Why An Approved Budget Does Not Equal Control

Do you think approving a budget means you have control? Think again. Budgets do not equal control. Especially in a startup.

Startup investors, especially venture capitalists, want assurances that their investment will be used appropriately to build value in the startup concept they invested in. This desire manifests in various ways ranging from seats on the Board of Directors to control/reporting provisions in the investment documents. A typical control provision is approving an annual budget and providing periodic financial reports. All of this is quite reasonable and reflects generally accepted business practices. Let me state, for the record, that I am NOT suggesting in this blog that we do away with budgets, financial reporting, or Board of Directors/investor oversight. However, I want to point out that these control mechanisms are largely illusory, and what is really important is building trust. 

Let me illustrate with a true story. Once upon a time, I was CEO of a startup company, and I had a board chairperson who kept wanting to focus on the budget. What was usually an annual ritual over a few weeks was turning into an every Board meeting focus, with variations from the approved budget being examined at an excruciating level of detail. Months out, the Chair began focusing a great deal of the Board’s energy and cycles discussing the next annual budget, setting up a multi-meeting approval process, and generally giving the process far more weight and specificity than is typical. For a while, I went along. It just did not seem that important to me. Annual budgets are a yearly ritual based on the best information that the startup management team can muster at the time. Yet, startups are so dynamic and fast-moving that it quickly becomes dated as the team pounces on opportunities, trims some costs here, invests in solving the next critical emerging problem, and generally learns more every day. If a startup is capitalizing on its most significant advantages (speed and agility), then the annual budget process that works well in a steady-state large business is just not responsive enough.

In contrast, my practice is to set and approve an annual budget based on the best information available at the time, and then update our financial model every month with a new forward-looking financial forecast that reflects the latest and most complete information we have at the time. Then we report actuals against both the annual budget (that eventually will be 11 months old) and against the forecasts we made in the prior month. Practically, because it is dynamic, I find that my Board members end up focusing on how the forecast looks because it reflects the most up-to-date synthesized information, with little attention paid to the annual budget, which just grows increasingly out of date as the startup adapts to changing conditions, lessons learned, and other changes.

Let’s get back to my story. Finally, I recognized that my Chair must have some need that was not being met. No other explanation made sense for this behavior pattern. I asked for a meeting to attempt to uncover what was going on. I asked what they were trying to accomplish with all this energy being poured into the annual budget.  The Chair looked at me incredulously and burst out that the annual budget was an essential control mechanism for a startup Board! Baffled, I probed. What were the experiences that had led to this control method since I wanted to make sure that the Board was getting what it truly needed?

I suppose I should not have been surprised when a story about a previous startup investment gone bad unfolded. So many times, our behavior reflects our attempts to avoid repeating bad experiences. In that case, the startup’s founding team had used the investors’ money to fund a social trip to the Caribbean and bought a hot tub!  Wow!  The critical thing to realize, however, is that this is an example of outright fraud. Fraud is not something that approving an annual budget will prevent. One of the earliest phases in my career was in banking, where I learned the limits of what financial reporting can do to avoid fraud.  Certainly, financial reports can sometimes provide hints that something foul is afoot; however, more often, if someone is determined to commit fraud, they are more than willing to fabricate financial reports to cover it up. Hence, my contention that if you are trying to avoid fraud, budgets and financial reporting are unlikely to be enough.

Once the fear was revealed, we could get practical about dealing with it.  As I discussed in Startup Fundraising is All About Trust, developing relationships that meet everyone’s needs required time, transparency, accountability, and ultimately trust. I shared with the Board Chair that an approved budget could not stop me as a startup CEO from committing fraud. Think about it. As a startup CEO, in collaboration with my finance team (CFO/Controller), I have access to our bank accounts, the ability to send payments to whomever, and an approved budget does not stop me from doing that. In fact, most fraud is deliberately designed to leave the illusion of the regular financial controls in place.  I explained that if I wanted to steal our investors’ money, I could do it.  Because of my banking background, at my startups, I always ensure that we set up our internal controls to ensure that my CFO/Controller prepares the payments and I approve them. However, that good practice does not actually give the Board of Directors control over the daily details of payments. And, while audits are a technique to try to catch problems, I suspect that these tools would not have stopped the purchase of a hot tub.  A Board’s only real control is that, if they were to uncover evidence of fraud, they would appropriately be responsible for firing and prosecuting me. While I never have and never would steal my investors’ money like that, a Board-approved spreadsheet will not prevent true fraud. To think otherwise is an illusion.

In this case, once I understood what the worries were, we could start forging a more effective approach to providing the visibility that the Chair craved while allowing me to engage in the dynamic management that drives results.  We ended up having a great conversation about how what trust looked like, how they could use my dynamic forecast approach to keep an eye on our spending, and once we discussed trust, I think they became much more comfortable. It might have come down to looking them in the eye and saying, you can trust me not to misappropriate your funds. Instead, I will do my best to use those funds to create value for our investors. For investors, it is worth it to do due diligence on the character of the startup leaders you are investing in. Check references. Ask about management practices. Be alert to warning signs like stories that do not add up. Ask for regular financial and business reports. And remember that earned trust can help empower a team and build the value you are looking for even while keeping a wise eye out for someone who decides to break your trust.