As a founder of a company, you have few responsibilities more critical than preventing the company from running out of cash. One half of that is minimizing cash outflow and the other is maximizing cash inflow.
Minimizing Cash Outflow
The obvious way to minimize cash outflow is to spend less money. But here are some less obvious ways:
- Minimizing accounts receivable (A/R). By collecting payments from customers upfront rather than allowing them to pay you, say, 30 days after receiving your product, your company will, on average, have much more cash on hand. How much? Roughly 8% of annual revenues!Other strategies for minimizing A/R include validating creditworthiness of your customers before doing business with them, converting checks into electronic funds transfers (EFT), e.g., using the Automated Clearing House (ACH), accepting credit card payments, and so on.
- Maximizing accounts payable. By negotiating best possible terms with major suppliers, you can also reduce your cash burden. Once again, if you can negotiate ‘net 60’ rather than ‘net 30’ terms on your payments to suppliers of your raw materials, you can increase your company’s cash on hand by another 4% (assuming that your cost of raw materials represents half of your revenues).
Twelve percent may not seem like much, but if you can succeed at implementing the above two strategies, you will have 12% more cash on hand, and that means you might need to attract 12% less money from outside investors, which means founders might end up owning 12% more of the company. When put like that 12% sounds like a lot!
In addition, minimizing the cash conversion cycle (i.e., time between paying suppliers and customers paying you) can also have a direct effect on increasing the valuation of your company; see Bessemer’s Top 10 Laws of E-Commerce for more details
Maximizing Cash Inflow
Only three ways exist to get cash into a start-up:
- Customers provide cash in return for the company selling them product.
- Somebody provides cash in return for the company promising to pay back that money plus interest.
- Somebody provides cash in return for a part ownership of the company.
More established companies have a fourth way: they can sell assets.
Let’s take a closer look at the three ways to get cash into a start-up:
Myriad books exist on how to drive revenue, but here is a quick summary of avenues at your disposal:
- Differentiate your product or service.
- Lower your price.
- Raise your price.
- Broaden your market.
- Narrow your market.
- Spread virally.
- Convince current customers to buy more.
Now let’s discuss how loans and investments increase your cash:
If you decide you need outside sources of cash, loans are one of two primary mechanisms. The primary advantage of a loan is that you do not have to give up equity in the company.
Primary disadvantages are (1) you have to repay it under the terms of the loan agreement, and (2) for most start-up businesses, you will likely need to co-sign for the loan personally, and that means your personal assets serve as collateral for the note.
In other words, if the company cannot pay back the loan, the lender will expect you to pay back the loan; and just because the company is a corporation does not free you from this obligation . . . and that is precisely why the lender will ask you to co-sign the note.
In effect, the lender is giving you a personal loan (based on your personal credit history) and is allowing the company to be a co-signer, thus initiating a credit history for the company.
Since start-up businesses are generally too risky for most banks to lend money to, the Small Business Administration (SBA) established the Basic 7(a) Loan Program. Entrepreneurs apply for a loan under this program through their local bank.
If approved, the bank lends the start-up between $200K and $300K, the SBA reduces the risk to the bank by underwriting 70-90% of the loan, and the entrepreneur provides collateral to the SBA. The loan can be repaid over 10 to 25 years.
Another kind of loan that start-ups can secure is bridge financing, often available from traditional investors such as angels or VCs. Bridge financing is a loan that is not intended to be paid off, but instead to be converted into equity upon the next round of investment.
Its raison d’etre is that you may need cash now, intend to raise a round of investment later, and some combination of the following two situations are true:
- You do not have time to create all the paperwork now for the investment round, or
- You do not want to establish a valuation for the company now because within a short period of time a major milestone will be met and the company will likely be worth a lot more then.
Bridge financing is one example of a convertible debenture, which is any loan instrument that provides the option to be converted into equity instead of being paid off.
The other major source of cash is investments. An investment is very simply a purchase of part of the company. It is thus an exchange of a percent ownership of the company (usually stock, in the case of a corporation) for cash. Typically, investors in a startup include entrepreneurs themselves, friends and family, angels, and venture capitalists.
Angels are high net worth individuals (often former or current entrepreneurs themselves) who invest their own money in startups, and often like to stay involved in the company providing wise counsel on an as-needed basis. Lists of angel networks can be found online at Gust (www.gust.com) and Angel Resource Institute (www.angelresourceinstitute.org).
You can also locate angels through incubators (find a list of incubators through the National Business Incubator — www.nbia.org) and accelerators (find a list of accelerators through the Global Accelerator Network — www.gan.co).
Venture capitalists invest other people’s and other financial institution’s money in startups. Unlike angels, they are professional investors; their careers depend on the success of portfolio companies they have chosen to invest in.
Many first time entrepreneurs focus their attention on profit and disregard cash; see my earlier blog, How Can a Startup be Profitable and Still Run Out of Cash, for a discussion of this issue. Yet every company that has failed has failed for the identical reason: it ran out of cash. Don’t be one of them.
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.
American Cash http://commons.wikimedia.org/wiki/File%3AAmerican_Cash.JPG from Creative Commons