20

It Takes Money to Make Money

THE FINANCIAL ASPECTS of starting and running a business are often underestimated, but they are arguably the most critical areas (and the areas that usually cause the most trouble) in your new business. In my FIRED-UP entrepreneur assessment, the very first step is the “F,” which deals with your finances. This is not a coincidence, because when you are considering becoming an entrepreneur, it is paramount that you have (or have access to) enough money to (1) start up or purchase the business; (2) operate the business, including the ongoing working capital and investment needs of the business; and (3) also live on (you still have to pay your bills, right?).

When you start or buy a business, you need to translate your business plan from written ideas about your business concept into a set of numbers called a pro forma financial model or financial projections. These financial models will do three very important things for you:

1. Help you evaluate if the opportunity makes financial sense (i.e., if it has the potential to produce an attractive return for you on your investment) and is worth you pursuing;
2. Help you identify how much money you need to start or buy the business, as well as have enough cushion to be able to fund business operations for the first two years; and
3. Provide a benchmark for the valuation of the company and how much ownership you will give up to investors if you need to raise equity capital.

I want to particularly emphasize number one above, because I have seen business plans that have no financial projections, limited financial models, or unrealistic financial models. You cannot (I repeat, cannot) evaluate whether you have a good business opportunity that is worth investing your money, time, and effort in from just a written plan and qualitative ideas. If you do not (or cannot) evaluate whether you will be making an appropriate return on your investment, and whether the financial trade-off of the business is worth the risk from a financial perspective, stop, drop, and absolutely do not quit your day job.

Garbage In, Garbage Out

Creating a financial model is a daunting task for many entrepreneurs, most of whom have about as much experience with Microsoft Excel and building financial statements as they do with Celtic dancing (the latter probably being less intimidating to attempt). In addition to being unfamiliar with the programs most often used to make the model work, many entrepreneurs are not well-versed in financial accounting. They don’t know revenue from profit, they can’t tell you what EBITDA stands for, and they certainly don’t know what a good gross margin for their product or service is.

Like anything you don’t have experience with, understanding and operating within the financial world is hard at first. In fact, financial modeling has a steep learning curve, which is why people who build and evaluate financial statements for a living usually get paid quite handsomely.

While you can find someone to help you with the mechanics of financial statements and assist you with putting them together, the financials of your business are its lifeblood. The financial model is built upon your assumptions for every aspect of the business, from the number of customers you will have, to the pricing of your goods and services, to the margin you will receive on your product based upon anticipated vendor costs. You will have to detail your growth assumptions, your expense assumptions, your ongoing working capital assumptions, and your anticipated start-up costs.

Even if you have someone who can build the model, the usefulness of the model is predicated upon the quality of the information you input. There is a concept that applies here—garbage in, garbage out. If you put garbage in (i.e., non-thoughtful numbers that are not backed by realistic assumptions), you will get garbage out (i.e., a model that won’t help you to evaluate the opportunity and the business’s financial needs and will put you in a pickle of a situation down the road). Norm Brodsky, an Inc. magazine columnist, makes an excellent suggestion in The Knack that you do your numbers by hand instead of with a computer program. He says “. . . . to be successful in any business you need to develop a feel for the numbers . . . tracking the numbers by hand is the best way I know of to learn the language.”¹ This suggestion can be used both to develop your financial model and to practice on an ongoing basis in your business.

Now, there will be people who say that projected financial statements are just guesstimates, and, to some extent, they are absolutely correct; you will never know exactly what will happen with your business, and there is a 99.99 percent chance that you will have to revise them frequently as your business evolves. However, your financial statements should be educated guesses based on a set of logical assumptions (e.g., if you need to capture 90 percent of a market to break even, you probably don’t want to be in that business). While you may not be able to predict everything that will happen with your business, you need to have a base set of realistic assumptions that show, under conditions that are considered achievable, you will make a worthwhile return on the investment. The more milestones you have hit, the more realistic those benchmarks should be.

Once you have your financial statements together and have established through numerical data that the upside financial reward of your business is worth pursuing, as well as how much money is required for you to start or buy and run the business, then you need to figure out if you need or want to raise capital. If so, you need to decide if you are going to do it through taking on partners who have ownership in the business (raising equity) or through getting a loan that you are ultimately responsible for (raising debt).

Whose Money Are You Using?

If you have the financial capability to do so, you may choose to use only your own money for the business. There are three good things about using solely your own money: (1) not having to give up ownership in your business; (2) not having to worry about the capital-raising process; and (3) not having to work with investors who may drive you crazy.

However, there are downsides to going solo. The first is that all the risk rests with you, and if you are using the majority of your net worth to fund the business, this means you have the added risk of having all of your eggs in one basket and potentially not being able to support yourself (and anyone else who needs supporting, like a family) for a couple of years while you ride out the ups and downs of the business’s early years.

Secondly, you may not have enough money invested in the business if you’re only relying on your means. Statistics show that most entrepreneurs don’t take on outside investors or lenders; however, most businesses are also severely undercapitalized, and this is a leading cause of their eventual failure.

A third disadvantage of footing the bill yourself is that if you start to run out of money, you aren’t going to have a partner with deep pockets to turn toward to help with the tough times (and trust me, you aren’t going to be able to raise new money during the tough times—struggling businesses are not desirable investments for the guys with the money).

If you don’t have enough money to fund the business, or you want to share part of the risk, you need a lender or one or more investors. Then you get the fun of raising capital. In a very unscientific poll that I continually take among entrepreneurs, backed up by a decade and a half of anecdotal evidence, 99 out of 100 entrepreneurs rate raising capital as one of the worst aspects of starting and running a business.

I know quite a bit about raising capital. Both by myself and as part of teams, I have helped companies of all sizes, ranging from a single entrepreneur with a business plan to large public companies, raise collectively more than a billion dollars for their businesses. What I know firsthand is that the smaller your business is and the more you need the money, the harder it is to raise the necessary capital. The earlier stage the business is in (i.e., a start-up) and the less money the business produces in terms of profits (and if you haven’t started, there are no profits), the fewer the number of organized entities devoted to investing in the business. It makes sense from a risk perspective, as the further along a business is in its development and business cycle and the more profits the business is producing, the less risk there is in the investment. Therefore, the more profits you have, the more investors that will want to jump on board.

In addition to knowing that there are few places for you to turn to for your capital needs, I also know one additional consistent truth about entrepreneurs and raising capital: early-stage and new business owners underestimate the cost of starting and running the business 99.99 percent of the time. In every early-stage business I have seen, the entrepreneurs say that their financial projections are conservative in terms of revenue and expenses. They also always claim that they are raising more money than they need and that they have a cushion. Every time, I have told them that their projections—as is the case with all entrepreneurs’ financial projections—are too aggressive. And every time, the entrepreneurs lecture me about why they are the “exception to the rule.” Then, a year later, after their revenue estimates have fallen short and their expenses are greater than expected, they give me the reasons why they have missed their projections. There has yet to be an exception to this in my personal experience.

Investors know this, and it is why seasoned investors always take a “haircut” to the projections when they evaluate the investments; they assume that they are overstated on the revenue line and understated on the expense line.

Wade Beavers, CEO, and Joe Sriver, founder and president of the mobile technology company DoApp, know this all too well. They said that the biggest surprise of a new business comes because the entrepreneurs “expect to generate revenue immediately” from the get-go. If you are not in business already, Wade says it is “hard to realize the complexity of getting a product to market and selling to people . . . it will probably take up to three times longer to generate any revenue than you expect.”

So, do yourself a favor when you build your financial statements. After you make your assumptions on your business and do your financial projections to find out how much money you need, go back and revise them so that the amount of money you actually need is one-and-a-half to two times the amount you originally thought you needed. I believe that is usually the scope of underestimation by entrepreneurs. This means that if you think you need $100,000, you really need $150,000 to $200,000. If you think you need $3 million, you really need probably around $4.5 million, maybe more. You get the idea.

If you need more of a cash outlay in the beginning, then you know what that means? Yes, it means that you need to put more of your own money at risk, find more investors, or have each investor you’ve already found write you a larger check.

Skin in the Game versus Sweat Equity versus Other People’s Money

Once you know how much you need (and have increased that figure because you underestimated it on the first pass through), you have to figure out how you are going to get the capital. The biggest surprise to you may be that you need to invest a meaningful amount of your own money. This is called having “skin in the game.” Nobody wants to invest when you are only contributing your ideas and time (also known as “sweat equity”). You will get partial credit for your time, but if you believe in what you are doing, you need to be financially invested as well.

If you decide to go the investor route—that is, to find other people to be your financial partners and give away ownership of the business—you have another set of headaches to deal with. First off, where will you find your investors? Most business models aren’t big enough in their scope to attract the attention of sophisticated investors like angels (individual or groups of high-net-worth investors) or venture capitalists. These investors want to invest in businesses that have the ability to give them a 30–50 percent return (or sometimes higher) on their capital on average for every year they hold the investment. They use this benchmark because they know a large percentage of their investments are going to fail (as most new businesses do) or be limited in the scope of their success, so they need the one that really succeeds to make up for the nine others that flop. These investors also need a way to get their initial investment (and hopefully a return as well) out of the business, so they expect that in some realistic time frame, usually five to seven years, the business will be big enough to sell or to take public in an IPO (Initial Public Offering). This set of criteria means that your business may not be a fit for an angel or venture capital investment.

So, if you are not fundable by seasoned angels or venture capitalists, you have to go to who you know—friends, family, and acquaintances who may consider investing in your business (sometimes called “DDLs,” an acronym for those doctors, dentists, and lawyers that your friends and family know who are expected to have some extra cash lying around). This is a tough task. It is hard to ask people you care about to give you money. Once you accept it, you make a deal with the devil of sorts, because now your relationship with this person has gone from its existing form to also being business partners. Sometimes you will have to make decisions for the sake of the business that will not make your friends and family happy. This makes for some seriously uncomfortable future interactions.

Even if your friends, family, and acquaintances happen to have enough money to help you fund your business, they may be a liability rather than an asset. They may want you to employ your lazy cousin Nick. They may demand free goods and services. They may ask you for a million favors in return. They may be so worried about their investment that they call you for reports every day (I hear about this one a lot). Think about this carefully before taking an investment from a friend, family member, or acquaintance.

If you are one of the few that does have a business that meets the potential criteria of venture capitalists, it is just as hard to get funded. Venture capitalists receive hundreds to thousands of business plans for review every year. They dismiss many that are received over the transom; that is, plans that aren’t introduced by someone that they know and that can vouch for them. So, if you are not in the inner circle of the venture capital community (and if you need the money, you often aren’t), your plan may not even get glanced at, even if your business has merit.

If you decide to forgo taking on an equity investor, you may decide to go the loan-taking route. This isn’t easy either. It may be hard to find an attractive loan without connections. Furthermore, because your new business doesn’t have major assets, most lenders will want you to guarantee the loan with your house or other major collateral, which adds to your personal financial risk. If you don’t have appropriate collateral, you may find it nearly impossible to get a loan for the business. Basically, you have to be somewhat successful and have proven your financial abilities to save toward your business in order to get a loan to start a business.

Whatever route you choose, raising capital takes a lot longer than you expect. Take whatever time frame you think it will happen in and multiply that by one-and-a-half to two times as much. If you have budgeted six months, it will probably take nine to twelve months—and if you are thinking one month, wake up, because you are dreaming. This is especially the case when raising money from individual investors. Even when people commit verbally to an investment, it is really hard to get them to write the check. Getting people to part with their money is challenging; people will wait as long as possible to part with their money (just ask the government what percentage of tax returns get sent in at the last possible moment and how many taxpayers file for an extension).

The worst part of raising capital is that it is rarely a one-time occurrence. If you ever want to grow your business (which you should, since the point of having a business is creating equity value and growing your business is a necessary part of that), you need to constantly be raising capital. There are a lot of businesses that start raising a new round of capital just months after they close on a round of financing, given the amount of time and effort that it takes to complete. If you want to open new locations, add employees, add new equipment or machinery, or make an acquisition, these are all going to require capital. Make sure to stock up on lots of Tylenol, because you are bound to endure the capital-raising headache for the long haul.

Financial Statements Aren’t a One-Time Event

Once you have capital in the business, you need to continually evaluate your financial statements. These tell a story about your business and the more astute you are at evaluating what these statements are telling you about your business, the better business decisions you will make going forward. You won’t be like my former clients (whom you will read about in chapter 24) who didn’t understand that they were losing money on a certain product line and shouldn’t have expanded their overhead (or even have been in that business).

And you won’t be like the managers (whom you will read about in chapter 28) who didn’t realize their company was not selling its products for enough money because its financial statements were both incorrect and skewed from of all of the gift certificates it was selling.

You will need to evaluate the potential return on your investment for any new business line you seek to launch or major business purchase you are contemplating. Sometimes, it seems like you need a super-secret decoder ring to really understand everything, but it is critical that you are able to understand the financial story of your business for it to be a successful venture in the long run.

Managing your business from a financial perspective is both an art and a science, not to mention intimidating and ever-present. The financial story of your business is the one part you will want to skip up front, but it is the most important and creates just another job and hat for you to wear when you venture out on your own. If this is not a hat you ever want to wear, then do not think about leaving your day job.

EXERCISE 12

TARGET FOCUS—OPPORTUNITY:

Understanding the Numbers So You Can Evaluate Risk and Reward for You and Your Venture

Write down the answers to all of the following questions:

1. What assumptions are you making that will drive your financial model? Some examples of the many assumptions you may make include:
   • How many customers will you be selling to?
   • How long will it take you to make sales?
   • How many repeat purchases will you have in what time period?
   • What are the costs of the goods or services you will be selling?
   • What kind of administrative expenses will you have to start and continue on an ongoing basis?

   You may want to consult with someone experienced in accounting and financial models to make sure you have thought through all of the assumptions.

2. Are your assumptions realistic? To evaluate this, review each assumption in context. For example, if your potential market has one million people and you have to reach 990,000 of them to start turning a profit, then your model probably isn’t realistic.

   For these two items, your answers will help you evaluate the viability of your business model as it stands now and also assess later on whether the upside potential is worth the risks you will be taking. If you find the business model isn’t viable or doesn’t create enough rewards for the risk you bear, you can either try to revise the business model so that it becomes viable and creates the right risk/reward balance, or discard the business model altogether. When you have a business model you feel is worthy of evaluation, you will later put the potential financial and qualitative rewards of the opportunity on the “rewards” side of your Entrepreneur Equation.

3. How much money do you need to start and run your business for two years?
4. Do you have the amount of money required by item 3? If so, are you comfortable with risking all of it?
5. If you answered no to either item in number 4:
   • How much money do you need to raise?
   • Who are you going to raise the capital from, and how much “skin” will you have in the game?
   • Are you going to seek equity (giving up a portion of the ownership of your business), debt (creating an obligation for you to repay and perhaps having to guarantee the debt with a major asset that you own), or both?
   • What are the pros and cons for your accepting money from each potential source of capital?
   • How does raising money affect the risks and rewards of starting the business?
6. Will you have enough money to live on while you start and run this business (for at least a year-and-a-half to two years)?
7. If you answered no to item six, or if something unexpected happens, if you have to choose between paying your personal bills and your business bills, what will you choose?
8. How much do you need to save to have enough money to live on and fund the business?

Use the answers to items 3 through 8 to assess whether you would be better served by waiting until you had more money yourself to invest in the business. Undercapitalizing a business will set you up for failure. If you are raising capital, evaluate what impact (both financially and qualitatively) accepting that capital has on your risks, issues, and potential rewards to assess the risk and reward balance for you. Later, you will put any risks, financial or otherwise, on the “risks” side of your Entrepreneur Equation later.

ENDNOTES:

1. Norm Brodsky and Bo Burlingame, The Knack (New York: Portfolio Hardcover, 2008), 75.