
4. Could be met or exceeded by Redfin without our having to imagine a magical transformation in our business.

#1 - #3 is the rock and #4 is the hard place. It drives us to keep taking risks rather than trying to consolidate the small gains we have already made.

Incidentally, from a venture capitalist's perspective, ZipRealty has not yet been an unqualified success; the company has an enterprise value of roughly $60 million on revenues of roughly $100 million. We had to spend plenty of time in money-raising meetings explaining why we hoped to be able to scale revenues more easily than Zip, at higher margins.

This is obviously an ambitious goal, as Zip has been far more successful than we have, but it is our goal nonetheless. We are all painfully aware of the odds.

[John]

Hi Glenn - thanks for taking the time to share this information. Chalk me up for another reader interested in a sanitized model.

Cheers.

[Lorenz Sell]

Glenn, this was an _awesome_ post. We're going out to raise our second round right now, and I wanted to update our projections. There are hardly any real world data or models available online. You'd figure all those failed startups out there would post their models as an act of helping others avoid their fate.

I would really like to see your sanitized projections. That would really help. Would you mind sharing the executive summary that you used to initially pitch the company?

Thank you so much.

[Blake]

Guy,
I loved your blog in the beginning and then it started to get watered down, like you forgot what the title of it was. This post is very interesting, helpful, and just might make the world a better place by making expectations more realistic and comprehensive.

[troll]

Great stuff Glenn.

Although I gotta say, I love the contradictory guidance that always comes with the venture process:

1. Aim low, so you can beat your numbers
2. Don't aim for more than 20% of the market
3. Admit that revenues are a mystery
4. Project $100mil in revenue in 5 years

C'mon Glenn, do you really stand up in front of venture guys and commit that Redfin is going to do $100million three years from now? Your most direct comp is Zip (by most measures very well executed). They hit $60mil in 5 years. Those were real estate boom years.

It's funny too because in my experience the advice is absolutely sound. You can't get their attention with a lesser ambition. While I can cite a handful of firms that have actually hit that number, there are thousands that get funded.

I find that I'm not creative enough to sound confident on that lie. So here I sit, bemused and bootstrapped (and not at all bitter, seriously).

[Thomas]

Wow Guy, I can't believe that you're advocating financial modeling!?! That sounds like business planning and we all know how much value that has, right?

[Lance]

Indeed, it always costs 2-3 times as much as budgeted and takes twice as long to accomplish your goals. Why you ask? Well, due to insane and over regulation. Too many lawyers scraping the cream. Too many other professional parasites and too many barriers to entry set up as trip wires in your path. Nevertheless, if you are not in it to win it and willing to say "damn the torpedoes" then perhaps you shouldn't be in business anyway.

Weakness, procrastination, hestitation, bureaucracy, and too many lazy friends in your company will accelerate your burn rate and run your rear out of money. Play to win or stay on the porch, start-ups are not for the weak. Live strong, Live Well and Live Longest - Lance

[Greg Solovyev]

Truly, the most useful blog post I read this year! Bookmarking it.

[James]

This is one of the most useful posts I've read in a long time - thanks Glenn!

I'll definitely add my vote for a sanitized version of your model. I think this would be useful for countless entrepreneurs.

[Jason Cardillo]

Glenn - great post and very informative. Like David, we're also currently working on a new project and it's interesting to see that some of the projections I had are right on, but others simply way off base. Count me in with those requesting a sanitized model.

Thanks!

[Bill Smith]

Thank you for sharing those numbers. It's good data.

[Tim]

Glenn,

Excellent post. So many entreprenuers 'fly the plane into the ground' when they encounter unexpected 'weather' - often feeling investor pressure to follow the plan that was sold. You provide some great tips for better flight planning as well as the sound advice to simply look out the window and react before entering a tailspin.

Our biggest execution challenge has always proven to be following through with our marketing budget. When sales don't come as quickly as we anticipated in a new market, we have tended to jumped ship on planned marketing spending and instead re-work the product itself.

Crazy as that sounds, I look back and think it was a wise decision the majority of time, at least for us. We had learned enough to be 'mostly sure' things were not going to be as rosy as we thought, and the saved money helped try the next strategy.

Thanks again for sharing your thoughts.

[Doug]

This is really great. Thanks for posting.

[marvin]

Hey Glenn,

This is great ! I can't tell you how frustrating it is to create financial models for a startup. Let me be one of the people to request a sanitized version of your model.

Thanks!

[Maki Papadopoulos]

Very informative! Thanks, Maki Papadopoulos

[David Jones]

Glenn, great info and timely as well; we're in the process of creating projections for a new product. I'd love to see that model as well - we've been using a format from PWC from several years back that has the assumptions pulled out in a "dashboard" as you recommend and it's been very helpful, but real world references like you've provided here are invaluable.

Thanks.

[Mario]

Hey Guy,

Wonderful post!

I would add another fact on business life:

Once we are getting some attention the business moves on and the cost rise to double every X months.

This would be the Moore's Law to Software Business.

Mario Ruiz
www.oursheet.com

[Al Sargent]

Thanks for a great post! Very helpful.

[Glenn Kelman]

Hey Adam, you're right; the iPod was the wrong example. The data I looked at bogus-ly included cell phones that play music.

Joshua, if others ask for the model we'll clean it up, otherwise I may just end up mailing it to you. On revenue, our conversion rate is unusually bad, probably because it's such a big leap to buy a house through a website.

[Cameron Watters]

"Even a hit like iPod doesn't have 20% market-share."

I'm not sure how "the market" is being defined in this statement, but I'm pretty sure the iPod has much greater than 20% market share. Even if you use numbers that haven't been tweaked by Apple, iPod market share is in excess of 50% for similarly functioning devices.

[Joshua McKenty]

Been endlessly impressed with your radical transparency at Redfin, and I would KILL to see that model. I've had one VC tell me our project isn't fundable because I made the estimates TOO conservative, so it's good to hear that $100-million-gross-at-year-five confirmed.

Speaking of revenue, the key driver of that for any internet business seems to be a.) traffic, and b.) conversion ratio. Any hints in that regard?