Startups Gone Bad
I have examined hundreds of small businesses over the past 30 years. Many possessed basic financial flaws: flaws that if caught and corrected early might have resulted in highly successful companies.
In many cases, the entrepreneurs lacked proper advice or adequate tools. The flaws remained unnoticed until they were so embedded in the company that it was no longer possible to undo the harm they caused. Let me give you some examples:
Gross margins with no margin at all A company planned to manufacture industrial lubricants with very unique properties. They intended to capture a large percentage of the market by (a) marketing unique properties that were the result of unique raw materials, and (b) price the products well below competition. That sounded like a great value proposition for all stakeholders.
A careful financial analysis revealed that the unique raw materials drove the cost of goods sold up to around 85% of the planned price. This left just a 15% gross margin, far too low to support infrastructure costs.
Unrealistic revenue projections A company proposed to be “the next Facebook®” by creating a social networking site with a few unique but easily mimicked features.
The founders had no software experience. To make matters worse, the company was also using unrealistic financial assumptions:
- First year projected revenues of $5,000,000, which were unattainable
- Second year projected revenues of $15,000,000, which were even more unattainable
- Combined marketing and sales expenses of just $100,000 for the first two years
- 80% projected profit in their first year, rising to 90% profit in the second year
- Investment goals of $2,000,000 to $4,000,000 in their first round, while their cash flow statement showed no need for any more than $300,000 in cash.
Investors would identify the business and financial strategy flaws immediately and walk away.
High risk and low return The founders of a company providing support to independent insurance agents were offering to sell 25% of the company for $1,000,000.
Assuming that the company met all goals and ended up being acquired in five years, the likely company valuation would be around $6,000,000. The 25% stake would thus be worth $1,500,000 at acquisition time, yielding an 8% internal rate of return for the investors.
Very few investors are interested in such a low return for such high risk.
This is why a financial plan before you launch your company is so important. You don’t want to waste your time or your investors’ money on a business that makes no sense.
But even more importantly, a financial plan that uses expected pricing, sales volumes, and expenses to predict outcomes such as profits and cash flow can give you the insights necessary so you can alter your strategy up front to achieve much bigger success with significantly lower risk.
This article is an edited excerpt from the book Will Your New Startup Make Money? by Al Davis. Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.
‘Going Out of Business’ Photo courtesy of Marius Watz (Creative Commons)