Category Archives: Financial Statements

Empty Wallet

How can a startup be profitable & still run out of cash?

New entrepreneurs often confuse profit and cash. Understanding the difference can be critical to your success. After all, it is possible for your company to be profitable and yet still run out of cash. And it is even possible to be unprofitable and have plenty of cash.

Making a profit is one good indicator of whether or not your company is successful. Having cash determines whether the company will be alive, i.e., whether the company will survive so it can be successful or unsuccessful. To help you understand the difference, let’s examine the two concepts.

1. Profit

Revenue (aka sales) is what you record on your financial books when you sell a product or service to a customer. For example, if you sell a 2,000 bottles of wine for $25 each to customers during a month, you record $50,000 in revenues for that month.

If it cost you $10,000 to produce those bottles of wine (by the way, that’s called cost of goods sold) and you paid rent and salaries during the month of, say, $25,000 during that month, your profit for the month will be $15,000, i.e., subtract your cost of goods sold and expenses from revenues.

2. Cash

A company can gain cash in four ways:

  • By receiving payments from customers when you sell them products/services.
  • By receiving payments from lenders when you apply for a loan.
  • By receiving funds from investors.
  • By receiving cash for selling fixed assets. [Very rare for a startup company]

A company can lose cash in a variety of ways:

  • Cost of goods sold or expenses. By making payments to suppliers.
  • By making payments to lenders on a loan.
  • Stock repurchase. By the company returning outstanding stock back to the treasury. [Very rare for a startup company]
  • Buying assets. By paying cash for the purchase of fixed assets.

3. How Cash Can Exceed Profit

Many scenarios can demonstrate how you can be unprofitable and yet have cash. Let’s look at some. In all the following cases, assume that at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

  • If you have negotiated “net 60” terms with your suppliers, you will still owe them $35,000 and you will end up with $50,000 in the bank at the end of the month (even though you had a profit of just $15,000).
  • On the other hand, if you took out a loan during the month of $40,000, you will end up with $55,000 in the bank at the end of the month.
  • On the other hand, if you accepted an investment during the month of $200,000, you will end up with $215,000 in the bank at the end of the month.

In all these cases, your profit is $15,000, but your cash was quite different, specifically, $50,000, $55,000, and $215,000, respectively.

4. How Profit Can Exceed Cash

Many scenarios can demonstrate how you can be profitable and have much less (or even no) cash. Let’s look at some. In all the following cases, assume that at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

  • If 500 of those bottles were sold to a customer that had negotiated “net 30” terms with you, that customer will still owe you $12,500 by the end of the month (by the way, that’s called your accounts receivable). You will have only $2,500 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you still owed $1,000 to a cork supplier from a previous purchase you had made (by the way, that’s called your accounts payable) and decided to pay it this month, you will have just $14,000 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you decided to purchase a major piece of equipment for $10,000, you would be unable to subtract that amount from your revenues, but you would have to spend the cash. Thus you’d have just $5,000 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you are a B2B company, and your customers (who are businesses themselves) are having cash problems, as is often the case during difficult economic times, so they may delay their payments to you. If half of your customers have failed to pay you by the end of the month, you will have $25,000 less than you expected. That means you will end up with a negative balance in your checking account, something that banks frown upon. Before long, you could be out of business.

In all these cases, your profit is $15,000, but your cash was quite different, specifically, $2,500, $14,000, $5,000, and minus $10,000, respectively.

In summary

The difference between cash and profit is not subtle. Many companies have been forced out of business due to lack of cash even though they were profitable. Understanding the difference and planning ahead is essential to prevent disasters.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?  If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

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What Financial Statements Investors Expect? Why?

You want to start a company and you want to fund the company by raising money from investors. What financial statements will potential investors expect to see?

Let’s talk about what they expect to get from two key phases in securing investment. The first is known as an “investor pitch”. This is a short presentation you deliver to investors about your great business idea.

The second is known as “due diligence”. This is the process investors use to convince themselves that investing in your idea is a sound undertaking . . . or not.

1. Financial Statements During Investor Pitch

If you are interested in attracting investment money from traditional sources such as angel investors or venture capitalists, they will expect you to make a short presentation to them, usually somewhere between 10 and 20 minutes.

Much of that time will be devoted to conveying the problem or pain you are addressing and your unique approach to solving it, but toward the end of the presentation, an entrepreneur usually includes three slides on financials:

  • Key Assumptions
  • Key Financials
  • Cap Table

Key Assumptions.

This slide lists the primary assumptions that you have made that drive the financial results to be shown on the following slide. Include only the most important assumptions.

This is an opportunity for you to demonstrate to investors that you understand what factors are the most critical to your business achieving its financial goals.

Here are some examples, but don’t use these; use the ones most important for your business:

  • Customer acquisition cost < $100
  • Average order size > $350
  • Annual increase in our cost of goods sold < 7%
  • By year 2, we will be able to negotiate ‘net 60’ terms with suppliers
  • Annual customer attrition rate < 20% (i.e., retention rate >= 80%)
  • We will be able to attract an effective VP of marketing for $75,000 plus a 10% equity stake

Key Financials.

This slide captures the most important data from your financial statements on one slide, without requiring a microscope.

Once again, this is an opportunity to demonstrate that you understand what is important. [Here’s one hint: omit cents!] Although the exact selection of data will vary based on the type of business, a good start is 5 columns (for 5 years) and 8 rows showing:

  • Number of units sold (or perhaps number of customers)
  • Annual revenues
  • Cost of goods sold
  • Gross profit
  • Expenses
  • EBITDA
  • Net cash from financing activities
  • Cash balance at end of year

If cost of goods sold is not important to your business, omit it and gross profit. Include a metric or two if you want to demonstrate something critical to your success, e.g., revenue/customer. Many entrepreneurs replace parts of this table with a graph. Here are two examples:

Example I shows key data from the income statement; none from the cash flow statement.

Example II shows key data from income statement graphically; with investment rounds highlighted in text boxes.

Capitalization Table

This slide shows the investors exactly what you are offering them. It shows how equity is distributed among shareholders currently, and how equity will be distributed among shareholders after the current stock offering. You can read more about how to create and interpret a cap table in How to Read a Cap Table: Advice for Entrepreneurs.

2. Financial Statements During Due Diligence

The investor pitch is designed to whet the appetite of the potential investors. If it succeeds, the investors will engage in an extensive process of discovery called due diligence. Its goal is to uncover all material facts.

They will ask questions, do research, and examine documents to determine the true state of the products, technology, competition, market, industry, personnel, financials, sales process, contracts, and relations with suppliers, partners, and customers.

Part of that due diligence process will include careful analysis of past performance (if any) and pro forma financial statements. This will include:

  • Income Statement
  • Cash Flow Statement
  • Balance Sheet

Income Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to determine:

  • Revenues and profit at the time of an expected liquidity event, so they can calculate a likely return on their investment
  • Revenue growth rates to determine if they are reasonable
  • Gross and net profit margins to determine if they are similar to other companies in your industry
  • Percentages of revenues being spent on R&D, marketing, and so on, to determine if they are similar to other companies in your industry.

Whenever anything seems unreasonable, investors will ask for clarification and/or explanation. You can read more about the income statement in Seven Things an Income Statement Tells You.

Cash Flow Statement.

Monthly for the next two years, and annually for at least the next 5 years.

This enables investors to:

  • Verify that the company is not going to run out of cash
  • See if you understand the need for sufficient cash cushion to handle unforeseen circumstances
  • Determine how many more investment dollars you will need to raise in the future
  • Learn what loans you will be making
  • Determine what fixed assets you need to purchase in order to conduct the business.

You can read more about the cash flow statement in Four Things a Cash Flow Statement Tells You.

Balance Sheet.

Annually for at least the next 5 years.

This enables investors to:

  • Quickly calculate current ratio and net working capital, to determine if you will be able to stay afloat
  • Compare accounts receivable as a function of revenues to industry averages to determine if you are being realistic with respect to receivables
  • Calculate return on equity.

You can read more about the balance sheet in Four Things a Balance Sheet Tells You.

In summary

Successful entrepreneurs need to be both detail-oriented as well as masters of abstraction. One of the many places where these skills come in handy is in the explanation and interpretation of financial statements.

Before the investor pitch, you should become comfortable with explaining your financials in 1-2 minutes. And yet in response to questions posed during due diligence, you should become comfortable with explaining any aspect of your financials with considerable detail.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Four Ways to Validate Your Great Startup Idea

You have a great idea for a start-up company.

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Validate your idea by answering four simple questions:

  • Is the market right?
  • Is the industry right?
  • Will it make money?
  • Will it need money?

Let’s explore these one at a time.

1. Is the market right?

Determining if the market is right means demonstrating that enough people exist who will purchase the product or solution you have developed, you can find them, and you can turn them into customers. For this you need to understand the size of your market and the characteristics of the buyers that personify your market.

Size of market

How large is your target market? You want your potential market (called the total available market, or TAM) to be quite large. But you want your initial target vertical market to be relatively small. By being focused, you can align your product features and marketing messaging with the unique pains/needs of this unique market.

And then you can claim you “penetrated 25% of your target market” instead of having to claim that you “penetrated .02% of your target market.” Sure sounds better to future investors!

You can measure the size of both your TAM and your initial target vertical market in terms of:

  • Number of customers
  • Dollars spent on products like yours
  • Units sold

Targeting Customers

NeedleHow easily can you find potential customers? Will they find you? Or will you find them? In either case, how? It is very easy to say “oh, we’ll just use Google AdWords and we’ll get tens of thousands of visitors every day.”

It is much harder to actually attract qualified leads. If you plan on finding the leads, how will you reach them and engage with them until they become customers?

Converting Customers

Catheter Solution 2Converting customers is not only influenced by the severity of pain your product is addressing. It is also influenced by how you position your solution and your messaging. Your target market must be able to identify with what pain your product resolves. The three bullets shown above demonstrate how one company, Adapta Medical, has honed their message to align perfectly with their target markets, C6-C7 quadriplegics and hospitals.

I like to use the words “clear and compelling” to describe the right message, i.e., when a lead hears or reads the message, they can relate immediately to the pain they are feeling and see clearly how your product will alleviate that pain.

2. Is the industry right?

If you want to do a thorough analysis of whether the industry is “right,” check out Porter’s Five Forces. But as a start, make sure you have a thorough understanding of your competitors, your potential partners, and your differentiators.

Competition

Few things turn off investors more than hearing entrepreneurs claim that they have no competitors. Every new company has competitors. If you really are the first to do something, then how are your target customers surviving currently? Here are some examples:

  • You’re “first” to provide on-line retail sales of gourmet food. Your indirect competitors include storefront retailers and catalog retailers of gourmet food. And your future competitors include on-line retailers of non-gourmet food (because they have all the logistics in place to add SKUs for gourmet food and thus become direct competitors).
  • You’re first to provide regular helicopter service from Denver to Colorado’s ski resorts. Your competitors include airlines, van shuttle services, rental car companies, and so on, all of which satisfy your target market with this capability using different means.

The way to determine if a company is a competitor is to imagine being a potential customer. If the customer could make a list of companies (including yours) and evaluate the pros and cons of each alternative (including price, convenience, safety, etc.), then those companies are competitors.

Partners

Look upstream and downstream on your supply chain. Who will you need to work with? Have you established those relationships yet? How easily will it be to establish? Can they control you (e.g., with price changes)? Or can you control them?

Differentiators

Think again about that list of competitors that a potential customer could create. What makes you special? Nobody cares about what you think makes you special! What will a potential customer think make you special when compared with the alternatives?

3. Will it make money?

In his February 20 article, Martin Zwilling explained how critical it is for you to use a financial model to determine if your company will be financially successful given the assumptions you currently believe to be true. I couldn’t agree with him more.

After creating such financial models for many dozens of startups, I would add that it takes many precious hours to create and debug such a model.

I would recommend that you use an online tool that has already considered and built in all the elements you must consider to be successful. Such tools allow you to enter your key assumptions one time, and they create your entire financial model. Then when any of your assumptions change, you just have to change one number, and your new financials are instantly created for you.


 

Offtoa Screen1


Martin provides 5 great examples of such “assumption changes” that are typical:

  • What if customers don’t want to pay the price for your product that you though they would?
  • What if the market size ends up being different than you expected?
  • What if your sales growth is different than expected?
  • What if your investors offer you an investment amount different than your expected?
  • What if your customer acquisition cost changes?

In reality, there are hundreds of such assumptions that could change.

4. Will it need money?

Another benefit of assumptions-based financial modeling is the automatic creation of monthly pro forma cash flow statements. You can easily scan the bottom row of these statements to determine exactly how much investment money you will need and when.

In summary

To prepare yourself for investors, you should thoroughly validate your business before you enter the shark tank. This article summarizes the key elements of such a validation. To summarize, here is the checklist:

☐ Is your total available market large enough?

☐ Is your initial target vertical market focused enough?

☐ Is it easy to find leads?

☐ Is it easy to convert leads into customers?

☐ Do you know your competition?

☐ Have you lined up your business partners (suppliers and distributors)?

☐ Are your differentiators unique and compelling?

☐ Will your startup make money?

☐ When your assumptions change, can you instantly see the financial effects?

☐ How much money do you need?

ABOUT THE AUTHOR:

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

ABOUT OFFTOA

Offtoa is a subscription-based SaaS that leads you, the entrepreneur, through a series of questions and transforms the assumptions you provide into a complete set of pro forma financial statements, including even a capitalization table and expected internal rates of return for the investors. Armed with this intelligence, you and your team are able to demonstrate to investors that you know your finances, understand your market, and have a winning proposition.

If you decide to subscribe to Offtoa because you read this blog, send me an email at adavis@offtoa.com and I’ll email you a coupon good for 50% off your first month’s subscription. This offer good only until May 31, 2015.

Needle in a Haystack photo by James Lumb (Creative Commons).

 

To Plan or not to Plan: That is the Question!

SignsI have been an executive in startups since the mid-1980’s, and still am. I have always proactively planned every business in detail, but the last “business plan” document per se I wrote was in 2001. How is this possible?

I want to address some basic questions:

  • What is the difference between planning a business and writing a business plan?
  • What should you include in your planning?
  • In what format should you document your plan?
  • How much detail? What is the right time horizon for business planning?
  • Why do you need to plan your business?

What is the difference between planning a business and writing a business plan?

A business plan is a polished, organized, physical document that describes every aspect of your proposed business and its environment. It usually cover 5-7 years from inception, ramp-up, through to exit. Although occasionally requested by investors, these days it is usually requested only by academics in “business plan competitions.”

Business planning, on the other hand, is the activity of lowering your risk by studying and understanding every aspect of your proposed business and its environment.

What should you include in your planning?

At a minimum, you need to thoroughly understand:

  • The macro market, that is, demographics of the general market you are aiming for. If you are creating a fast food restaurant for diabetics, how many diabetics are there? And are their numbers growing or shrinking?If you are creating a company to provide assistance to early-age retirees, how many individuals are retiring early? And are their numbers growing or shrinking?When tracking dimensions of a macro market, you could measure it in terms of number of customers, number of dollars spent for products like yours per year, or number of products like yours sold per year.

    Great demographics for your macro market are helpful to the success of your start-up. However they are neither necessary (after all, Starbucks succeeded quite well in its North America expansion efforts in the early 1990’s even without a dramatic increase in the number of coffee drinkers) nor sufficient (even terrific growth of a market cannot compensate for sheer management incompetence).

  • The micro market. As an entrepreneur, you need to focus on a specific target market that you can penetrate successfully. By aiming for a specific (usually narrow) target market, you can create a marketing campaign aimed directly at that market and its unique pains.Members of that market then quickly see how your solution addresses their pains and become easy converts and thus customers. On the other hand, if you aim for a more general market, your marketing campaign will have to address more general pains by necessity, and will then be successful at converting a lower percentage of leads. You want all odds in your favor when you start a company.Meanwhile, start with just one target market; if you start with two, you’ll double your marketing costs (or you’ll halve the effectiveness of your marketing by watering down the message).

    The research you need to do concerning possible micro (aka target) markets includes characteristics such as size, growth rate, accessibility (i.e., how easily can you find potential customers?), ease of conversion (i.e., do potential customers “feel the pain” vs. do you have to first convince them that they have a pain? how easily can you convince them that your solution to their pain is by far the best solution available?), and so on.

    As a general rule, having an unfavorable micro market is considered by most experts to be a showstopper. If your target market is not already focused on trying to solve the problem that your product solves, you are fighting an uphill battle.

  • Your competition. Almost every prospective entrepreneur I have come across understands the need to identify “the competition,” but many limit themselves to direct competition, i.e., those companies providing products similar to the start-up’s, which address the market’s needs in a similar fashion.Don’t ignore substitute competition, which customers can choose to address their need in an entirely different fashion. For example, in the electronic note taking industry, over 200 small companies compete with 2-3 very large companies for customers. They are all direct competitors.But this industry suffers from substitute competition from at least two sources: (a) pen and paper, and (b) standard word processors on tablets. Business planning for a start-up in the electronic note taking industry must acknowledge the reality that a very large percentage of the total available market will not be purchasing any company’s electronic note taking software product.
  • Threat of entry. Ideally, (a) you want it to be easy for your start-up to enter the industry, and then (b) once you enter, you want it to be incredibly difficult for others to enter and subsequently compete against you.Concerning point b, when planning your business strategy, what can you do now to make it more difficult for others to copy you? For example, do you have intellectual property that you can protect with patents, copyrights, trademarks, and trade secrets?Can you enter the market quickly enough so that your large market penetration deters others?

    Can you establish contractual relationships with either suppliers or distributors that make it impossible for them to work with competitors?

    Can you provide such good service that no customer would want to change to a competitor?

  • Your Differentiators. What makes you special? Why is your product better than the competition? Saying that you will have a “better user interface” will not cut it; everybody says that. What specific value does your product provide that the market will appreciate and that the competition does not already provide?Here are some examples:
    • We are the only e-tailer that provides restaurant chef-quality gourmet ingredients to the home chef.
    • We are the only manufacturer of a catheter that C4-C5 quadriplegics can use for self-catheterization.
    • We enable online purchasers to donate to their favorite non-profit at no cost to them.
    • We deliver products to your door using drones within 4-hours of ordering.
    • We provide Wal-Mart prices without the long check-out lines.
  • Your Marketing and Sales Strategy. If you haven’t already done so, read Eric Ries’ The Lean Startup. In it, you will discover only three ways to create revenue:
    • You can pay for new customers. So, how do you plan to make the market aware of your products? How will you convert leads into customers? What will you do explicitly to retain customers?
    • Current customers can refer new customers? So, what will you do to encourage referrals?
    • Current customers can buy more. So, what will you do to encourage customers to increase their purchasing?
  • Pro Forma Financials. Income statement, cash flow statement, and balance sheet. Maintain all your assumptions that drive these financials in a list.
  • Cap Table. Only needed if you are interested in investors.

In what format should you document your plan?

This is a matter of taste. I strongly recommend against printing all your plans, polishing them, adding an introduction, table of contents, etc., and binding the document. The problem with this approach is that every one of the planning components is constantly evolving. If you polish and print it, it will be out of date by the following week. This is why I say I am against business plans, although I am for business planning.

Personally, I maintain a series of electronic company folders; each has a corresponding physical notebook containing selected key excerpts. Each folder contains all information I have collected on one aspect of the business. They combine “plan” and “actual” and are:

  • Market and Industry. This folder contains all my macro and micro market analyses and competitive analyses (old as well as latest in chronological order). It also contains copies of any related articles or reports others have written.
  • Marketing and Sales. This contains copies of marketing and sales plans (strategic and tactical). [Once the company starts, I add ad copy, brochures, web page designs, and so on.]
  • Equity. Initially, this contains just the projected cap table. [Once the company launches, it will also have copies of private placement memoranda, investor subscription agreements, accredited investor questionnaire forms, the stock option plan, all stock options granted, updated versions of the cap table, and so on.]
  • Board. Initially, this contains articles of incorporation and the bylaws. [Once the company launches, it will also include updated bylaws, board meeting minutes, and actions by written consent.]
  • Organization. Initially, this contains the organization chart and hiring plan. [Once the company launches, it will also contain employment contracts and updated organization charts and hiring plans.]
  • Financials. This contains pro formas by month and year for 5 years. At the front, I maintain a list of all assumptions, including all expenses (by year and by category), customer acquisition cost, sales cycle, average order size, periodicity (how often each customer will purchase), retention rate, viral coefficient, viral cycle length, and many of the items from the above folders. [Once the company launches, I add actuals.]

I also maintain a 10-minute slide presentation that captures the essence of some of the above.

How much detail? What is the right time horizon for business planning?

You should be as lean as possible without being irresponsible. Here are my thoughts on the specific parts of planning:

  • Analysis of Market. I believe that you must understand your market as thoroughly as possible or you are being foolhardy. The lean community might argue that truly revolutionary products create their own markets and it is impossible to understand the market until you test its behavior with your minimally viable product (MVP) in hand. The right answer lies somewhere between these two extremes.For example, let’s say your idea is to create fast food restaurants for diabetics. I would argue that it is important to fully understand both the demographics and the dietetic needs of diabetics before endeavoring down this path.On the other hand, you will not be able to determine exact recipes or menu items until test marketing (i.e., creating MVPs), and you won’t understand the risks associated with attracting diabetics to your restaurants when their family members are not diabetics without experimenting.
  • Analysis of Competition. Absolutely essential.
  • Threat of Entry. It is never too early to start planning for how you will protect yourself. If you delay, it may be too late.
  • Differentiators. Here, time horizon is important. You have to perform a delicate balancing act between what you believe are long-term differentiators for the majority of the market and what you believe are short-term differentiators for early adopters.The only sensible approach is to build a series of successively larger MVPs, learning as you go, adapting to what the market is telling you. All the time, however, you must acknowledge that you may not know if you are accommodating the needs of just early adopters or if they are indeed representative of the market majority.For planning purposes, do two things:

    (1) define what you believe are long-term differentiators. After all, without these, it is unclear why you should even be in business.

    (2) define a series of experiments to validate which features, delivery mechanisms, prices, promotions, marketing mechanisms, sales techniques, suppliers, and so on (collectively called differentiators), are most effective with the market.

  • Marketing and Sales Strategy. As stated above, you will have three components of your marketing and sales strategy: paid, referrals, and organic. As part of your plan, you should calibrate all three of these components with your goals. See Five Steps to Get and Keep Your Startup on Track. Once the company starts, you will revise these goals with actuals.
  • Financials. You are lean and are taking one step at a time. However, you still have a responsibility to verify that you are stepping in a direction that could yield great financial results. Create your pro forma income statement, cash flow statement, and balance sheet annually for at least 5 years, and monthly for at least the first two years.

Why do you need to plan your business?

The reality is that investors place their bets on startups less than 3% of the time[1]. The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that a market is willing to buy their product.

But when they bet on a startup, they demand a detailed plan for the business.

They won’t necessarily ask for a business plan per se, but they will perform due diligence. And when they do due diligence, they will be asking every possible question about your market, industry, product, marketing and sales, financials, governance, equity structure, intellectual property, and so on, so you need to have all this information somewhere.

If you are not planning on having investor money, why would you do anything less? After all, you are an investor in your own company, with time and money.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

[1] http://www.forbes.com/sites/dileeprao/2013/07/22/why-99-95-of-entrepreneurs-should-stop-wasting-time-seeking-venture-capital/

Are Financial Goals Compatible With Investors’ Goals?

Square Peg in the Round HoleEntrepreneurs have their own ideas about what they want to accomplish financially. Articulate these goals and make sure that your business partners share your goals and your investors or lenders understand and support your goals.

 

Here are some general frameworks for financial goals:

External investors plus exit (Classic).

You’ll accept investments from a variety of sources, most likely angel investors and/or venture capitalists. You’ll ramp up revenues and profits and plan an exit strategy in which your external investors can achieve a great return based on an IPO or acquisition.

During execution, you need to focus on revenue growth and profit, and finding sustainable sales growth independent of cash infusions from lenders or investors. The value of the company upon the liquidity event will be based on a combination of trailing financial performance and future (leading financials) earnings potential.

External investors plus exit (Proof of Concept Only).

You’ll accept investments from a variety of sources, most likely angel investors and/or venture capitalists. You’ll perform research and development to prove a concept and plan to be acquired by a company that wants to commercialize that concept for which you have reduced the risk.

Upon acquisition, external investors can achieve a great return. Notice that you may not have necessarily achieved any revenue or profit prior to acquisition.

This approach works in only a few industries, e.g., pharmaceuticals, although it has occasionally worked in industries where “eyeballs” (i.e., having many visitors to your website, not necessarily generating revenues, let alone profit) could be seen by acquirers as potential sources for future revenue.

Two great examples are Corus Pharma and Instagram. Corus Pharma was acquired by Gilead Sciences in 2006 for $365 million, based on terrific proofs of concept for two new drugs, although it had effectively zero revenue.

Instagram was acquired by Facebook in 2012 for $1 billion, based on its “eyeballs,” although it had effectively zero revenue.

This is usually a highly risky “plan” for a business. Although such companies make headlines, so do lottery winners.

External investors with income.

You’ll accept investments from non-traditional investors. You’ll ramp up revenues and profits and distribute profits annually to the investors who can achieve great returns in the form of income.

This tends to be appealing to “non-traditional” investors because neither angels nor venture capitalists are commonly interested in income-producing deals. Friends and families might be. During execution you need to focus on profits.

Lifestyle company.

Your plan is to grow and achieve enough cash from the company so you can support your family. You may or may not accept loans, but if you do, you plan to pay them back with interest. There is no “exit.” During execution, you need to focus on cash generation.

External investors with MBO (Management Buyout).

I see quite a few inexperienced entrepreneurs put together business plans that call for this option.

They really don’t want investors as business partners. Investors are simply a short-term source of capital, a necessary evil; not business partners.

Typically, their business plans are highly optimistic and generate huge amounts of cash, so their plan is to buy out the investors and get rid of them.

This framework has a few problems:

(a) First of all, this is not a management buyout; this is a stock repurchase. The “proposal” calls for the company’s cash to purchase the investors’ stock, not thefounders’ cash.

(b) Second, if the company is doing extremely well, the investors likely want to be part of the action, and they have a vote! Of course, if they want to exit, and you don’t want to exit, there is a mismatch in objectives and the right thing to do is to help the investors exit, but that’s not something you’d plan to do from inception!

(c) Third, rarely do new entrepreneurs appreciate how much uncontrolled risk external investors are taking, and thus how much return they expect (and deserve). If the company is doing extremely well, they want big returns.

(d) Fourth, in all likelihood, the company will not be creating as much cash as the plan calls for. In fact, a responsible company reinvests its cash into ongoing operations to insure future growth; it doesn’t hoard its cash.

Summary

Obviously, it is also possible to combine various elements of the above. Your company can achieve financial success if it is on the path toward accomplishing any of the above five scenarios. Make sure that you understand what you are trying to achieve and make sure that all your business partners understand and have compatible goals as well.

 

Alan DavisAl Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Four Things a Balance Sheet Tells You

BS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a cash flow statement and a balance sheet.

Based on a set of assumptions, a pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity).

These are the four questions the balance sheet answers for you and your potential investors:

  1. Will you be able to pay your bills?
    – A current ratio less than 1.0 is a fairly good indication that the company is going to have problems. As your company evolves, your current ratio should become (and remain) above 1.2.
    – Net working capital defines the cash you have available for paying off debt and running your company on a day-to-day basis.
    – A negative value means you have a shortfall, and unless something drastic is done (like securing short-term loans), you will not be able to continue as you are.
  2. Where are you getting capital from? The debt to equity ratio (D/E) tells you what proportion of your capital is coming from loans vs. investments.– A value of 1.0 means that you are getting half from loans and half from investors.
    – A value greater than 1.0 means that more of your money is from loans and less is from investors. The disadvantages of this are that you must continually make payments on loans (this drains cash and decreases profits), and loans are extremely difficult for start-up businesses to secure without collateral. The advantage however is that you will likely be able to maintain more ownership.
    – A value less than 1.0 means that more of your money is from investors and less is from loans. This is more typical for a start-up.
    – 
    There is no single right value for a D/E ratio for a start-up. The two primary drivers of what will be the right value for you are: (a) the standards for your industry, and (b) your comfort level with debt.
  3. How efficiently are you using investors’ money to produce profit? Return on equity (ROE) tells you the answer.
    – Most start-ups will have a negative ROE for the first 1-2 years, and will eventually have a positive ROE.
    – For publicly traded companies, a ROE of 15% to 20% is considered good, but this measure is not so important for a start-up. On one hand, most investors are more interested in the internal rate of return (IRR) on their investment upon an acquisition than the annual ROE. On the other hand, an acquirer is likely to pay a premium price for a company with a high ROE because it indicates a more solid company.
  4. How quickly are you moving your inventory?
    – If higher than industry averages, you run the risk of running out of stock. If lower than industry, you run the risk of spoilage and/or obsolescence.
    – If much higher or lower than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such changes without specific actions.

Let’s take a look at a balance sheet to understand how these four questions get answered.

The figure below shows a balance sheet for the first five years of a company.

Sample BS

All balance sheets are organized into two basic parts – (1) Assets and (2) Liabilities & Shareholders’ Equity:

Assets

Assets are a list of all items that the company “owns.” Two kinds of assets exist: current and other. Current assets are those that can be easily converted into cash in a reasonably short period of time, specifically one year.

Assets include:

  • Cash (or cash equivalents) – a statement of any assets that can be converted into cash almost instantly.
  • Accounts receivable – amounts owed by your customers for products they have purchased.  You have booked the revenue, but have not yet received their cash payments.They are considered current because it is assumed that customers will be paying you soon.
  • Inventory – considered current because it is assumed that you can sell it to customers (or if you are a manufacturer, you can transform the raw materials or work in process into finished products, which you can then sell to customers) within a year.
  • Total current assets – the sum of the previous three items.
  • Fixed assets – the major purchases that you have made, less their depreciation. It is shown on a line labeled property, equipment, and improvements, net.
  • Total assets – the sum of the fixed assets and current assets.

Liabilities and Shareholders’ Equity

This section contains current liabilities (i.e., money the company owes that is due within 12 months), other liabilities (i.e., money the company owes that is due later than 12 months) and shareholders’ equity:

Liabilities include:

  • Accounts payable – items purchased from suppliers or vendors, booked as expenses, but not yet paid for. It is considered current because it is assumed that you will pay it soon.
  • Accrued liabilities – expenses (such as salaries for your employees) that you incur on a regular basis but do not pay until the following period. Since most start-ups pay their employees monthly, accrued liabilities at the end of any month (and in fact at the end of any year) will equal one month’s payroll.
  • Short-term debt – the balance of all your loans (both those that are due within 1 year and those payments that are due within a year for longer term loans).
  • Total current liabilities – sums the previous three items.
  • Long-term debt – the balances of all loans due after one year.
  • Shareholders’ equity   – composed of two parts: (a) paid-in capital, i.e., the actual amount that investors paid for their stock, and (b) retained earnings or accumulated deficit, whichever applies, copied directly from the cum net entry of the income statement.

If all calculations are done correctly, the sum of all assets should equal the sum of all liabilities plus shareholders’ equity.

Financial Ratios

Below the balance sheet, some companies report values of some standard financial ratios. These often include:

  • Current ratio. Your current assets divided by your current liabilities; both of these values appear right here on the balance sheet.
  • Net working capital. Your current assets minus your current liabilities (it’s not really a “ratio”!); both of these values appear right here on the balance sheet.
  • Liabilities/equity (aka D/E aka debt-to-equity ratio). Your total liabilities divided by shareholders’ equity; both of these values appear right here on the balance sheet.
  • Return on equity (ROE). Your net income after tax (from the income statement) divided by shareholders’ equity (from the balance sheet).
  • Inventory turnover. Your cost of goods sold (from the annual income statement) divided by the average inventory (from the balance sheet). Average inventory is generally calculated as the average of inventories at the beginning and end of the fiscal year. Inventory turnover is a measure of the number of times during a year that the entire inventory is sold (or otherwise used). It is highly dependent on the industry. Thus, for example, a fresh seafood retail business would expect an inventory turnover of around 365, while an art dealer would expect an inventory turnover of around 2.

The balance sheet differs from the pro forma income statement and the pro forma cash flow statement.  The pro forma income statement, which tells you if you will be making revenues and profit, and the cash flow statement, which tells you where your cash will be coming from and going to, are dynamic reports.  They show you what will be happening over periods of time.

Unlike those reports, the balance sheet shows you the state of your company at a point in time. It shows you what your company would look like if the calendar and clock could be stopped for just one moment; it is like a snapshot, showing you everything the company owns and owes at that moment.

In the case of a person, the difference between what you own and owe is your net worth. In the case of a company, that difference is the shareholders’ equity.

Using your balance sheet is the best way to view everything the company owns and owes at that moment.

 

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Simon Cunningham (Creative Commons).

Four Things a Cash Flow Statement Tells You

CFS PhotoWhen you plan to start a company, you need to create pro forma financial statements. Pro forma financial statements include an income statement, a cash flow statement and balance sheet.

A pro forma cash flow statement shows all cash that you expect will come into the company and all cash that you expect will go out of the company during a period of time based on your stated assumptions.

The cash flow statement answers four questions for you and your potential investors:

  1. Does the cash at the end of the period (the last line of each column of the cash flow statement) equal the top line (i.e., cash and cash equivalents) of the balance sheet? Make sure you are comparing a cash flow statement that ends on the same date as the date of the balance sheet.
  2. Does the company run out of money? Is the cash balance at the end of any period negative? Check on both the annual cash flow statement and on the monthly cash flow statement.
  3. Does the company’s core business eventually generate enough cash to sustain itself? You will learn this by examining the line net cash provided (used) by operating activities. For the first few years, this is likely to be negative (with the cash shortfall made up for by influxes of cash from loans and/or investments).But eventually, the company should be able to sustain itself. When net cash provided (used) by operating activities becomes positive, the company has achieved a sustainable growth engine (see Eric Ries’ The Lean Startup).
  4. Is an investment being used to pay off a loan? Most investors want their cash to be used to grow the company; they do not want it used to retire debt. Such a situation can be most easily seen by examining the monthly cash flow statement. Look at any month in which the line issuance of stock has a positive entry. Is there a corresponding negative entry on the line proceeds from (payments on) notes payable? If so, there could be a problem.However, in some cases this could be okay, e.g., when the lender holds a convertible note and the note is simply converting into equity. In such cases, no cash is actually changing hands; it is simply a bookkeeping entry and a conversion from debt to equity for the same party.

Let’s take a look at a cash flow statement to understand how these four questions get answered.

The figure below shows a cash flow statement for the first five years of a company.

Sample CFS

All cash flow statements are organized into three horizontal sections, each corresponding to a different set of events that cause cash to flow into or out of the company:

 Cash flows from operating activities

Cash flows from operating activities show cash that relates to your primary business. The first entry is profit or loss from the business (copied from the bottom of the income statement). The rest of the entries are adjustments because not all profits or losses are reflected in cash. So, for example:

  • Depreciation was on the income statement and contributed to expenses (and thus decreased profit), but unlike other expenses, it caused no corresponding reduction to cash. Therefore the first thing we do on the cash flow statement is add back the amount of depreciation.
  • Any decrease (or increase) in accounts receivable between the last period and the current period must be reported here as an increase (or decrease) in cash.Notice that if customers pay you during the current period for something that they purchased in a previous period, no entry is made on the income statement, but you did have a positive cash event. That cash event is recorded on this line.
  • Any increase (or decrease) in accounts payable must be added to (or subtracted from) cash for the same reason as explained above for accounts receivable.
  • If there is any change in the accrued liabilities between the last period and the current period, that change needs to be added to or subtracted from cash.
  • Any changes to inventory would not be reflected in your income statement but would affect cash. Specifically, if you increased your inventory since the previous period, that needs to be reflected as a net cash loss, and a decrease would be reflected as a net cash gain.

The sum of the above items is shown as net cash provided (used) by operating activities.

Cash flows from investing activities

Cash flows from investing activities show cash that relates to your major purchases (or sales) of fixed assets (e.g., real estate, equipment, acquisitions, vehicles, computers, and so on.)

Notice that although such major purchases cannot be subtracted from your earnings in the current year (that’s why they don’t appear on your income statement), they do impact cash!

The full amount of their purchase is recorded here because the company is incurring the entire cost of the asset from a cash perspective. Their sum is shown as the net cash provided (used) by investing activities.

Cash flows from financing activities

Cash flows from financing activities show cash that relates to financing your business, e.g., loans you accept (or make payments on) and investments received by the company.

It is shown on two separate lines, one for investments, and one for loans. Notice that loans and investments you accept have no effect on your income statement but have a significant effect on your cash, which is why they appear here. Their sum is shown as net cash provided (used) by financing activities.

Summary lines on your cash flow statement

At the bottom of each column a few summary lines appear:

  • The net increase (decrease) in cash line shows the sum of the net cash subtotals from the three aforementioned sections.
  • The cash at beginning of period starts at zero when the company is founded. Each subsequent year just copies the value from the end of the previous year.
  • The cash at end of period is calculated by adding the net increase (decrease) in cash to the cash at beginning of period.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash. You could also be unprofitable and have cash (e.g., with the help of highly optimistic investors).

Using your cash flow statement is the best way to find out exactly where your company is getting and spending its cash.

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Ken Teegardin (Creative Commons).

Seven Things an Income Statement Tells You

Photo for income statementWhen you plan to start a company, you need pro forma financial statementsPro forma financial statements include an income statement, cash flow statement and balance sheet.

Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.

It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions.

The income statement answers seven questions for you and your potential investors:

  1. Are revenues growing fast enough to make it an attractive investment?
  2. Are revenues growing so fast that your credibility will be questioned?
  3. Is your gross profit margin (i.e., gross profit divided by revenues) within acceptable limits for the industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? It won’t happen by accident!
  4. Are expenses within acceptable limits for your industry? Or are you predicting significant revenue growth without the corresponding expenditures incurred by others in your industry?
  5. Are EBITDA/Revenues and Net income/Revenues within acceptable limits for your industry? If higher than the rest of your industry, have you explained what specific strategies you will be implementing to make that happen? One does not achieve such higher performance levels by just being “good.”
  6. Is the first year profitable? For most start-ups, EBITDA for the first year will be negative . . . and that’s okay!
  7. Is the company predicted to “dig itself out of the hole.” Although the first year will almost always exhibit negative profit (aka a loss), cum net tells you how long it will take for the cumulative profits to compensate for the early losses.

Let’s take a look at an income statement to understand how these seven questions get answered.

The figure below shows an income statement for the first five years of a company.

Sample IS

All income statements are organized into 4 horizontal sections:

Revenues

The first section shows all primary revenue sources.

Cost of goods sold (aka COGS)

The second section shows costs associated with actually creating products that were responsible for revenues. This includes the cost of raw materials, shipping products to customers, and labor associated with manufacturing and maintaining inventory.

Just below this section, COGS are subtracted from revenues to calculate gross profit. It is used to determine how efficiently your company produces its products. It is most meaningful when compared to other companies in your industry.

Expenses

The third section lists all expenses incurred by the company categorized by corporate division: General and Administration, Manufacturing and Production, Marketing and Sales, and Research and Development.

Summary lines on income statement

The fourth section is a series of totals and summaries that help you understand the company. They include:

  • EBITDA. Literally, earnings before interest, (income) tax, depreciation, and amortization. This is calculated by subtracting expenses from gross profit.
    –  This is the value that most investors look at when they are trying to determine how well the company is predicted to do. Also, for most industries, it will be one of the primary determinants for valuing the company in the case of an acquisition.
  • Depreciation. This is calculated from the depreciation schedules and useful lives of major purchases (i.e., fixed assets) you have made. Specifically, it is the sum of all depreciations for major purchases made prior to or during this period.
  • EBIT. Earnings before interest and (income) tax. Calculated by subtracting depreciation from EBITDA.
  • Interest. Any interest earned by the company from its assets, or any interest paid by the company.
  • Provision for income taxes. This is calculated by multiplying your income tax rate by EBIT.
    – However, if you had previous years of accumulated losses, they will be subtracted from the current year’s EBIT first. Notice, for example, in the company shown in the figure, no income tax is shown for fiscal year 3, even though it was profitable; losses from its earlier years were subtracted from its profits of year 3.
  • Net income (loss) after tax. Calculated by subtracting interest and income tax from EBIT.
  • Cum net. Cumulative net earnings. The sum of all net incomes for all periods up to and including the current period.

Except in very unusual circumstances, revenue is terrific, but revenue without gross profit is not sufficient. Similarly, gross profit is terrific, but gross profit without positive EBITDA is not sufficient.

Read Four Things a Cash Flow Statement Tells You to learn more about the pro forma cash flow statement.  At that point, we’ll also see that positive EBITDA is great, but positive EBITDA without positive cash flow is also not sufficient.

Using your income statement is the best way to find out exactly how much revenue and profit (or loss) your company is generating; and how efficient it is in generating that profit from the sales.  These are imperatives for launching and running a viable business.

Other articles you may find helpful in the series:

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Photo courtesy of Jessica Wilson (Creative Commons).

Why My Startup Need Pro Forma Financial Statements

by Al Davis and Nicola Roark

Money launchWhen you plan to start a company, you need pro forma financial statements.  Pro forma financial statements include an income statement, cash flow statement and balance sheet.

Do these really matter or could you take your great idea, score some investment money and get your product to market more quickly without pro formas?

This question puzzles a lot of startups so let’s answer it.  While there’s no wrong answer, each path has its own likelihood of success:

No pro forma financial statements = low probability of success

The reason this path has low probability of success is not because you don’t have a great idea!  Your idea is probably fantastic but it’s even better when you can back it up with financial assumptions that make sense.

The reality is that investors place their bets on startups less than 3% of the time[1].

And when they bet on a startup, they demand pro forma financial statements and at least some kind of detailed plan for the business.

The other 97% of their money goes to businesses that have already been through rounds of funding and have demonstrated that there is a market willing to buy their product.

Pro forma financial statements = high probability of success

Investors take their risks with those that have a reasonable chance at being successful and returning their investment, plus some, to them.  Investors want to know when to expect a return on their money.  Pro forma financial statements tell them that.

Let’s take a quick look at the pro forma financial statements that all investors expect from a startup. Understanding the value of each adds tremendous power to running your business, growing your business, and to the proposition you make to investors.

Your pro forma income statement (also called profit and loss statement, or P&L statement) is the tool used by businesspeople and investors to determine if a company is profitable (or not) over a period of time.

It shows what the revenues, cost of goods sold, expenses, and profits of a company would be, based on a set of given assumptions. Your income statement answers seven questions for you and your potential investors.  To learn more about these questions and their answers, read Seven Things an Income Statement Tells You.

Using your income statement is the best way to find out how efficient your company is in generating that profit from the sales.  These are imperatives for launching and running a viable business.

Your pro forma cash flow statement shows all cash that you expect will come into the company and all cash that you expect will go out of the company during a period of time based on your stated assumptions.

Many new entrepreneurs confuse cash with profit. Your company could be profitable (as reported on your pro forma income statement) and you could still run out of cash.

The cash flow statement answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Cash Flow Statement Tells You.

Your pro forma balance sheet shows all the things your company would own (its assets), all the things it would owe (its liabilities), and their difference (shareholders’ equity), based on your assumptions.

The balance sheet answers four questions for you and your potential investors.  To learn more about these questions and their answers, read Four Things a Balance Sheet Tells You.

Understanding the value of your pro forma financial statements is not only a benefit to you and your business, it’s an expectation from investors.  They are the compass on your business journey and without them you’ll quickly start drifting.

Using your pro forma financial statements to chart your course, demonstrate your business acumen, and recommend course changes is the most reliable compass you, and your investors, can have.

Al Davis is a Serial Entrepreneur, Angel Investor and Author of six books. He is CEO of Offtoa, Inc., his fifth startup.

Nicola Roark is a Marketing Consultant and Strategist working with entrepreneurs and startups. Her business allows her to do two things she loves; collaborate with businesses who have a dream and develop the strategy and content to take it to market. Visit her website: www.exhilarationmarketing.com or email her: nicola.roark@exhilarationmarketing.com for more details.

Startup: Loan or Investment?

Wordle Loan or InvestmentYou have a great idea for a company.

You’ve validated that the market wants the product and is large enough. You’ve determined that their pain is significant and you’ve found the right messaging that hits their pain point.

Your product is unique and early tests indicate that customers want your product much more than they want competing products.

You’ve found ways to protect your intellectual property so competitors cannot copy you.

You’ve created financial models that show you can be profitable by the end of the second year, and cash flow positive by the third year.

You have just one problem left: You need $350,000 to get the company started. The big question is: should you try to obtain a loan? Or should you try to obtain an investment?

For experienced entrepreneurs, it is an easy answer based on experience. For the new entrepreneur, the choice can be gut-wrenching. Let’s explore what the choices of loan or investment and their pros and cons.

What’s an Investment?

An investment occurs when investors (usually angels or venture capitalists, but it could also be friends or family members) provide the company with $350,000 and you sell them a part of your company.

For example, if you and the investors were to agree that your company was worth $1,050,000, then you could sell one third of the company to them for $350,000. If you and your co-founders owned, for example, 1,000,000 founders’ shares and the company needed $350,000, the company would need to sell 500,000 shares to the investors and they would then own 500,000/1,500,000, or 1/3, of the company.

Notice that it would not be sufficient for you and your co-founders to sell them a third of your 1,000,000 founders’ shares. If you did that, the investors would need to pay you $350,000, and the company would get nothing!

Some variations exist:

  • As managers of the company, you have complete control over the success of your company. The investors have almost no control; yet all their investment is at risk.

    For that reason, and to make the playing field just a wee bit more level, most investors demand 
    preferred shares. Many possible preferences could be requested by investors, but the most common is called a liquidation preference, which means that investors get back their original investment (or a multiple of it) prior to a general distribution of the proceeds of the sale of the company.

What’s a Loan?

A loan occurs when a creditor (usually a bank, but it could also be a friend or family member) provides you with $350,000 and you promise to pay it back in even installments over a period of time, with interest.

For example, if you were to obtain a 7-year, $350,000 loan from a local commercial bank with an 8% interest rate, you would need to pay $5,500 each month for 7 years to repay the loan.

In general, lenders expect personal guarantees; if your company cannot make payments on the loan, you will be personally responsible to make the payments, and that means you could lose your house or your car.

Whether or not you are willing to put these items up for collateral is a good indication to the lender as to whether or not you believe in your own company. If you wouldn’t risk your house, why would you expect them to take the risk? At the end of the seven years, you would be free of any obligation to the bank.

Some variations exist:

  • A balloon loan lowers the monthly payments during the term of the loan, but then includes a much larger one-time payment at the end of the term. In the above example, monthly payments could be $4,000/month, and then a balloon payment of $166,000 would be due at the end of seven years.
  • An interest-only loan allows the company to pay just the interest on the loan each month, but then must repay the entire loan at the end of the term. In the above example, monthly payments could be $2,333/month, and then the company would pay the bank $350,000 at the end of seven years.
  • A convertible loan allows the creditor to convert the outstanding balance of the loan into equity. In the above example, interest would accrue but not be paid, so if the loan converted to equity at the end of one year, the creditor would become a shareholder with $379,000 worth of stock.

Advantages of getting an investment

The advantages of obtaining investments rather than loans include:

  • No monthly payments required.
  • Investors can generally provide much larger sums than lenders can.
  • Owning a smaller piece of a huge pie rather than a larger piece of a tiny pie.
  • You might not be able to find a lender interested in your company.
  • Generally no collateral is required.

Advantages of getting a loan

The advantages of obtaining loans rather than investments include:

  • No loss of “control”.
  • You might not be able to find an investor interested in your deal.
  • You might be in an industry that produces returns insufficiently high to attract investors.
  • You might be in an industry without any possibility for liquidity.
  • You and your co-founders may want to manage a life-style company and never sell the company (no liquidity event -> no investor interest).
  • Interest rates are much lower than investors’ expected internal rates of return (IRR).

Summary

If you need cash for your new company, many options exist, but don’t expect anybody to take the risk without you taking at least an equal risk.

If that risk is a loan, you will need to risk your personal assets. If it is an investment, you will have to offer preferences, which puts your personal piece of the pie at risk. However, as long as do well, there will be plenty of returns for everybody. Neither lenders nor investors want more than they deserve; what they want is shared risk.

Al Davis is a serial entrepreneur currently in his fifth startup.  He is also an angel investor and the author of six books.