Saturday, November 18, 2006

How to Cut Off A Dog’s Tail – Reducing Costs In Startups

Let us take as a give that nobody wants to do something as painful as reducing costs (or for that matter, cutting off a dog’s tail). However, if you do find yourself in a situation where you need to take a painful action, it is better to do it well than poorly.

This document discusses a series of observations on the most effective ways to reduce costs in a startup. In particular, it walks through the steps for achieving a cost reduction:
  1. Cut enough: determine the overall percentage of the budget to be reduced (e.g., 30%) but make sure it is enough so that you don’t have to repeat the exercise in 6 months!
  2. Work with top-down budgets: start with a top-down version of the budget broken out by department (e.g., sales, marketing, G&A, R&D) and by expense item (e.g., salaries, rent, travel).
  3. Reduce non-salary costs. For the non-salary items like rent and travel, come up with a realistic cost reduction amount.
  4. Restructure the bonus costs and timing. Determine how much savings you can get from changing the bonus plans
  5. Delegate the salary reduction decisions. For the salary reductions, come up with a departmental target based roughly on the percent of budget allocated to each department, then let the department heads be responsible for recommending which salaries to cut in their department.

Having to reduce costs is one of the most painful tasks any manager can undertake. For eternally optimistic, growth oriented entrepreneurs, cutting costs and laying off people feels like a betrayal of your deepest values. Yet there are times when it must be done and done well for the survival of the company.

It’s easier to cut the dog’s tail only once
The first and often most emotional question to answer about a cost reduction is how much to reduce. There is always an amount that seems fairly easy to reduce (typically 10-15% of current budget) and an amount that seems almost impossible to reduce (typically 20-30% of budget).

There is a basic rule of thumb for cost reduction in companies with revenue – you should cut costs to break even over the trailing 12 months of revenue. For companies without revenue, the rule of thumb cut costs to keep the company alive for another 12 months without additional funding.

As painful as it is to make this kind of deep cuts in the organization, it is much more painful to make a series of shallow cuts. The analogy is that it is better to cut the dog’s tail only once, rather than having to cut it off several times.

Work top-down
Most finance department budgets are bottom-up: they build up the organization’s costs from a very detailed level to an aggregate level. These kinds of spreadsheets are useful for fine-grain budgeting but bad for the kind of fast, what-if analysis needed for cost reduction.

Start with the top-down budget and then create a detailed list of the savings that are going to be made to get to the new budget number. Once you have a clear top-down picture of how the costs are going to change, make the appropriate changes to bring the bottom-up detailed budget into alignment. If you try to work from the detailed budget you will get bogged down and lose momentum in the process.

Reduce non-salary costs
In a typical startup, there are usually not too many non-salary costs to start with and limited scope for reduction. The best bet is usually trying to renegotiate your rent with a landlord. This usually requires a good relationship with the landlord and a reasonably flexible lease, so think ahead when you sign that lease!

Be careful here of making promises you cannot keep. Cutting the travel budget in half may seem like a good idea during cost cutting but may not prove feasible if every sale requires travel to the customer.

Restructure bonus costs and timing
One of the most promising cost reduction areas is bonuses. As a rule, 80% of bonuses go to executives, so in practice this means some serious discussions about the nature of a bonus plan. The starting point in the discussion to decide whether it makes sense to pay bonuses in a company that is unprofitable. If so, that means that the VCs are funding the bonus plan and the executives are reducing their incentive to run a profitable company.

The best bonus plan is one which pays annually, based on the company achieving its goals, including sufficient profit to pay out the bonuses! A good alternative is to split the bonus between an objectives-based bonus (MBO), say 30% of the total bonus, paid quarterly based on personal achievement; and a profit-sharing bonus, the other 70%, which is paid annually or quarterly providing there is enough profit to fund the bonus and other objectives have been achieved.

The profit-sharing bonuses create a great deal of company alignment around achieving profitability. They are also very helpful in conserving cash when the company doesn’t achieve its revenue goals.

Delegate decisions to reduce personnel decision
The CEO and CFO decide what the cost reduction targets are, the VPs for each area decide who is affected. It is very counterproductive to have VPs taking pot shots at each other’s people. The VPs are responsible for making their organizations work with a reduced staff – pay them the courtesy of letting them make recommendations for how to achieve the cost savings.

Each executive in turn should do a force ranking of their employees, from most valuable to least valuable. The ranking should be based both on hard skills as well as soft skills (attitude, contribution to team morale). In addition, the ranking should take into account value for the money – is this person performing at the level they should given their cost?

In general, a cost reduction should not drive a change in strategy. For example, deciding to eliminate the sales team and use only indirect channels is something that should be decided as part of a rethink of the entire strategy, not as an opportunistic cost reduction.

Never fire your stars or your songbirds
There are always some “A” people in the company making lots of money and delivering lots of value. If you start firing your “A” players, you are dooming the company, because you will never re-start a company with a mediocre staff.

Similarly, there are always a few people people who contribute greatly to the morale and ambiance of the company but who are at risk during cost reductions because they are in non-critical jobs. People who contribute to the spirit of a company can be even more important than people who bring strong skills to the company.

Work quickly but do the right thing
Regardless of how good you think your secrecy is, your people know something is going on. Every day is agony to an organization waiting for the hammer to fall. Don’t rush decisions but work as quickly as possible.

Although working quickly is important, do not neglect to follow all the proper steps from an HR and legal perspective, both to protect the company and to protect the employees who are being let go. Treat the people who are leaving with respect and compensate them fairly – how companies treat people who they have “discarded” is one of the truest tests of company culture.

Talk to your company
After you announce the reductions, call a company meeting to tell them what has happened. This is not a cheerleading session, but a chance to let people ask questions and a way to keep a feeling of togetherness during a difficult time for the company. In the week after the reductions, go out of your way to communicate the strategy of the company, to give people a vision for how the company will restart the growth process.

Cost Reduction Examples
This example shows a cost reduction exercise for a software firm with trailing 12 month revenues of $6M (averaging $1.5M/quarter). The current budget calls for total costs (expenses + cost of sales) of $2M for the next quarter. The current budget also calls for revenue of $1.8M for the next quarter, but this number is optimistic.

Initial budget (departmental) $’000 % tot costs
Revenue 1,800
Cost of Sales (prof svcs) 100 5%
Sales 500 25%
Marketing 400 20%
R&D 600 30%
G&A 400 20%
Total Expense 1,900
Total costs (exp+COS) 2,000 100%
Income (200)

The next table shows the budget broken out by expense item.
Initial budget (by expense item) $’000
Revenue 1,800
Cost of Sales 100
Fixed salary (incl taxes) 1,000
Sales commissions 200
Bonuses 300
Rent 100
Travel 200
Fees (legal, etc) 50
Phone 50
Total Expense 1,900
Total costs 2,000
Income (200)

Steps to cut budget
1. Cut enough: assuming revenue for last 3 quarters averaged $1.5M, will need to reduce total costs by $500K, or 25%
2. Work with top-down budgets: budgets are shown here – note that the number to focus on is total costs, which includes cost of sales. Most CFOs break out cost of sales separately; make sure to include it because it affects your break-even point.
3. Reduce non-salary costs (50K). For the non-salary items like rent and travel, come up with a realistic cost reduction amount. Here, a reduction of 50K may be realistic.
4. Restructure the bonus costs and timing (210-300K). Changing the bonus plan for this company has a huge impact. Simply making the bonus contingent on profit can reduce the break-even point for the company by 210 - 300K or 15% of total costs, depending on whether the whole bonus is contingent on profit or only 70% of the bonus. Note that if the profit-sharing bonus is not paid in a given quarter, it can be deferred to the next quarter, giving the company a huge incentive to have a big Q4.
5. Delegate the salary reduction decisions (150-240K). For the salary reductions, come up with a departmental target based roughly on the percent of budget allocated to each department. Assuming the reduction salary reduction target is 200K, this would be assigned as follows: sales 25% x 200 = 50K, marketing 20% = 40K, R&D 30% = 60K, G&A 20% = 40K, Prof Services 5% = 10K. It is up to each executive to propose salary reductions to reach their target number, then negotiate these reductions with the CEO and CFO.