Category Archives: Lean Startups

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.

6 Reasons You Should Never Start a Company

Do Not EnterIf you are looking for reasons why you should not start a company, read on!

1. You Could Lose All Your Savings

As a founder, you are investing in your startup. You’re investing your time and your energy; you’re investing yourself. In addition to that, it’s also wise to invest financially in every round if you can. That way when you are raising money and potential investors ask “do you have skin in the game?” you can honestly answer “yes,” and when they ask or “if I say yes, will I be the first investor?” you can honestly answer “no.”

Putting you own money into the company demonstrates commitment. If this requires you to take out a second mortgage or a personal loan, so be it.

If you can’t commit to losing your savings, how can you expect others to put their assets at risk?

2. You Could Lose Other People’s Money

I thought that losing my own money was painful, but that was before I lost other people’s money. Now that’s painful! After all, when investors give you their cash in return for equity in a company you have founded and are leading, they are making a loud and clear statement that they believe in your idea and they believe in you.

Even when you involve your stakeholders and keep shareholders informed of all decisions being made, even when the vast majority of investors bear no hard feelings whatsoever, you spend considerable time looking back at past decisions wondering “what if I had done things differently?”

Bottom line: When you accept other people’s investment dollars, be prepared for the possibility that pain might follow if you fail. That pain might be self-induced, or might come from the investors.

3. You Could Hire the Wrong People

You can’t do it all yourself. You need to hire others to help make the dream come true. If you make the wrong hires, quality will be compromised, too much money will be spent, customer service will go down the tubes, the morale of the “good hires” will suffer, and so on.

4. You Could Lose Control

You like control. After all, the company you are envisioning is “your baby.” You want to control it. When you need to raise cash, you will be telling potential investors how much cash you need and what you plan to do with it. The percent of the company they get for that investment will be up for discussion.

Let’s say you need $500,000. You want to maintain control so you have no intent to sell more than 49% of the company. But the investors value your company at just $800,000. That means if you want their $500,000, you’ll need to sell them 5/8 of the company.

5. You Could Build the Wrong Product

You raise $500,000 from investors and build the “perfect product” for the market. You execute an expensive product launch with a major media presence. And nobody buys the product. The product is a total flop. You either misunderstood the needs of the market, you were too early or too late in the market window, or the competition outsmarted you with an even more impressive product.

6. Your Customer Acquisition Cost Could Be Much Higher than Expected

You did extensive financial planning, and that included modeling the sales process. Only one problem: you think it will cost you $250 to acquire each new customer. What happens if it actually costs you $750 to acquire each one? Now everything in your financial plan falls apart.

In summary

If the above situations scare you, you have an easy way to avoid them: Don’t start a company. Starting a company is not for the pessimist or for the risk-adverse. Nor is starting a company for those who want to get rich quickly and live on a beach.

Starting a company takes courage and optimism.  It requires stubbornness and the ability to rewind and clinically assess mistakes. It tolerates failure but demands success. As crazy as it may sound, if that excites you, you might be about to take your great idea and start your own company!

Let me close by sharing with you three of my favorite quotes:

 “Far better to dare mighty things, to win glorious triumphs, even though checkered by failure, than to rank with those poor spirits who neither enjoy much nor suffer much.  [They] know not victory, nor defeat.”

Theodore Roosevelt

“It is good to have an end to journey toward; but it is the journey that matters, in the end.”

Ursula K. Le Guin

“First, say to yourself what you would be; then do what you have to do.”

Epictetus

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?

Dilemmas of Founders

HartebeestsIf you are considering starting a company, or if you have recently started a company, an essential item for your reading list is Noam Wasserman’s The Founder’s Dilemmas. Based on years of solid research and experience, this book surveys many of the biggest problems facing founders of high growth start-ups. I want to share with you some of the thorniest of those problems here. But please don’t take my word for it. Buy the book for the complete story [No, I don’t get a commission].

1. Career Dilemma

You are currently employed and earn a comfortable salary. You have a great idea for a new start-up. How do you determine what to do?

If you stay with your current job, you maintain the security of a paycheck but likely give up the dream of starting a company, spreading your wings, and perhaps “getting rich.” Most investors will not invest in a startup without the founders/officers demonstrating a significant level of commitment, and that means “quitting your day job.”

If you quit your day job, you have the chance to make it big, but you give up the security of a paycheck. Can you afford to do that? Most start-ups cannot afford to pay the founders a salary for the first few years, so you need to have a significant enough nest egg put away to afford a few years of financial drought.

2. Co-Founders with Complementary Skills

Often entrepreneurs co-found companies with others who have very similar backgrounds as themselves. The advantage of this is you all speak the same language. The problem is that starting a company requires a diverse set of skills: technology, marketing, sales, financial, legal, and so on.

The best teams tend to ones that combine diverse skills and diverse personalities.

3. Title for the Founder

Many individual founders believe that they should lead their companies with a title such as CEO. Derived from Wasserman, the figure on the right shows the starting role that the “idea person” serves in start-ups. Although the initial idea person may be the perfect CEO for the start-up due to commitment and passion, the skills required for leading the company through long-term growth may not be present. Only 75% of founder-CEOs are still in the CEO position by the time of the first external investment round, and only 39% are still in that role by the time of the fourth round.

4. Who is in Charge?

Most start-ups have a single individual who serves as leader; s/he could have any
of a variety of titles; chief executive officer, president, and chief operating officer are typical. This individual reports to the board of directors. If you are considering having nobody in charge, or having two or more co-presidents in charge, think again. Tough times will come. And when those tough times arrive, somebody needs to make the tough decisions. The movie, Startup.com, exposes many start-up problems, not the least of which is what happens to relationships when one of two co-founders thinks they are “co-CEOs.”

5. Liquidation Multiples

When investors purchase preferred stock, they typical ask for (and receive) a liquidation preference, which specifies what multiple of their purchase price they will receive upon a liquidity event prior to general distribution of the remaining funds to all shareholders. I described some of the problems related to liquidation preferences in an earlier blog called Liquidation Preference and Avoiding Dilution.

According to Wasserman, Series A investors in 78% of all start-ups that raised external investments had a liquidation multiple of 1; 9% had a liquidation multiple of 1.1 to 2; 5% had a liquidation multiple of 2.1 to 3; and 8% had a liquidation multiple of greater than 3.

The dilemma is: Do you accept an investment whose terms include high liquidation preferences even though it in effect makes earlier investors’ return nil [and significantly dilutes the founders], or do you turn down the investment hoping for better terms from another investor?

If you accept the terms, you have thrown your earlier investors under the bus. If you refuse the terms, you may be throwing the entire company under the bus. Therein lays the dilemma.

6. External vs. Internal Boards

If you have a board of directors composed of the inner circle, e.g., co-founders and/or fellow officers, you can make decisions with your co-leaders and know they will be endorsed by the board. But now you have no “sounding board.” You have no independent thinkers. You have no checks and balances. The primary reason for a board should be to hear other opinions.

7. Control vs. Wealth

In an earlier blog called You Are Not Your Company, I described the problem founders have of trying to control their companies vs. distributing ownership and creating a much bigger pie to share among more mouths.

8. Compensation

Should officers of the company (and in fact all employees) receive cash compensation equal to what they would receive at a non-start-up company? Should they receive stock options as an incentive to join the company? Should they receive stock options in lieu of cash compensation? What is the right balance among these three?

There is no right answer. However, the decision is affected significantly by the amount of cash the company has (and this is affected by the desire to attract investors and/or the desire to time investments based on company valuation) and the amount of control that the founders demand or are comfortable with sharing.

9. How Long Should Vesting Be

When options are granted or stocks are sold to employees with reverse vesting, how long should the vesting period be?

On one hand, a long vesting period sounds like an incentive for the individual to stay with the company for that long period of time.

On the other hand, a long period of vesting could also cause a frustrated individual to say “I can’t wait that long; I might as well leave now.” The table on the right, from Wasserman, shows how long the vesting period is in start-up companies for founder CEOs vs. non-founder CEOs.

In summary

Starting a company is not for the faint of heart. Fortunately books like Wasserman’s Founder’s Dilemmas exist to guide you through the tough times.

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?

Photo of fighting male hartebeests by Filip Lachowski (Creative Commons)

Four Ways to Validate Your Great Startup Idea

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

Thumb

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).

 

Start-ups: How to Release New Products

Like all lean startups that also practice agile development, our company makes small releases of the product and website roughly twice a month. With each release, we gather valuable information, reach tentative conclusions, and incorporate what we learn into subsequent releases.

However, every once in a while, the time comes to launch an entirely new version of the product. This blog is about the mechanics and psychology of a major launch.

FearFirst, let me digress for a moment about the role of fear. Early in my life, I thought that the fears I felt (e.g., fear of embarrassment, fear of failure) were character weaknesses. Now I see them as strengths. These fears drive me toward careful planning and fastidious preparation for major events so that neither embarrassment nor failure becomes likely.  With this planning and preparation comes a desire for perfection.

As an entrepreneur, I cannot explicitly look for colleagues who possess a similar “gift of fear,” but the team members that succeed with me do share my attraction to planning, preparation, and perfectionism, regardless of their motivation.

So, how does this all apply to launching a major release of a product? Product releases have dozens of interrelated moving parts. The proper functioning of each part relies on the unique talents of your team. Seamless interconnections between the parts rely on communication between the individuals on your team. And all of the parts and their interrelationships are highly visible. If anything fails, the opportunities for embarrassment and failure are huge. Now you see where planning and preparation, and thus fear, play roles.

Let’s talk about some of the parts, how they interrelate, and how to avoid failure to launch well.

Product

  • Add enough new features so you can seriously claim (from a press release perspective) that this is indeed really a new version of the product
  • Select features based on plenty of customer feedback. To do this, read my article on the art of triage.
  • Make sure you update all your help screens to match your new features
  • Buggy software is a great way to lose all your customers. Thorough testing is a necessity. At Offtoa, we spend 2-3 months doing system testing on a new major release of a product after development has finished with it and before we release it to the general public. Is this overkill? Perhaps. But like I said above, we don’t like to be embarrassed!
  • Use your loyal customers to help with testing. We bring on board such beta customers toward the end of our own system testing. We don’t expect them to find anything wrong, but if they do, any damage is well-contained.

Website

  • Usually, a major new release of the product coincides with refined messaging and new differentiators. So, a newly designed website is almost always in order. Certainly content will need to change.
  • A major new release of the product is also a great time to freshen up the website with a similar look and feel.

Marketing

  • Since a new product release always implies new differentiators (or else why are you building a new release?), you should be spending considerable effort on a new marketing campaign.
  • As a guideline for software companies, I spend equal resources on marketing and development in preparation for each major new release.
  • Target 1-2 specific vertical markets.
  • Make sure you fully understand the pains of your targeted vertical markets and the messaging that drives home how your product relieves that pain. This is essential to conversion rates and low customer acquisition costs.
  • If you are using Google AdWords (or equivalent) to drive traffic to your website, you’ll need to use all you have learned from earlier campaigns about which search words attract the most qualified leads from of your targeted vertical markets.
  • Make sure you have built customized landing pages for each AdWords campaign to help convert leads into customers. Once again, earlier campaigns should have helped you hone the messaging.
  • Construct and disseminate press releases to appropriate media outlets to help drive both customer traffic and analyst interest.
  • Instrument (e.g., with Google Analytics or equivalent) your website so you understand how leads become customers.

Customer Support

  • Contact your current customers in advance about the new release so they have plenty of warning.
  • Create a transition plan to seamlessly transition your current customers to the new product without any pain felt by them. You need to convert all customer data.

Twenty years ago, software development companies released all new functionality in huge new releases. Today we have learned the value of both minimally viable products (MVP) as well as small incremental releases. However, even with this new knowledge, major new product releases are still necessary on occasion. And these are fraught with risk. Avoid failure to launch well, which hurts the credibility of your company and your product, and consider these tips when you are about to embark on your major release.

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.

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?

Photograph of Cover

Fear photo is a screen capture from the public domain film ”Carnival of Souls.”

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/

When should you ask for investments?

1024px-Wonderland_Walker_2A successful startup company needs to create a sustainable growth model using paid, viral, and sticky strategies. However, before it gets there, a startup usually needs some cash investments to get things going.

Let’s say you have performed a financial analysis of your startup company and have determined that you will need $1M to keep it afloat until it can sustain itself.

When should you raise the $1M? No simple answer exists. In general, the longer you wait to raise any round of investments,

  1. The higher your valuation is likely to be because you have likely reached more milestones, like generating more revenue, obtaining more partners, producing more product, and so on. The higher the valuation, the less of the company you will have to “give away” to investors for a given amount of money.
  2. The higher risk you have of running of cash, so unscrupulous investors could take advantage of you by delaying their investment decision until you are desperate, thus forcing you to accept a lower valuation.

Some advisors will tell you to ask for all the money you need at one time because the investment-seeking process is so time-consuming that you want to do it as infrequently as possible. Get it over with at one time so you don’t have to do it again.

Some advisors will tell you to always raise more than you need because you have probably been overly optimistic in many of your predictions, and you want the cash cushion.

Some advisors will tell you to always raise less than you need (i.e., be as lean as you possibly can be) because your company’s valuation will always be higher later and you can raise less expensive money later.

Only you can make this decision. It is a delicate balance act.

What does cash flow look like?

Every startup’s cash flow looks like the following graph:

Cash Flow Figure

Notice that in the ideal world a successful company would burn cash at a slower rate of speed after each successive investment round; note that the slopes of subgraphs A, B, and C increase with each round. Eventually, the company sustains itself (at point C in this case) from operations without additional infusions of cash from external sources.

If the entrepreneur waits too long to raise investment round 2, line A will continue its downward trend below the horizontal zero line and the company will be out of business. If the entrepreneur doesn’t wait that long, but long enough so investors can see the company running out of cash soon, investors could just delay their decision.

In Summary

Entrepreneurs have to make their own decisions.

Some prefer to bootstrap using revenues to grow their businesses; this approach maintains ownership among founders and employees, but usually means slower growth because they can be cash-strapped.

Others prefer to raise as much as possible . . . and then spend it as fast as possible, reducing the risk that a competitor will beat them to the market.

Others take a middle of the road position of raising just enough capital, and spending is judiciously.

All a matter of style.

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.

WYNSUMM Cover

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?

Photo of Nik Wallenda (Wonderland Walker) courtesy of Kevint3141 (Creative Commons).

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).