KNOW YOUR FINANCIAL KEYS
Intimately tied to your core concept is a set of financial keys that reflect the trajectory and health of your venture. Most founders don’t possess financial modeling skills, and detailed financials won’t be necessary for all businesses. But every founder can work to understand the right numbers and ensure that the necessary calculations are done, even if these are sketched out on a legal pad or the back of an envelope. Entrepreneur Bob Reiss, in his book Low Risk, High Reward, calls this ability “numeracy,” the numbers equivalent of literacy, and likens it to understanding a second language. “Numeracy is a way of thinking,” he writes. “Thinking in numbers is a vital, vital skill.”5 If your financial projections do require complex calculations, partner with a talented finance pro who can help you conduct analyses at the right level of rigor and detail.
The first purpose of these financial keys is to determine whether your core concept is economically viable so you can avoid pouring your time and your passion into a money-losing business model. Just as important, understanding and focusing on the right numbers allows you to monitor and improve your concept as you go. It gives you a reliable instrument panel as you fly through the early startup fog.
Depending on the size, stage, and complexity of your venture, you will need to develop a system of financial forecasting and tracking that works for you. Regardless of the type of business you are launching, however, the following financial keys will provide a solid foundation for growing a healthy venture:
■ Understanding profitability dynamics
■ Building pro forma financial projections
■ Mastering cash flow
UNDERSTANDING THE PROFITABILITY DYNAMICS - Grasping the factors that will drive profit within your particular business model is the starting point for building a compelling math story. Investors and owners use several common metrics to think about profitability and returns, including return on invested capital (ROIC), return on assets (ROA), and return on equity (ROE). Tools for calculating these measures can be found in any startup finance book or on countless websites. The differences between these measures are less significant than the common question they pose: What is your venture's return on the resources and assets that you (and possibly others) have put into it?
Keeping it simple, the fundamental truth related to your startup’s profitability and prospects for growth is reflected in a universal formula, popularized many years ago by Ram Charan and Noel Tichy in their book Every Business Is a Growth Business.6 The formula can be applied to any business, large or small, simple or complex. Charan and Tichy make the point that successful street vendors, as well as CEOs, understand its truth, and I have found it to be a powerful tool in helping new founders cut through financial complexity and get to the heart of profitability. It is:
R = M x U
Where R stands for return, M refers to profit margin (what is left over after expenses have been subtracted from sales), and V refers to velocity (the rate at which your total asset base creates revenue). In the airline business, the profit from each flight represents margin, whereas the number of flights that can be squeezed into a given time period represents velocity. In a consulting business, each billable consulting day generates a fee with a built-in profit margin. Velocity measures how many consulting days are sold and delivered per consultant.
Think about dinner at your favorite restaurant. The owner wants to maximize her “return on dinner.” Her basic profit margin (M) will be a function of the average dinner ticket per customer (how much each customer orders and at what prices) minus the average cost of serving each customer (total costs divided by total number of customers). Great restaurant managers are continually looking for ways to increase margins. They can raise prices, squeeze out costs, or steer customers toward higher margin dishes. Velocity (V), in this example, is represented by how many guests can be served during a single dinner period. To increase velocity, the owner can turn tables more quickly with reservation schedules that accommodate three seatings per night, or the owner can streamline the processes for seating customers, serving them, and taking their payments. The more customers she can serve in a given space and time, the greater the velocity and, therefore, the greater her “return on dinner.”
Any founder can use R = M x Vas a framework for thinking about how to increase profits and grow his or her business. How can you utilize these two big levers for making money? How can you improve your margins? Do you have any upward flexibility on price? Can you reduce your cost of sales, your cost of delivery, or your fixed cost base? How can you increase your velocity? How do you increase sales volume? Generate repeat purchases? Deliver your product or service more efficiently to clear the way for new sales? How can you “turn your tables" more quickly?
Note that margin and velocity are both tied to market realities. They both depend on the fit between your offering and customer demand for it. The price your customers will pay for your offering is a function of how well you are solving a core problem for them. And the world’s greatest strategy for quickly turning tables won’t matter if enough customers don’t show up.
Also, nearly every entrepreneur encounters tradeoffs between margin and velocity. Actions taken to increase your margins can lead to reductions in sales volume. Alternatively, pumping up sales might call for tactics that cut into profits. The key is to understand how the two factors interact within your particular business model, and use this knowledge to optimize the relationship and any tradeoffs between the two.
BUILDING PRO FORMA FINANCIAL PROJECTIONS - At the heart of your math story are projections that trace the expected economic path of your startup over a specified future period. Pro forma is Latin for “according to form,” and these forecasts lay out your trajectory if all goes as planned. In addition to a standard profit and loss (P&L) pro forma, showing expected revenues, expenses, and bottom line results over the first few years, you also want to do cash flow and balance sheet projections. For prospective investors and bankers, you typically need to provide monthly projections for year one and annual projections through at least three years.
Most venture founders develop detailed forecasts on interactive spreadsheets, often with the help of a skilled financial analyst, but, in some cases, simpler tools will do. Many years ago, when I was building my first solo consulting practice, I sat down at the beginning of each year with several blank sheets of paper. I sketched out expected revenues for the coming year per client and client category, noting any anticipated changes to my operating budget and when those expenses would occur. Using these pages, I could easily anticipate cash flows, based on knowledge of client payment schedules and vendor costs, and determine where and how to direct any business development efforts. This pencil-and-paper system worked fine for me, because my business model was simple. Margins were high, and revenues, expenses, and cash flows were easy to track. This system allowed me to sketch “what if” scenarios and explore the effect of hypothetical changes in my client base, my fee structure, and so on.
As with all attempts to predict the future, your pro forma will be a guess. For some founders, it’s a highly informed, educated guess. For others, it’s a pie-in-the-sky dream. Either way, it’s likely to be wrong. So, beyond the obvious reason that investors or bankers might require them, why go to the trouble of building detailed financial projections?
First, building your pro forma is an exercise in logic that helps you pinpoint those variables most critical to your success. I once worked with the founder of a pre-revenue startup who obsessed over finding the cheapest possible outsourced vendor to create his first technology product. He had resisted running financial projections on his startup idea, but my partner and I insisted. Once projections were available, he easily saw how outsourcing costs were virtually nothing compared to his guaranteed salary and that of his co-founders. His focus quickly shifted to the question of how to radically reduce salary payments until a few projects could generate reliable revenue.
Second, the pro forma is a soft tablet through which vital connections between the critical elements of your business story can be understood. Your first pro forma statement will be an unanimated snapshot of the future, but with the help of a skilled analyst, you can run sensitivity analyses between key variables, playing out various “what if” scenarios. What happens if we launch more aggressively than planned, doubling our staff and doubling our sales? How would this affect cash flows? Or what if we launch much more conservatively, bootstrapping our way to growth? What kind of capital would each scenario require and at what times? In this way, you can spot potential trouble spots, as well as unexpected windows of opportunity, far enough in advance to do something about them.
To guard against the common tendency toward overly optimistic projections, you will be wise to run best-, mid-, and worst-case scenarios for your sales and expense projections. Lynn Ivey encountered three major negative forces as she attempted to get The Ivey up and running: a grand opening that occurred six months later than projected, a first year of sales that fell more than 90 percent below projections, and a steep recession that started a year after she launched. She never seriously factored these scenarios into her planning, and instead relied on a single, optimistic view of the future. When these events unfolded, she had no strong contingency plan.
Third, your pro forma will train your eye on the path to profitability and key milestones along the way. One of these is the highly anticipated day that you break even, the day you begin to generate cash instead of burn it. Whether it’s projected to be in your third month or your third year, your breakeven point has a kind of catalyzing pull to it. Like a visible hilltop, it’s a milestone that you and your team will strive to reach.
Finally, your pro forma projections will help you estimate how much capital will be needed to get your business safely off the ground. You can anticipate cash needs or crises and prepare for them in advance. By the time Lynn Ivey’s money became dangerously thin, her initial funding sources were tapped out, and she had to scramble to raise funds from a position of weakness rather than strength.
MASTERING CASH FLOW - Cash is like oxygen for a new venture, so mastering cash flow is a pivotal challenge for all entrepreneurs. Joel Kurtzman, through his extensive research underlying the book Startups That Work, identified positive cash flow as one of a handful of critical success factors for venture success and a key driver of longer-term value creation.7
As any seasoned business owner or investor can attest, profitability doesn’t guarantee healthy cash flow. Cash is a product of payment timing, forward-looking investments, billing and collections practices, and other variables that, taken together, can have a counterintuitive effect on cash levels. One of the ironies of early venture success is that rapid growth can cause uninvited cash flow crises to arrive with little or no warning.
I am not ready to jump on the trendy bandwagon of pundits proclaiming bootstrapping, launching your business at minimal expense and with scant starting capital, as the only credible way to build a business. As I’ll outline in the next section on funding, I believe that startup founders who afford themselves a healthy financial cushion, in whatever form, enjoy a higher likelihood of success than the typical entrepreneur. But even the most well-financed entrepreneur can operate with a bootstrapper’s mindset to ensure healthy cash generation and management.
Beyond the usual focus on prudent spending practices, I recommend the following keys to managing your cash.
First, stay on top of your cash situation. Make this a non-negotiable management practice. Review your cash levels, cash flows, burn rate, and budget vs. actual expenses on a frequent, regular basis, at least weekly early in your launch. Bob Reiss advocates for the creation and review of a weekly financial snapshot, or “flash report,”8 and most highly successful businesspeople I know sit down on a regular basis to conduct such a review. For some, it’s Saturday morning coffee with their finance person. For others, it’s a routine weekday meeting. It sounds boring, and it sometimes is, but skip this practice at your peril.
Second, look far ahead down cash-flow road. The definition for “far” will vary depending on your type of business and your situation, but once you realize that you have only a few months of cash left, it’s often too late to do anything about it. Raising money often takes four to six months in the best of circumstances, and major expense cuts can take several months to have a positive impact on cash flow.
Third, don't delegate your ultimate accountability for the numbers. Many startup founders wisely outsource bookkeeping and financial analysis tasks. Eventually, with growth, you’ll need a trusted controller and/or
CFO in-house to stay on top of the numbers and conduct forward - looking analyses. But you should always be plugged in to what’s happening with your financial keys. When it comes to early stage financials, you are the worrier-in-chief. Don’t count on anyone else to be lying awake at three in the morning, deciding where to trim costs or find additional capital.