The number one cost driver in most pre-A and pre-B round startups is R&D. Compared to Sales & Marketing costs, where the ability to analyze reasonability is relatively easy, the R&D budget is much “trickier”. Examples of Sales & Marketing budget referrals (ratios) are % of ARR/Revenue, impact on CAC, Lead-to-Deal time frame, and average quota per sales rep.
The common practice is to take last year’s R&D budget and extrapolate it based on the scope of work derived from the “product roadmap”. That approach is way too easy, extremely simplistic, and sometimes inefficient.
So how to prepare an adequate, reasonable R&D budget? Here’s the approach I advise growing software startups to adopt while structuring their R&D budget:
- Focus on the “D” - Software companies that passed “product-market-fit” should focus on “D” (i.e. Development) rather than the “R” (i.e. Research).
- Remember Agile Principles – Agile development processes promote sustainable and efficient development using regular intervals (“sprints”) in the product roadmap. “Sprint” is a “molecule” that can set all sides on the same page. Calculate the average “sprint” in days and dollars, and add an “unknown factor” (20%-25%). That is your sprint’s “price tag.”
- Categorize in Portfolio Budgeting – split the product roadmap into features/categories and prioritize while quantifying (using price tags). Define what the cost-benefit for each feature/category is. Focus on the customer perspective but also conclude unit economics. Then the R&D budget discussion becomes more strategic and “decision-making” oriented.
- Check it out from the Top-Down View– keep comparing your R&D budget with other business and financial KPIs, such as revenues, Sales, and Marketing costs (i.e., the percentage out of those elements). In a growing company, you can expect ratios’ to improve compared with the previous year.
- Benchmarks – try to find benchmarks compared to companies from the same industry that are or were in your stage. Look at successful companies and also take notes from failing ones. Compare the R&D budget from an absolute dollar amount and the R&D cost/Revenue ratio. That analysis should help you with overall budget reasonability.
A common language with the R&D team is essential to starting budget discussions on the right foot. With these tips, you can implement an ongoing R&D budget process. It will ensure a flexible, structured environment that enables dynamic and efficient decision-making for your startup.
