As an angel investor, I’ve listened to a lot of elevator pitches from a number of aspiring entrepreneurs. More than once, a confident presenter would say to me, “All I need is $3 million so I can really make this business work!” This seemed like an unreasonable declaration, since they only had pro-forma financial projections and no real paying customers.
What I heard instead was, “I am not sure how much money I need, but I want to get enough from you that even if I fail, I can get paid during the next few years.” As a result, I never funded these entrepreneurs. I wanted them to be as careful with my money as they would be with theirs.
Many entrepreneurs actually waste too much cash when starting their company. In fact, they typically overestimate the amount of money they need in the first year of business.
The Kauffman Foundation found that the average startup uses about $30,000 in capital. Investing too much capital up front is also very risky. Most of the funding typically comes from the founder’s savings account or family and friends. Spending money from these sources can be emotionally stressful and distracting. Additionally, securing loans from banks still requires a personal guarantee, so they still need to be paid back, even if the company fails.
The smart entrepreneur doesn’t undercapitalize their business, but carefully tracks where and when the money is invested in the company. They put only enough money in as is required to achieve the desired results. From the initial investment, they use 25% now. Then they set aside 25% to be used for later growth and another 25% to cover unexpected expenses. Finally, they keep 25% for a personal parachute out of the business if it fails.
Putting too much capital in the company at the start is almost a guaranteed waste. I have always said that “too much money will make you stupid.” Every small business owner needs to be frugal, but not cheap. They need to make investments in growing their company, but not waste money, especially in the first three months when the entrepreneur is giddy and feels immune to failure.
Use these metrics to determine how much money you need and where you should spend it.
The Business Metrics
Determine the profitability of each unit or service sold. It is key to know—on a broad basis—how much profit is in each sale, and how much customer revenue can fund the overall cash needs of the company. Businesses that get most of their gross profits through their customers grow in the safest and most ideal way.
The Revenue Forecast
This starts with forecasting unit sales over the next year to 18 months. Unlike most graphs, the growth will not be linear and will be slower than planned. Look at the forecast based on how much is being spent to attract customers.
Determine the customers’ lifetime value (how long they will stay). Forecast the variable expenses (cost of goods or cost of sales) associated with each transaction. Finally, cut the forecasted revenue in half, then double your expenses, since no forecast from a startup entrepreneur is every truly conservative. This will get the numbers closer to reality.
Click here to read our guide to forecasting and budgeting.
The Fixed Expenses
These are company expenses that are necessary no matter how successful—or unsuccessful—the company is at selling its product. These costs typically include rent, utilities, employees, website upkeep, phone service, etc. This is sometimes called the “monthly nut” that has to be paid to keep the company in business regardless of sales.
The Cash Flow
All companies operate on how much cash they actually have in the bank. Expenses can’t be paid with receivables or customer promises. Every entrepreneur needs to know how to read a cash flow statement or, at the very least, look at their bank statement once a month to see if cash flow is shrinking or growing to cover ongoing expenses.
The real amount of required capital will be shown on the cash flow statement on a monthly basis. It will be based on company profitability and how quickly customers pay their bills and inventory investments.
See our guide to cash flow statements to download a free customizable cash flow statement template.
Track Actual Results Over Time
Whatever you think is going to happen almost never does. The results you have in mind may also not be reality. Review your financial statements monthly to know exactly how much capital the company needs at every step. For an in-depth guide to financial statements, check out our infographic on financial reporting.
Every startup goes out of business for the exact same reason: lack of capital. This usually happens not because of a lack of an initial investment, but because of a lack of careful planning of how the money is being used. So focus less on getting money and more on how you spend it, and that can set you on a path to success.