Making Sense Of The Startup Payroll Forecast
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
A newer and updated version of this post is available here.
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Every founder and business owner deals with the challenge of building a payroll forecast.
It could be to support the cash flow projections or to analyze the number of future hiring, but payroll forecasting is a significant element for every business’s forecast.
In this post, we’ll cover the five steps for building a robust payroll forecast for your business.
When building a financial model, there are hundreds of assumptions you must incorporate and hundreds of micro-decisions to make along the way. These assumptions are the heart of the model and build up your revenues and expenses forecasts.
In previous posts, I covered two aspects of financial modeling. The first one (Startups Financial Modeling: Simplicity is King) was a general post covering the importance of keeping the model simple and easy to follow. The second (Breaking Down The Startup Revenue Forecast) was a more specific post, discussing how to build a revenue forecast.
This post continues the series on financial modeling and concentrates on one of the most significant difficulties with financial modeling: the payroll forecast.
Payroll accounts for most of the spending at most startups, especially software-focused startups, where payroll can comprise up to 90% of overall spending.
On the surface, payroll expenses are the most natural part of financial planning. You multiply the number of employees by their annual or monthly payroll, and you’re all set. It is more complicated than that. There are five steps to take when building a payroll forecast: four steps are focused on the headcount forecast, and one on the payroll.
Step 1: Mapping All Activities
The first step in building a useful payroll forecast is to map all activities in the business that are currently running and the activities that will run in the future. To do that, we must first break the business activity into four categories: customer support, product development (R&D), sales and marketing, and general and administration. In some business models, there might be additional categories, such as fulfillment or operation, but the four categories above are the categories all businesses should have.
Breaking its activities into those four categories lets the company understand what information it needs to build the payroll model for each category, and the steps it must take to get there.
These are the definitions that I often use with my clients for these categories:
Customer support: any activity directly related to post-sales support to clients, or that happens once a product is available to clients and required to enable a sale.
Product development: every activity directly related to the development of future products. This category could include developers, designers, coders, managers, and product and project managers.
Sales and marketing: every activity directly related to selling and marketing the company’s services or products.
General and administration: this includes all support functions (finance, HR, office management, etc.), executive team, and headquarters support.
Step 2: Product Roadmap
To forecast the number of employees a business will have a few months or quarters or years from now, you need to map the entire set of business activities and the required resources based on the product roadmap. The roadmap should trigger hiring, affect growth plans across the company, and set future profits when translated into payroll expenses.
The roadmap should include any milestone that is significant enough for the company and that affects either sales or the headcount. If a business plans to release a new feature that will add substantial value to clients but will not require additional resources and will not generate direct additional revenues, than that feature is not significant enough. A new release that will require 10 more developers and will open a new price point with new clients is a significant milestone.
The product roadmap will directly affect product development resources, but not only that. Sales and marketing are also affected since they might have new products to offer or features to advertise. Customer support is affected, since new products might necessitate more post-sales help to the clients. Even the general and administration category could be affected in some cases.
Step 3: A First-Degree Headcount Impact
Once we have the business's roadmap, we must translate it into business actions on the revenues and the spending. I covered the impact on the top line in a previous post and will touch on only the spending side this time.
Every milestone in the roadmap should be broken down into the functions and activities that must be completed to accomplish that milestone on time. This breakdown should include the headcount per function and the time when employees should be recruited. If we assume that it will take eight months to develop a specific feature, headcount will probably have to increase before that, perhaps 9‒10 months before the release.
It is important to remember that this is not a hiring plan, but a plan for the optimum level of resources to meet the company's roadmap. It means that we're looking for the number of resources per function required to accomplish a milestone. Later, we'll touch on how to quantify this as an expense. Other hiring aspects are out of the scope for this exercise, even though they can be merged if needed.
Step 4: A Second-Degree Headcount Impact
We can map the indirect implications of the roadmap and headcount growth on the business once we understand the direct impact of the business roadmap on the headcount growth. The second-degree impact will complete the full effect of the roadmap.
The first immediate, indirect impacts will be on customer support and sales. Having significantly more products and clients will require more resources to handle them and more resources to sell new products. However, having more resources overall in the company will necessitate adding middle management per some legend that we set.
Also, as the company grows, more support functions are needed. But before adding HR, finance, and legal employees, it is better to think about the benefits of these functions to the organization, when to add them, and the rationale of increasing each function.
Step 5: Adding Payroll Per Employee
The last step is to translate the headcount forecast into dollars by multiplying the number of employees by their respective payrolls. In some cases, the annual salary will be used, in other instances, monthly. There are a few essential elements to consider.
Salaries should vary according to function and location.
Bonuses and employer taxes (which vary between countries) should be included.
Annual increases in base salary should be taken into account.
Sales commissions should be calculated separately and should reflect compensation based on the company’s sales made by the sales team.
In some places and job roles, recruitment costs should also be included.
When putting everything together, we should have a headcount plan that clearly states the total number of resources required each month or quarter or year, multiplied by the payroll per employee that includes all the aspects in this step 5.
Summary
Building the payroll forecast is a massive effort that includes hundreds of micro-decisions, assumptions, and data points. To create a robust payroll forecast, it is essential to work step by step and to cover all aspects of payroll forecasting.
As I have written many times before, it’s important to remember that every company is different, with different dynamics, drivers, and business models. What works for one business will not necessarily work for another.
We have most of the financial projections ready once we complete the payroll forecast and add it to the sales forecast we built earlier. All we need is to add the non-payroll expenses, and our financial model is done.