Making Money

You go into business to make money.  It’s as simple as that.  It doesn’t matter if you are opening a sandwich shop or starting the next Google, you can’t stay in business for long if you don’t make money.  Heck, even non-profit organizations need money to survive.

This chapter deals with all aspects of making money, from the best ways to finance your business to building a financial model.  You’ll learn important strategies on how to stretch your bank account, why the first dollar you earn is the hardest, and the best way to forecast your revenue in the years to come.  You might prefer to drag your nails on a chalkboard than think about this stuff, but you can’t be a well-rounded entrepreneur if you don’t understand what drives your bottom line.

Know Your Do-or-Die Numbers

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Every business has its make or break financial assumptions.  Also known as Key Performance Indicators (KPIs), these do-or-die figures are the drivers of your business.  A web company’s KPIs might include the conversion rate (number of visitors who convert into customers) and average time spent on the site.  A restaurant business might focus on the time it takes to turn a table, or the average ticket size.  As your company grows, your financial drivers will determine your success.  Neglecting them will result in lost potential, or worse.

Drivers vary by industry.  If you’re not sure what your KPIs are, start by looking at industry reports.  Read the 10-Ks of public companies in your industry and pay attention to what its managers focus on.  Another great way to determine which indicators will most impact your business is with your financial model.  Analyze the sensitivity of your inputs by testing each at different levels.  The inputs that drastically affect your revenue or profit are likely your KPIs.  Once you figure out you KPIs, make sure you know your numbers cold.

How Much Runway?

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One financial number that you should always have in the back of your mind is how much runway you have left.  How many months until you run out of money?  Shoot for 18-24 months of runway at all times so you can focus on your business without worrying too much about money.

Calculate the runway left by dividing the money in the bank by your loss at the end of the money.  For instance, suppose you are losing $10,000 per month, and you have $100,000 left in the bank.  You have 10 months of runway left ($100,000 / $10,000 per month = 10 months).

There are three things you can do to lengthen your runway – generate more revenue, lower your expenses, or raise more capital.  If you increase your revenue and lower your costs, resulting in a $2,500 loss per month, then you’ve just increased your runway to 40 months ($100,000 / $2,500 = 40 months).

Undercapitalization is the number one reason small businesses fail, so make sure that you always have enough runway to get your startup’s wheels off the ground.

Fall In Line

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Your financial projections are based on hundreds of assumptions and unknowns, so you have to sanity check your results.  There are a couple great ways to do this.  By far, the most important sanity check you can do is to compare your financial ratios with your industry’s standards.  By combining the financial performances of companies in an industry, you can get an understanding of the industry norms.  One great resource for this is the Risk Management Association, which provides industry ratio reports.  Compare these results to year five of your projections.  Are there any significant variations?  If so, be sure that you understand which assumptions directly affect the variance and check their validity.  If there are any discrepancies, the safest approach is to revert to the industry’s ratios.

Next, go through every assumption in your financial model with your advisors.  There might be an important oversight or error in your calculations, or you might have misjudged a key assumption.  Industry or startup veterans should be able to uncover weaknesses quickly.  Either way, getting a second pair of eyes on your work will help fine-tune your model.

If you’re going after investors, your financial projections will get the most scrutiny.  If your ratios are off, or assumptions are aggressive, you better have rock-solid explanations at the ready.

Gut Check

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By the time your financial model is built, your business model should so well understood that you could go toe-to-toe with any banker or investor.  Now it’s time for a gut check.  Let’s use those projections to calculate the sales required to breakeven.  While a straight-forward calculation, this is often an eye-opening number.

Let’s consider a gift shop as an example.  The average order size at this shop is $3, and the cost to deliver is $1.  This makes the gross profit per unit $2.  Next, suppose the overhead (rent, utilities, inventory, and employees) to keep the doors open is $30,000 per month.

By dividing the monthly overhead of $30,000 by the gross profit of $2, we see that the shop needs to sell 15,000 units per month to break even.  Sounds reasonable enough, right?  At this point you might hear an entrepreneur say something along the lines of, “There’s a ton of foot traffic, so we can make this work.”

Well, let’s break it down further.  15,000 units per month is 500 per day.  Even if the founder is breaking her back working for 12 hours a day, she still needs to sell about 42 per hour.  That’s one sale every 1.5 minutes, all day every day – that’s not the most realistic plan.

Do a breakeven analysis for your company to see if you’re on the right track, or if your business model might need some re-engineering.

Build a (Bad) Financial Model

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Yes, your financial projections will be wrong.  But that doesn’t get you off the hook.  A financial model is valuable not due to its accuracy, but because building one forces you to think through every nook and cranny of your business.  All of your assumptions will be quantified in your model, helping you determine whether your business, as you currently envision it, has potential or not.  Often, businesses that make sense in the abstract are unrealistic when modeled out.  Plus, now that you have a financial model, you can use it to manage your business.  You can update your assumptions as you collect more data, and get instant feedback on how these changes affect your bottom line.

Because your model is so important, it would be a mistake to use a template.  You need to go through the process of building it yourself.  You need to know what’s going on under the hood, so you can explain how it works, and fix it if something breaks.

A financial model that incorporates all of your assumptions will help you take a holistic view of your business’s dynamics.  The financials are where the rubber meets the road in business.  So go ahead and build a bad financial model.  It’s not about the inaccurate projections, but the process that counts.

Bottoms Up

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A key component of any business feasibility analysis is the financial projections.  The projections will reveal the financial feasibility, scale, and investment required to get your business going.  A common mistake is to create these projections from the top-down, rather than bottom-up.  A flawed approach, top-down projections are made when the entrepreneur takes a percentage of the whole market without justification.  For instance, a top-down revenue projection might say that by capturing 2% of a billion dollar market, the company’s revenue will be $20 million per year.  This is the wrong way to go about it.  Instead of guessing a percentage based on the total market size, build your case from the ground up.  With a bottom-up approach, each sale must be justified and tied to a business activity.  You can tie sales to traffic to your site, a sales team, joint ventures, or advertising spend.  To project the revenue of a sales team, for example, calculate how many calls a salesperson can make in a day, the percentage of those calls that result in sales, and the resulting number of sales made in a month.  Multiply this total by the number of salespeople and you have successfully completed a bottom-up sales projection.

Anytime you’re projecting into the future, build your case from the bottom-up and you’ll have a solid and realistic foundation to stand on.

The First Dollar is the Hardest

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When it comes to personal wealth, people always say that “the first million is the hardest.”  With startups, the first dollar is the hardest.  There are so many things that can go wrong. Making your first sale – no matter how small – is a significant achievement.

Earning your first dollar helps in a variety of ways – it gives you feedback from the market, the cash flow extends your runway, and it shows you who will buy and why.  This is all valuable, but the psychological boost is probably the best part of your first dollar.  Getting your first customer can take months – or years – in product development.  The buildup to launch is always a trying time, riddled with uncertainty and doubt.  Getting to that first sale gives you the confidence you need to keep going.

The vast majority of founders say that they wish they got to market sooner.  Do everything you can to quicken your pace to market and get that first sale under your belt.  Do this and you’re well on your way.

You Are Running Out of Oxygen

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Think of your startup as a submarine that’s miles below the surface.  You have to get to the surface – profitability – before you run out of oxygen.  Especially at an early stage, revenue enables you to keep breathing and fighting for the surface.  Even if the business is not yet profitable, revenue is a strong feasibility signal, and cash flow helps keep things moving.  Revenue also speaks volumes to potential investors who might contribute to help you fight on.

So get to oxygen as quickly as possible.  Get a sellable product out there as quickly as possible and see if people are willing to pay you for it.  Learn what customers really want and what they’re willing to pay for, and then create it for them.  Adapt based on what you learn.  Ask for the sale, and breathe life into your startup.  It’s only a matter of time before you’re out of oxygen without revenue.  As soon as that happens, the game is over.

The First Rule to Making Money

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Here’s an obvious truth: you can’t make money until you have something to sell.  If you have a website that’s half-built, or a product still under development, there’s no way to generate revenue.  Every day you spend in product development is another day that you’re not selling anything, which is one day closer to going out of business.  This is why the Minimum Viable Product is so powerful – build only what you need to get out of the building and start engaging with customers.  Make your offering “good enough,” and then start selling it.  The longer you delay, the longer it will take to start making money, and the harder it will be for your business to survive.

New entrepreneurs frequently overlook the fact that if you want to make money, you have to have something to sell.  Releasing your baby into the wild is never an easy thing to do.  You’ve given a significant part of your life to get to this point.  And the potential rejection looming around the corner is scary.  But that’s also why you’re going to succeed – you’re willing to put yourself out there and make it happen.

Fire Your Customers

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When starting out, you’re desperate for validation, customers, and revenue.  So you take on any customer who will have you.  To land customers, you make big promises and shower them with attention.  But then your business starts growing and your customer base becomes too big for such tender loving care. While this is a great thing, chances are that your first customers will always expect the same special attention and treatment.  They don’t understand (or care) that you’re trying to build a scalable business.  They want what they’ve always gotten.

Keep an eye on your customer base, because these kinds of demanding customers can quickly become a major organizational distraction, and damage your growth prospects.  Sometimes it makes sense to fire a customer.  Obviously, start by explaining your situation and asking them to fall in line.  If they don’t seem to get it, cut the cord.  You’ll be better off without them.  Don’t let imposing customers keep your business from reaching its potential.