Good business ideas need capital and the more they grow, the more capital they need. They also need liquidity: enough cash, and cashflow, to meet the business’s needs and obligations.
There is a lot to be said for “bootstrapping”, the colloquial term for starting a business with little to no capital or assets. There are lots of pages on the Internet extolling its virtues: starting a business lean and the founder retaining all of their equity.
The missing question is: “do you have enough savings, credit cards and unpaid hours of ‘sweat equity’ to pull it off?”
A hopeful outlook and a willingness to sink savings and any available personal credit lines into a startup enterprise might seem like “a good idea at the time”. The belief being that once sales grow, the money comes right back. In the vast majority of cases, it won’t. The business will actually get hungrier for cash and the moment its appetite cannot be met, its ongoing growth will be strangled.
What begins with using up savings, a bit of personal debt and ‘sweat equity’ can create a toxic problem: a negative balance sheet (caused by the accumulated debt) and a liquidity crisis (a lack of cash/working capital). Under these circumstances, the business can neither trade nor attract equity – nor secure any more debt.
Why?
Are the business ideas behind these situations bad ones then? Often they are not. But when enthusiasm and naivety displace proper business planning, things can turn sour rapidly. This is not an argument against bootstrapping (I’ve done it myself more than once) but it is an argument for proper business planning to confirm the founder(s) can afford to bootstrap the enterprise.
A couple of examples…
A gentleman identified an opportunity to make specialist garments. He had a reasonable pot of savings and access to some credit lines. The forecast profit margins were good and customers loved the garments. How hard can it be? Purchase stock at c.20% of RRP, sell to shops, or direct online, for margins of 60%-80%.
He was able to place an order with overseas factories to buy a large quantity of stock. But he underestimated the time, and cost, of sales and marketing so his capital got locked in stock.
To add to the misery, his accountant prepared accounts showing all the money put into the business as ‘directors loans’. This recorded a substantial liability and a negative balance sheet. On paper the business was presented as cashless and worthless. (On my advice the balance sheet was revised to show a positive value by converting the ‘directors loans’ to shares – which has another useful benefit to the founder in that tax relief can be claimed on investment in a business, but not on lending to a business.)
Even with an improved balance sheet, the business was still cashless (cashflow insolvent). There was healthy profit lurking in the stock – but no money for the sales and marketing needed to shift it.
What chance of investment or borrowing? Very slim indeed – but lenders would be sub-prime (high interest rate) or investors will pay a very low price for equity (an even greater cost to the founder than sub-prime borrowing, but maybe the price of survival). If sub-prime debt is taken on – further degrading the balance sheet value and hurting the Profit & Loss account – investors will be even more wary.
My second example is slightly different: the intention was to bootstrap a business with savings, personal loans, sweat equity and – on an accountant’s advice – customer prepayments. There is nothing wrong with prepayments when they amount to no more than rearranging the cashflow timeline into a more favourable sequence. But when it mutates into money taken for promises that subsequently cannot be met, one is wandering inexorably towards fraud.
Luckily, I was invited to review this one at the planning stage. The fundamental problems were a lack of understanding of the ‘sales gradient’ and business capacity.
Sales gradient. If one forecasts sales of, say, £500,000 in the first year it might be tempting to consider monthly sales on an average basis: £41,666.67 per month. But, starting from zero, the early months will be less than £41,666.67. To achieve an average of £41,666.67 in a year when some months are far below this level means that other months must be far above this level – which would require considerably more capacity than the business may possess. The zero to hero line is the ‘sales gradient’.
In the business in question, the monthly capacity was close to breakeven (begging questions about pricing and headcount). The prepayment problem was such that cash from customers was forecast to accumulate month by month (great for cashflow) resulting in aggregate commitments to customers greater than capacity in future months. In basic arithmetic terms, 10 times the value of work done was received in cash each month – within months, all the outstanding work owed to customers could not be met by the business’s capacity.
I guided the founders through a mixture of price adjustments and recognition that more people would be needed in the business, which led to understanding the importance of designing a business to make money and the revelation that although working IN the business might seem sensible or ‘cost effective’, it is commercial suicide when it obstructs being able to work ON the business. In other words, in forming a business where the shareholder/directors are also the workers, the director/shareholders may be obstructed from ever generating enough profit to free themselves to direct effectively.
The upshot was that they needed to raise almost three times the capital they initially thought they needed but this alternative business plan would look far more attractive to investors and lenders than the initial bootstrapped version. The proof of the pudding was that the founders raised all their capital within a month and, since starting trade, are exceeding their plan goals left, right and centre.
It is an often heard maxim that a lack of cash kills more businesses than a lack of profit. The two examples above underline the truth of it: both could make healthy gross profits and had pretty low cost bases – but both would be wiped out by a lack of cash. One of them was not recoverable whilst the other was steered to a better course before it accidentally set off to crash and burn.
If you would like me to review your current position, or help you with a business plan, please drop me a line.
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