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.

Go Bootstrap Yourself

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You “bootstrap” your business when you start and grow it without outside capital.  The vast majority of companies started in the U.S. are bootstrapped.  Why bootstrap?  Most new companies can’t get generate the returns to get investors excited.  Even then, many entrepreneurs still avoid bringing on investors until absolutely necessary.  While an injection of capital can be a godsend, investors can distract you from building your business.  Fundraising is a full-time job, and managing existing investors can be a headache.  What’s more, the day you take an investment is the day you commit to selling your business.  By bootstrapping, especially early on, you stay in the driver’s seat.  You can’t always bootstrap at the outset, of course, but it’s worth the extra effort.

Bootstrap-friendly businesses are those that can get to revenue quickly.  You have to get rid of distractions that don’t get you to revenue while bootstrapping.  Revenue will keep you alive and able to grow.

If you plan to bootstrap, make sure you know how much money it’s going to cost to get to profitability.  The last thing you want is to run out of money without a backup plan.

Prefer Variable to Fixed

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There are two kinds of costs – variable and fixed. Variable costs are those that increase or decrease along with a specific activity.  Fixed costs, on the other hand, are those that are incurred on a routine basis, regardless of business activity.  For example, consider salaried employees versus commissioned salespeople. An employee on salary will be paid every month regardless of the performance of the business. This person’s salary is a fixed cost. Conversely, a salesperson paid 100% commission is a variable cost because he only gets paid when a sale is made.

Startups should always prefer variable costs to fixed costs.  Hire independent sales reps instead of salaried employees.  Work with a contract manufacturer instead of building your own manufacturing plant. Outsource billing, sales reports, inventory to an accountant instead of bringing on a salaried CFO. Hire a PR firm based on performance, not retainer.

If you run out of money you’re dead in the water. The fastest way to run out of money is to take on too many fixed costs.  So develop a strong preference for variable costs when building your company.  The secret of survival is to keep your overhead as low as possible, for as long as possible.

Gross Profit Margins

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One of the most important financial metrics you need to understand is your gross profit.  The gross profit is difference between the revenue and the cost of making a product or providing a service. For example, if you sell a widget for $10 that costs you $4 to manufacture, your gross profit on each unit is $6.  Gross profit is more commonly expressed as a percentage of revenue, which is called gross margin. In this case, the gross margin on your widget is 60% ($6 gross profit / $10 revenue).  There are two ways to improve your gross margin: increase unit revenue or decrease cost.

It almost never makes sense for a startup to compete on price with low margin products. Your competition can tap into its war chests to outspend you.  Instead, look for a differentiated product that will allow you to charge a premium, resulting in high gross margins.

Gross margins are so important for startups because higher gross profit creates a financial cushion, which pays your overhead, gives you freedom to experiment, buys you more time, and increases your margin for error.  For a startup, gross profit equals survival.

How Do You Make Money?

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Not to be confused with a business model, your revenue model is how your company makes money.  There are dozens of potential revenue models, including subscriptions, product sales, data sales, lead generation, advertising, licensing, freemium, and fee for service.

Google’s primary revenue model is selling advertising on its search pages.  Walmart’s revenue model is product sales.  But dig a little deeper you’ll quickly realize that Google and Walmart make money a lot of different ways, not just through advertising and product sales.  A hybrid revenue model is often in order.  But don’t get distracted early on – focus on your core (the tree trunk) initially, and slowly branch out from there.

So what revenue models should start with?  Unless your differentiator is the way you charge customers, follow the leader and mimic the industry leaders.  It’s probably too risky to try to change the traditional business model while introducing a new product to the market.

Clearly understanding how your business makes money is crucial.  Don’t fall into the temptation of glossing over this.  You’re much more likely to stay alive and fight the good fight if you clearly understand how you’re going to make money.

The Best Source of Capital

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Too many entrepreneurs are obsessed with investors.  These kinds of founders are easy to spot – when you ask them how their businesses are going, a normal response would be something like, “Great, we just raised another round of financing!”  Unless you’re in the fundraising business, raising capital is not a business milestone.  You’re in business to make money, not raise capital.  Fundraising is a full-time job and significant distraction when you’re trying to build a business.  Of course, there are times when your business will need a significant capital infusion.  But by the time you’re ready for this investors will be chasing after you, not the other way around.

Instead of worrying about investors, focus on profitable growth as the primary way to fund your company. There are a lot of ways to do this.  Instead of spending the next two years building a cutting edge platform, what can you build in the next month or two that solves the same problem and starts generating revenue for you immediately?  Is it possible to consult for the same customers now and start building strong relationships, so they’ll support your first product?  Profit is the best source of capital, so make your focus making money.

What’s Your Business Model?

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It’s easy to get confused with academic definitions of “business model,” so let’s put it in the simplest of terms—a business model is how your business makes a profit.  Note that’s profit, not simply revenue.  If you want to focus on revenue only, that’s what’s known as a “revenue model.”  This difference is important because there are many other considerations that you should take into account other than revenue.  You have to factor in the cost of creating the sale.  Did you have to buy the inventory before you could sell it?  Did you have to pay a big commission to a salesperson?  You also have to factor in your overhead expenses.  Do you need an expensive storefront, or can you get by with a website and home office?  The questions that have to do with the financial dynamics of your business combine to create your business model, and indicate how lucrative your venture could be.  There are a few useful tools you can use to help you through the process, such as the Business Model Canvas or the Lean Canvas.  All aspects of your business have financial implications, so make sure you’ve got all the bases covered.