FINANCING A STARTUP
(BUT DOES IT NEED TO BE?)
Article By: Ashish Rajadhyaksha
Money and Cash flow are a businesses’ life blood! It’s not an exaggeration, but without it oiling the machinery, the whole enterprise comes to a screeching halt. Most of us aren’t well trained either in understanding how to get money or how to manage cash flow, especially in the initial formative years of the business. When most first-generation entrepreneurs think of getting financing, they get nightmares about the whole process, but that’s majorly because our parents and education system haven’t taught us critical life skills of how to get and manage money.
In the first part of the “How to Launch Your Own Business” Series, we looked at different types of entrepreneurs, their motivations in starting a business, reviewed the simple Business Concept Template that helps crystallize thoughts, and creates a foundation for writing a formal business plan that any entrepreneur would need. In the second part, we reviewed various online resources available for new entrepreneurs to Get Going on their journey with an inventory checklist to accomplish market research, business strategy, brand positioning, figuring out an appropriate corporate name and tax structure, operational details, etc.
Now in this third and final part, we’ll focus on the financing aspect of the Planning Stage of a business (later stages being Building, Running and Future Stage). Exploring various financing alternatives is part of the Planning Stage because although finance is needed on an ongoing basis in later stages too, all types of resources have to be put in place prior to starting a business. Not only does it set a correct tone for future growth, but also proper structures are need to be put in place especially if there are other investors or partners involved. Raising money and exploring different types of investors is primarily about three factors:
- Nature of Business
- Use of Funds (How much $ needed?) and
- Time Horizon.
If there’s a mis-match between either of these factors, it can cause a lot of stress and disruption.
Primary Funding Sources for Start-ups :
◊ Family & Friends
◊ Bank Loans
◊ Government Entities
◊ Credit Cards
◊ Angel Investors/VC’s
Simple Pros and Cons of each:
◊ Self →Pro: Total control in decision making and project execution; Con: Other than a simple online business, need significant personal savings and expertise.
◊ Family & Friends→ Pro: Wider network of well-wishers and support system available; Con: Usually not much value added in terms of complementary expertise, but with a very high probability of ruining relationships if money is lost on the project (Need to consider this very carefully).
◊ Co-Founders→ Pro: Usually value added in terms of complementary expertise and financials; Con: Avoid friends as partners due to very high probability of ruining relationships if project goes sour (Need to consider this very carefully), and also there’s a significant loss of operating control and concept execution.
◊ Bank Loans→ Pro: Depending on the economic environment and country involved, loans with lower rates and longer maturity are possible (especially if governments are promoting entrepreneurship and local job creation); Con: Almost always need hard collateral, IP, firm Customer PO’s to secure loans.
◊ Government Entities→ Pro: Many government assistance programs available for exports, job training, tax credits and other incentives for the “priority” sectors; Con: Most government agencies are very bureaucratic and time consuming, but knowing the right person usually does the trick.
◊ Credit Cards→ Pro: Most people have credit cards in their wallets, so a cash advance from credit cards isn’t the worst thing if business survival is at stake; Con: Usually interest rates make this option prohibitive, but sometimes teaser rates could make this a short-term viable fix.
◊ Angel Investors/VC’s→ Pro: Widens the access to capital and provides a network of experts and advisors in diverse fields to mitigate risk and increase execution capability; Con: Need to match industry focus criteria (Angels and VC’s usually are industry specialists), and then significant dilution of entrepreneur’s equity in the business, and possible loss of operating control in the enterprise if hurdle rates not achieved.
To select the right financing source from above, the financial plan that forms a critical part of the overall business plan needs to consider the Sources & Uses of Capital. Here’s an example of what this table should look like, although specific name labels and allocation will change based upon the business:
To put together the Balance Sheet, Income Statement (P&L) and Cash Flow Statement by month for the first 2 years, and then quarterly for additional 3 years, assumption inputs are extremely critical. Any bank lender, VC or any other type of investor worth his or her salt will look at the reasonableness of these assumptions. Everyone understands variance of actual performance from plan documents, but what’s critical to them is the Logic Behind those Numbers (can’t be pulled from thin air); Absolute Integrity and Solid Qualifications of the Founders; Hard or Soft Collateral of the Business; Backup Resources to Survive Any Business Disruption; and ROI Expectations (Principal + Interest + Fees for Banks; IRR for Angels/VC’s).
Financial Statement Assumptions (Example of a Café Concept) To Be Presented as a Spreadsheet:
Revenue Mix→ 4 possible revenue segments of Beverage, Food, Events, & Any Merchandise Sales.
COGS (% of Sales)→ 4 possible direct labor and material costs by Beverage, Food, Events & Any Merchandise Sales.
SG&A (Selling, General & Administrative Expense or Overhead Schedule) (% of Sales)→ Payroll Expense; Rent; Utilities; Repair & Maintenance; Cleaning ; Insurance; Advertising & Promo; Supplies; Credit Card Fees; Laundry/Uniform; Other Expenses; Interest Expense/Loan Amortization.
Working Capital Ratios→ Days Sales Outstanding (DSO); Days Average Inventory On Hand (Days of COGS); Days A/P Outstanding (Days of COGS) (These flow through Balance Sheet and Cash Flow Statements).
Depreciation and Amortization Schedule→ Equipment Costs (5 Yrs.); Setup Costs (5 Yrs.); Construction Costs (7 Yrs.); Professional Fees (5 Yrs.) (Depr and Amort timeframe defers as per country’s tax laws, and flow through Income Statement, Balance Sheet and Cash Flow Statements either in the current year or reduces the outstanding balance).
To really impress your bank lender or VC, here’re some additional financial data points that are worth inserting in the Financial Plan: Ratio Analysis and Break-Even Analysis
Ratio Analysis→ Total Debt/EBITDA; EBITDA/(Total Interest Expense); Total Debt/FCF; FCF/Total Interest Expense; Gross Margin; EBITDA Margin %; Current Ratio; Accounts Receivable as a % of Sales, Inventory as % of COGS.
Break-Even Analysis→ Monthly or Annual Total Fixed Costs Divided By Average Gross Margin (Gross Profit/Total Sales).
Now armed with all this financial information, you the Entrepreneur is not only better prepared to answer all the banker’s and VC’s questions, but also more informed about where you stand in the fund raising and business startup process.
Remember Knowledge is Power, Now Use it Wisely and Get Going!
This Article is the 3rd and last in the series :“How to Launch Your Own Business?”