Category Archives: Startups

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

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.
Photograph of 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? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com,.

7 Steps to Calibrating Your Startup Growth

640px-Mahr_Micromar_40A_0-25mm_MicrometerWhen you start a company you naturally have two immediate and equally pressing priorities.  Those priorities are to solve a problem for customers and to validate that you can make money solving that problem.

To validate that you can make money and to understand when you’ll make it, you need to build a pro forma income statement. A pro forma income statement shows how much revenue you expect to receive from the sale of your product and what expenses you expect to incur over your first few years of doing business.

Three basic approaches exist to predict startup revenues:

  • You can just guess. But beware!  Nobody will believe the numbers.
  • You can estimate that you will achieve some percentage penetration of the total available market. Sadly, nobody will believe these numbers either.
  • You can determine which processes you will use to achieve sales, estimate how efficient those processes will be, and then derive how much revenue you will achieve based on those assumptions.

This article explains how to do startup revenue estimation using the third approach. It involves the calibration of seven key variables.  You’ll start with the initial estimation of the seven key variables and then refine them as you learn actual values.

The Seven Key Variables:

  1. Customer Acquisition Cost (CAC): For those new customers that you attract as the result of your marketing activities, how much does it cost you per customer? This is one of the most difficult to estimate. You will start with just a guesstimate based on the (very) few published data from other companies in industries similar to yours and using sales techniques similar to yours.
  2. Sales Cycle (SC): How many months transpire between your expenditure of marketing dollars and the acquisition of new customers? This will also be just a guesstimate based on your past experience.
  3. Average Order Size (AOS): How much revenue do you expect to generate each time a customer makes a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  4. Periodicity (P): How often will each customer make a purchase? You should have a pretty good idea of what you want to achieve here based on your product, pricing, and business model.
  5. Retention Rate (RR): What percent of existing customers will remain customers at the end of each year?
  6. Viral Coefficient (VC): How many people will each existing customer attract and successfully convert into new customers? This is a one-time conversion; once a customer refers this many new customers, we assume they no longer refer more new customers. Very few companies achieve a VC as high as 1.0.
  7. Viral Cycle Length (VCL): How many days will transpire between customers becoming new customers and their referrals becoming new customers?

Before you launch your company, verify that the estimates you’ve made for the 7 key growth drivers could result in a successful company. That is, there must be significant revenues and profit, and solid returns for all shareholders to be considered successful. If not, realistically adjust the values until the company shows returns. But don’t just change the values to make the company look like it will be successful; the new values must be achievable!

Refine the Seven Key Variables:

After launch, every month, compare your actuals to your planned values for the 7 key growth drivers. Enter actual values for CAC, SC, AOS, P, RR, VC, and VCL into your plan. It might be helpful to graph each one. You will likely find that

  1. CAC and SC will start off quite large and will only converge to stable (and lower) values after you learn how to find your target market and how to optimize your messaging.
  2. You will not be able to ascertain actual values for RR, VC or VCL until after a year or so.

Verify that the actual values for these 7 key growth drivers still result in a successful company – i.e., significant revenues and profits, and solid returns for all shareholders. If so, you are on track! If not, you need to pivot.

How to Change Actual Values for the Seven Key Variables:

  • To decrease CAC and SC: Improve your understanding of the target market. Hone your advertisements to the specific pains of your target markets. Focus on benefits rather than features of your products. Offer better pricing or better promotions to increase close rates.
  • To increase AOS: Offer quantity discounts. Improve your product.
  • To increase P: Offer frequent buyer programs. Improve your product.
  • To increase RR: Improve your product’s stickiness.
  • To increase VC and decrease VCL: Offer referral programs, especially ones that incent both referrer and new customer. Make products so exciting that they create a buzz. Add features that increase your product’s value to customers.

Summary:

As you can see, these seven key variables are fundamental to understanding your startup’s revenue. They are not easy to estimate, but you can at least determine during the planning stage what values you must achieve to be a viable company.

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.
Photograph of CoverIf 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.

Startups: When Will You Be Profitable?

When Profitable PhotoAs the founder of a startup company, you should be able to determine when you will be profitable. But how can you do that before you even start?

The answer is you need to make some assumptions. In fact, you need to make many assumptions. It is very important to record all these assumptions because during the first few months of your company, you will have to create experiments that validate whether or not these assumptions are true.

So the first step in determining when you will be profitable is recording all your assumptions. See my earlier blog, What Assumptions Does an Entrepreneur Make, for a sample list of such assumptions.

The second step is to create a pro forma income statement based on those assumptions. If you are not familiar with what an income statement is, see my earlier blog, Seven Things an Income Statement Tells You.

The third and last step is to examine the row of the income statement labeled EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) from left to right looking for the first entry that is positive. If that entry is in the second column, then the answer is you will be profitable in the second year of your business. If it is in the third column, then the third year, and so on.

Most startups are not profitable in their first year. This is because of high starting expenses, as well as the inevitable high cost of goods sold associated with low volume sales. So, if your assumptions show you as profitable in year #1, you may want to rethink your assumptions. And if you are seeking investment capital, I can assure you that investors will look more favorably upon your enterprise if you show realistic numbers, not overly optimistic ones.

 

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.
Photograph of CoverIf 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 (and also as a tool to transform your assumptions into financial statements), sign up for www.offtoa.com.

Office Space

Trials and Tribulations of Leasing Startup Office Space

A few years ago, I co-founded a software company. At our peak, we employed 14 people and had over 100 customers. This is the story of the trials and tribulations associated with trying to provide the best possible office environment for our employees during our four years of existence. Our hurdles included irate neighbors, no toilets, and rent payments we couldn’t afford.

Phase 1. My Basement

Many start-ups are launched in the basement of a home or a garage. We were no exception; our first office was in my basement in Colorado Springs. This space was occupied for over a year, and we managed to squeeze nine people into two small rooms.

We were quite content even though we were bursting at the seams. However, an irate neighbor threatening to call the police for violating the subdivision’s covenants. His comment to me one day was “I didn’t move to this neighborhood to stare at a line of cars parked in the cul de sac every day.” Omni-Vista was forced to find new digs.

Phase 2. Unfinished Office Space with No Toilets

We found an office building whose owner was willing to allow us to occupy 1,800 square feet of unfinished space for a period of time for no rent prior to moving into finished space within the same building. This seemed ideal. It preserved cash short term, and allowed us to move into nicer Class A space after we became more financially solid.

We ended up staying in this unfinished space for nine months, although neither the landlord nor our employees thought it would be that long.

The real problem was that this unfinished space had no bathrooms. We found a gym next door that had bathrooms. We asked the gym owner if our employees could use his facilities. The answer was, “no, only members and their guests.”

We asked how many guests could a member bring. The answer was, “one at a time.” Armed with this information, we asked, “If half our employees joined the gym as members, could all our employees use the bathrooms?” The answer was a resounding yes.

My co-founder had a great idea: the company decided to offer to pay half the annual gym membership fee for any employee who wished to join. The result: more than half the employees joined the gym, and all twelve of us used the bathrooms next door.

Phase 3. Class A Space but We Couldn’t Afford the Rent

We finally moved into our new, grand 3,000 square feet of Class A offices. It included a server room, bathrooms (great news!), reception room, large classroom that could double as a boardroom, break room with kitchenette, storage room (for future expansion), and around 10 offices. The space was not luxurious, but it was certainly very nice. We had to sign a five-year lease, and I was required to be a personal guarantor for the full five years of rent.

After a year in the nice office space, with cash dwindling, and the company’s need to reduce staff, it was clear that we needed to get out of the lease. But where would we move to? And what about my personal guarantee for the rent for all five years? My co-founder and I discussed this at length and decided we needed to simply present the dilemma to the landlord and see if we could reach some mutually agreeable termination terms.

I stewed for a couple of days before finally getting up enough nerve to approach the landlord. I woke the next morning with the plan to call the landlord and discuss this sensitive matter. I expected the worst. I rehearsed my words from 6am to 8am that morning with my co-founder. At 8 am the phone rang. The landlord was calling me!

The landlord explained that he had something very awkward to discuss with me and would like to meet with me right away. Later that day, the landlord explained that he had a major tenant (from another building) who wanted to expand into the vacant space currently available in the building that we were occupying, but they also needed the space we were in, and he would like to “buy out” our lease. Would we be willing to vacate the space within thirty days?

I considered playing hard-to-get and hold out for the best deal I could get. But deciding to not look a gift horse in the mouth, I simply asked him what he had in mind. The landlord offered us our last month for free if we would vacate at the end of it. I agreed. He made the departure quite pleasant, and released my personal guarantee. Sometimes, things do go right!

Summary

Startup companies usually need office space to house their employees; exceptions are those that can remain virtual. Unless if you have frequent visitors who you need to impress, stay in your basement or garage for as long as you can, and then, when you need to emerge, satisfy yourself with “good enough” office space.

As a startup founder, you will need to sign a personal guarantee, but in general the less prestigious the address, the shorter that guarantee will need to be (and the lower the lease payments).

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.

Interior of Thiruvanmiyur station (Prateek Karandikar from Creative Commons)

Mine

Five Fatal Flaws in Financials

One of the first and most important steps to take before you launch your startup company is to create pro forma financial statements to verify that your company makes financial sense if all the assumptions that you are making end up becoming true.

The three pro forma financial statements we will be referring to are the income statement, cash flow statement, and the balance sheet.

Three types of “financial sense” can be derived from the above financial statements:

  • Fatal flaws: These are conditions in your financial statements that indicate that the company cannot survive. These are the subjects of this blog.
  • Universal non-investible flaws: These are conditions in your financial statements that make it highly unlikely that any right-minded investor would consider investing in your endeavor. The presence of universal non-investible flaws implies that the company could survive but will not produce extremely good financial returns.
  • Situation-specific flaws: These are conditions in your financial statements that may or may not preclude good financial returns, depending on the specific industry or unique situation.

Fatal Flaw 1. Negative Cash

The bottom line of every column of the monthly cash flow statement is always labeled “Cash at End of Period.” It tells you (based on all the assumptions you have made about your company) how much cash you will have in your company’s bank account at the end of every month.

No entry in this row can be negative.

If some column has a negative value in this row, you must do something to your assumptions prior to this month, for example (these are just four of dozens of possibilities),

  • Get a loan
  • Raise money in an investment round
  • Sell more product
  • Spend less money (on expenses)

What you cannot do is just launch the company and hope that things will work out. Hope is not a strategy. The fact is many things will change once you launch, but you have to at least start with a plan that has a fighting chance of working.

Fatal Flaw 2: Negative Gross Profit

Near the top of every column of the annual income statement will be lines for

Revenues
– Cost of goods sold      
Gross profit

Gross margins indicate how efficient the company is at acquiring and using raw mate­rials for its products. Different industries tend to experience radically different gross margins based on (a) inherent cost of goods sold within those industries, and (b) level of price competition.

Your company can tolerate a negative gross profit in its first year while you figure out pricing, find best suppliers, and hone manufacturing and internal processes. However, by year 2, you had better have a positive gross profit.

New companies rarely emerge in industries where gross margins are low. Reasons should be obvious: investors will likely not see a return on their investment based on an ROE calculation.

Here are some ideas on how to increase gross margins:

  • Decrease cost of raw materials. This is the most straightforward method to reduce cost of goods sold, and yet it is the most dangerous because of potential to adversely affect product quality.Some ways are: (a) find alternative suppliers, (b) replace expensive components with less costly substitute components, especially when customers are unlikely to perceive the difference, (c) use less of a raw material in your product, and (d) purchase in larger volumes
  • Outsource, insource, offshore, or onshore. Find the lowest cost source of doing tasks while still maintaining acceptable levels of quality.
  • Increase prices.
  • Change the product. If your product cannot be sold profitably, consider selling a simpler product that solves fewer customer problems and price it lower. Or consider selling a larger product that addresses more customer pains and price it higher. Or maybe you should rent or lease the product instead of selling it?

Fatal Flaw 3: Insufficient Cash from Operations

The top third of the annual cash flow statement captures cash flows in or out of the company that result from the core business of the company. The bottom line of every column of this top third is always labeled “Net Cash Provided (Used) by Operating Activities.” It tells you (based on all the assumptions you have made about your company) how much cash the company’s business is generating without the contributions of loans, investments, or sales of property.

Almost all startups experience negative cash from operations for the first few years. During this time, they rely on infusions of cash from external sources such as investments or loans.

However, a successful company must at some point be self-sufficient; it must be able to sustain itself with being on life support.

It is possible that a high-growth company with a huge market could plan to stay on a high-growth trajectory for many years and continue to need capital infusions to fund its growth. So, I guess the best way to describe this fatal flaw is to ask if the cash from operations would be positive if the cash from financing were set to zero.

Fatal Flaw 4: Current Ratio Less than One

On the annual balance sheet, divide current assets by current liabilities for each year. This current ratio gives you a pretty good indication of whether your company will be in a condition to pay off debt when it becomes due.

A value less than 1.0 indicates that the company is going to have problems, although there could be short-term fixes for short-term problems. As your company evolves, your current ratio should become (and remain) above 1.2.

If your current ratio is less than zero, it means your current assets are negative (current liabilities can never be negative), so this is equivalent to fatal flaw 1.

Fatal Flaw 5: No Profit

Near the bottom of every column of the annual income statement is a row labeled “EBITDA,” short for earnings before interest, taxes, depreciation, and amortization. You can think of it as the company’s profit (without some of the “noise”).

Most startups experience negative EBITDA for the first one or two years, and that is okay. In fact, it is highly unlikely to have positive EBITDA during those first few years.

However, by year three or so, EBITDA should be positive, and stay positive for the remaining years.

Summary

Although many dozens of potential problems can be detected in advance by examining the pro forma financial statements, the above five conditions are easy to detect and are almost always fatal for your company if not fixed. If you find them to be present in your company’s financial statements before you launch, don’t launch! Instead, fix your plan.

After you fix the plan, and know that it is possible to succeed, then launch the company. It is always good to start knowing that failure is not guaranteed.

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.

Auto Comfort Compressed

Seven Steps to Starting a Startup

Step 1. Do Some Homework

If you try to know everything about your industry and market before you start your company, you will never launch it. Instead, learn the most important aspects of the market and the competitors.

Start with the great checklist of things you should try and learn about your market and industry from Mullins’s book, The New Business Road Test: What Entrepreneurs and Executives Should Do Before Launching a Lean Start-Up, but concentrate on looking for showstoppers, i.e., reasons why you perhaps should not start the company.

Step 2. State Your Business Idea as a Set of Assumptions

Since you cannot possibly know everything about the market and the industry, record all assumptions you are making about your business. What products will you sell? At what price? How large is your market? How many will you sell each year? How much will it cost you to purchase and/or manufacture the product? How many employees will you need? How much will you pay them? And on and on.

There are dozens of such assumptions. You can find a checklist at What Assumptions Does an Entrepreneur Make?  Many reasons exist to record these assumptions:

  • It forces you to think through every aspect of your business idea. You don’t want to be 6 months into a business and say “Oh, I wish I had thought of that earlier!”
  • The numeric assumptions can drive the creation of all your pro forma financial state­ments, which you will need anyway.
  • You can assign a red flag to each assumption that is not yet confirmed. Remove flags as assumptions are confirmed.
  • Assumptions that are critical to your success and still have red flags become targets for experiments. Build and deploy prototypes, run focus groups, do anything it takes to find out as early as possible if those assumptions are true or not

Step 3. Determine if Your Business Idea is Financially Sound

Pro forma financial statements enable you (and others) to easily assess the expected financial health of a company. As a result, they are extremely useful in assessing the likely outcome of a company if all your assumptions prove to be true.

So the next step is to transform your assumptions into financial statements and confirm that the company makes financial sense. Some of the checks you want to perform are:

  • When is it profitable?
  • How much cash does it need to get started?
  • Does it grow fast enough?
  • When is breakeven?
  • How much of a return do investors make?

Step 4. Refine the Assumptions

If the financial statements fail any of your checks, you need to decide how critical the failure is. For each check, you can change your business assumption, or you may have good reasons to ignore the alleged problem. If so, make sure you fully understand your rationale and can articulate it because investors and other stakeholders will ask you about it.

Step 5. Launch and Run the Business

As you start to run your company, you will discover that some assumptions you made during the planning stage will prove to be false and you will need to make adjustments. If you are smart, you will actually run myriad experiments with your customers to explicitly prove or refute the most crucial assumptions.

Step 6. Change Refuted Assumption and Determine if Your Business Idea is Still Financially Sound

Whenever you determine that a stated assumption is no longer valid, change that assumption based on what you just learned. Next check that the company is still on solid financial ground using the same techniques you used in Step 3.

If so, continue on the current path.

Step 7. Pivot when Necessary

If not, revise other assumptions to compensate for the new reality. Verify that this makes financial sense using the techniques you used in Step 3, and then manage your company in the new direction as defined by the new assumptions. This is called a pivot.

Summary

The odds of success for a startup are very low.  Improve your chances by diligently planning and being ready to adapt when new information emerges.  These 7 steps will help you balance both.

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.

Mouse Trap

Eight Things You Never Say to Investors

When you approach potential investors about investing in your new company, you should avoid certain expressions. They are traps that you either make you look weak, or from which you will have a difficult time extricating yourself. Here are some examples.

1. “I have no competitors”

Everybody has competition, even if they offer a substitute product. A sophisticated investor will be turned off immediately if you imply you have no competition.

Every startup launches because its founder has thought of something new. It is either

  • a new product or service, or
  • a new market for an existing product or service, or
  • a new way to deliver an existing product or service.

But just because you have thought of something new doesn’t mean you have no competition. You provide products and services as solutions to customers’ problems/needs/pains. Ask yourself, “How do people satisfy their problems/needs/pains currently?” Even if the answer is “They don’t,” then the status quo is competition!

Let’s look at some examples:

  • A new 3rd generation canine cancer-fighting drug. The competition includes: (a) less effective 2nd generation cancer-fighting drug, (b) not treating the dog (could be cost effective), or (c) pain killers for the dog to enhance quality of life.
  • The first online gourmet recipe ingredient store. The competition includes: (a) general on-line merchandisers like Amazon, and (b) storefront sellers of gourmet food.
  • The first allergy clinic franchise embedded inside of physician offices. The competition includes: (a) standalone allergy clinics, (b) allergists, and (c) physician assistants and nurse practitioners specializing in allergies.
  • The first online bookstore (i.e., Amazon). The competition includes all the brick and mortar bookstores.

Bottom line: just because you are the “first” does not mean you have no competition.

2. “All I need is your money; not your opinions”

Investors, whether angels or venture capitalists, usually consider their business acumen to be of considerable value to their portfolio companies. When you make a statement like this (or imply it through your actions) you will likely alienate the investors sufficiently so they will not invest.

3. “My time is worth as much as your money”

During an investor pitch, investors will often ask “how much money have you raised to date?” They want to know how much cash has been invested in the company so far. All founders devote enormous hours in birthing their companies, but labor hours just don’t count.

Yes, you can and should offer to work for no cash compensation (this could be a factor in encouraging investors to invest), and yes, you can suggest that you will accept options in lieu of such compensation. This is all good.

But don’t go into a monologue explaining how your time is worth $100,000/year, so you have thus far invested $100,000 into the company by working for a year without salary.

4. “I will guarantee you an X% return on your investment”

“Danger! Will Robinson. Danger!” You cannot guarantee anything to your investors. You are selling them securities in return for their payment and the terms of this transaction are spelled out in a written subscription agreement.

When you state that you “guarantee” such a return, you are inviting a class action law suit from investors if such a return is not delivered. Do not do this! And the limited liability of the corporation will likely not protect you as an individual (or your personal assets) from claims by the investors.

5. “This is a risk free investment”

By their very nature, startups are risky. The graph to the left shows the survival rates for startup companies, and emphasizes that the rates have been the same regardless of the year they were started. Notice that only 50% of companies survive for 5 years or more.

But even ignoring the data, making such a statement is foolhardy. You have an obligation (legally and ethically) to potential investors to understand and spell out all the risks involved in investing in your startup.

And your attorneys, when they draft your subscription agreements, will insist on including a clause that spells out the likelihood of total loss of the investment.

6. “All I have to do is build my product and the customers will come”

This is a classic statement made by engineers without any marketing savvy. By saying it, investors will know you are a geek. Only three ways exist to create revenue:

  • You can “buy” a customer. That is, you can spend resources (usually money) to raise awareness of your product, you can pull or push leads to you, and you can spend more resources to convert those leads into customers.
  • You can convince existing customers to buy more, or buy more often, or not stop being your customer.
  • You can encourage existing customers to convert non-customers to become customers.

That’s it! Nowhere in this list is “Build my product and  customers will come.” Creating and growing revenue takes work. Plain and simple. Investors know that. If you don’t know that, you will be seen as naïve, not street smart.

7. “We’re almost out of cash”

The timing of raising capital is always a challenge. If you wait too long (e.g., you get close to running out of cash), less respectable investors could take advantage of your situation by delaying their decision to invest until you are desperate and you may end up being forced to accept less-then-ideal terms.

On the other hand, if you solicit investments too early, company valuations might be lower than you would like, and you may end up having to sell a larger percentage of the company to raise necessary cash. No perfect answer exists, but unless you are about to hit a major valuation-changing milestone, I would err on the side of too-early rather than too-late.

Whatever you do, don’t ever suggest to the investor that you are desperate for cash; that will invite even scrupulous investors to make lower offers. The best advice is manage your company so you are never desperate for cash.

8. “The market is so huge; all we need to do is capture 1/10 of 1% of it.”

This might sound impressive to you, but it doesn’t to the seasoned investor. Investors want to invest in market leaders; they want you to have a large percent of some market. Market leaders lead. Market laggards lag.

Successful startups first focus on penetration of relatively narrow vertical markets; it is called the “rifle shot.” Such an approach enables you to target your desired audience with a marketing campaign designed specifically to their particular pains.

Bragging about a “huge market” and the sufficiency of a tiny capture to “make millions” demonstrates that you don’t understand the dynamics of focusing. It sounds like you are going to take the “shot gun” approach, one that usually results in failure because of overly broad messaging.

In summary

Investors are much better at negotiations than you are; after all, they do it over and over again, and you do it rarely. They have heard all the “lines” before and they can see through BS immediately. They also know how to take advantage of your vulnerabilities if they desire to.

I have a few other cautionary bits of advice. They don’t fit into the category of “never say these,” but they are close:

  • “It will be easy to steal customers from competitors because they provide such terrible customer service.” Competitors may in fact be providing terrible customer service, but never underestimate the power of inertia. Many customers would rather stick with a known, but poor, service provider than venture into the unknown.
  • “Our key differentiator is a great user interface.” Sorry, but every new startup claims that it will provide the greatest user experience. You might actually plan on doing so, and you might even be able to do so, but because you sound like every other entrepreneur, your claim will be summarily dismissed.

 

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?

“Clippesby drainage pump – overgrown door” © Copyright Evelyn Simak and licensed for reuse under Creative Commons License. Original photo from Geograph Project.

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.

wordle

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.