Category Archives: Business Financing

Entrepreneurs: Profits are Overrated

Business Financing, Business Mistakes, , , ,

Real entrepreneurs don’t make profits, and for good reasons. Huge oil companies make excess profits, sure. Smart entrepreneurs don’t.

And I don’t mean just the land-grab web companies like Facebook and Twitter don’t make profits. Growing companies don’t make profits. Can you be more successful than amazon.com and Jeff Bezos? Amazon didn’t make profits until relatively recently. No, I mean small business everywhere.

Ideally, you do want enough in profits to support an increase in working capital, which would be a single-digit percent of sales. But that’s rare in growing companies.

Where do profits come from? Money you take in as sales that you don’t spend in cost of sales or expenses. And if you want to grow, then money that might have been profits goes right back into expenses as more product development, more marketing, more smart people on payroll.

When Palo Alto Software was growing at double-digit rates during its teenage years, I made the order of priorities as clear as I could: cash flow break-even first (we didn’t have outside investors); growth second; profits third.

What do you think?

Planning vs. Accounting: 2 Different Dimensions. And Why You Care.

Business Financing, Business Planning, , ,

Just as the stargate in the picture was a gate between two different dimensions (from the 1994 movie), today is also the stargate between planning and accounting. Accounting starts today and goes backwards in time in ever-increasing detail. Planning, on the other hand, starts today and goes forward in time in ever increasing summary and aggregation.Stargate Movie Poster

The catch that causes many misunderstandings is that the tables look very similar.  Your accounting system produces an Income statement (alias Profit or Loss), a Balance Sheet, and a Cash Flow statement.  A good business plan has at least the same three statements as “pro-forma” (meaning projected) statements. The form, presentation, and order of appearance of these financial statements are almost identical, but their information content is quite different.

Why do you care? Because the two concepts don’t mix well. And people who approach planning from an accounting point of view suffer. Accounting is reporting off of a database of transactions. Each transaction is recorded and kept, and the accounting sorts and selects and reports. Instead of guessing future monthly totals, they want to figure out an imaginary database of imaginary transactions, and then report results from them. They sweat, the suffer, they get digestion problems, and it doesn’t work.

Planning is to help steer the business. It helps with decisions, tracking progress, and managing change. Accounting is also for information and management, of course, but there are legal obligations related to taxes. Accounting must necessarily go very deep into detail. Planning requires a balance between detail and concept, because there are times when too much detail is not productive.

Accounting can never be wrong. It’s about taxes and governments and actual money transactions. Business plans, however, are always wrong, which is fine, because they’re about setting down assumptions so you can manage and track results, and steer the company. Steering is a matter of constant corrections. So is planning.

True Story: Why We Bought Out Our VC Investors

Venture Capital, , ,

It started in 1999. We had already grown Palo Alto Software from zero to more than $5 million in annual sales in five years, without investment. But valuations had gone crazy, and our bplans.com site was already getting millions of visits every month. So we decided to look for venture capital to grow the company and sell it.

The boom seemed temporary, and we decided to take advantage before it waned. We had a sense of a very large open window that was going to close.

But we were too late. We signed a deal early in 2000, just a few weeks before the dot-com bubble burst. Very quickly we saw our web properties, which had been worth tens of millions of dollars, settle into more realistic valuations. And more realistic wasn’t interesting to us. We didn’t want to sell the company for what it was worth in 2001, based on sales multiples. We had wanted to sell it in 1999, when valuations were based on website traffic.

Which left us and our investors with incompatible goals. They wanted to flip the company, while we wanted to build it, grow it, and keep it.

We liked our investors. They believed in us, wanted the same thing we did, and offered useful suggestions. They were smart, honest, and respectful. But we ended up with minority owners who wanted only to sell the company, and we no longer wanted to. So we negotiated a deal, and bought their share back from them. That was in 2002.

The buy-back deal wasn’t easy because we’d spent the money to grow and didn’t keep it liquid. But we didn’t want minority investors to be trapped in our company with no hope of a near-term liquidity event.

It all worked out. We still see them on occasion, and they are still friends. But it is one good example of a case in which you don’t want incompatible goals in the ownership of your company.

7 Financial Terms Every Entrepreneur Should Know

Business Financing, , , , , , , , , ,

This is a rewrite of an older post, but it seems like a good one to repeat. You don’t have to be an accountant or an MBA to do a business plan, but you will be better off with a basic understanding of these six essential financial terms. Otherwise, you’re doomed to either having somebody else develop and explain your numbers, or not having your numbers correct. financial words

It isn’t that hard, and it’s worth knowing.  If you are going to plan your business, you will want to plan your numbers.  So there are these six terms to learn.  I’m not going to get into formal business or legal definitions, and I will use examples:

  1. Assets: cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns are assets. Assets can usually be sold to somebody else. One definition is anything with monetary value that a business owns.
  2. Liabilities: debts, notes payable, accounts payable, amounts of money owed to be paid back.
  3. Capital (also called equity):  ownership, stock, investment, retained earnings.  Actually there’s an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital.  That means you can subtract liabilities from assets to calculate capital.
  4. Sales: exchanging goods or services for money. Most people understand sales already, but the timing of sales is important. Technically, the sale happens when the goods or services are delivered, whether or not there is immediate payment, and regardless of how long ago you paid for what you’re selling.
  5. Cost of Sales (also called Cost of Goods Sold (COGS), Direct Costs, and Unit Costs): the raw materials and assembly costs, the cost of finished goods that are then resold, the direct cost of delivering the service. This is what the bookstore paid for the book you buy, it’s the gasoline and maintenance costs of a taxi ride, it’s the cost of printing and binding and royalties when a publisher sells a book to a store for resale. And timing is important for this one too: it gets into the books at the same time that the sale is made, regardless of when you bought it or paid for it.
  6. Expenses (usually called operating expenses): office rent, administrative and marketing and development payroll, telephone bills, Internet access, all those things a business pays for but doesn’t resell.  Tax and interest are also expenses. And the timing is supposed to be when you are committed to the expense, regardless of when you pay for it.
  7. Profits (also called Income): Sales less cost of sales less expenses. Expenses in this case includes depreciation, amortization, interest, and taxes. And if you don’t know what depreciation or amortization are, don’t sweat it, neither one of them belongs in my list of six essential terms.

Sure, you can spend a lifetime analyzing and getting to know the ins and outs of it, but these are basics every business owner and entrepreneur should know. In my opinion.

(Image: eyeidea/Shutterstock)

5 Steps to Better Financial Projections

Business Financing, Business Planning, , , , ,

(Note: this is reposted from my post Monday on Amex OPEN forum. It had a different illustration there, and I’ve changed it to the hockey stick here in honor of so many sales forecast charts that looked like hockey sticks)

Every spring, I read and review dozens of business plans as a member of an angel investment group and a judge at several business plan contests. I love it. The plans I’ve seen are better than ever this year. But, for some reason, their financial projections are the worst I’ve seen.

How can the plans be better while their financials are worse? I think product/market fit, defensibility, scalability, market need and management experience are much harder to fix than bad financials. A good business with poor financial projections will survive and grow.

Still, it’s a damn shame. The worst, and by far the most common mistake, is absurdly high profitability. So, in honor of this epidemic of bad financials, here’s my five-step plan for better financial projections.

1. Start with a sales forecast

Make it bottoms-up, always; never tops-down. This means that you start with unit and price details and build up to sales from specific, concrete assumptions. For example, if it’s a website, base your forecast on metrics you and others can compare to other websites, such as unique visits, page views and conversions. If it’s a product going through distributors to retail stores, then look at the number of stores you can reach and the distributors required to reach them, and forecast units per store per month.

Never get caught forecasting a market by assuming the total market size and then projecting your market share. That doesn’t work. Nobody who matters believes it.

Do it monthly for 12 months, then annually for the second and third year. Think of it as a spreadsheet with months and years horizontally across the top and category names vertically along the left-hand side.

Your sales forecast should include your direct costs (also called unit costs) and costs of goods sold (or COGS). This is how much it costs you in direct costs, unit costs, per units sold. These are costs you don’t pay if you don’t sell. They go up and down as sales go up and down.

If you have no idea, don’t throw your arms up in frustration; don’t say “but it’s a new business, how could I know?” Break it into unit economics and unit assumptions. Get some comparisons from similar industries to show you what gross margin (sales less costs of sales) might be, and average profitability. Google “standard financial ratios” for leads, and don’t expect to pay more than $100 for one industry profile.

And if you still have no idea, then: 1. keep your day job; or 2. find some partners who know the industry.

2. Forecast running expenses

We call these operating expenses, such as rent, utilities, payroll, advertising, websites, travel and so forth. Here again, if you have no idea, you need to find financial profiles, take in a partner, talk to somebody who’s done it before, or maybe keep your day job. You don’t want to have no idea.

This is also a spreadsheet, with the same months and years as in the Sales Forecast horizontally across the top, and the categories vertically down the left side.

By the time you’re done with expenses, you’ve got everything you need to do an estimated profit or loss analysis. The standard format starts with sales, then subtracts direct costs to calculate gross margin. Then you subtract operating expenses to calculate profit before interest and taxes (called EBIT, with the E standing for “earnings.”)

If your projections have profits higher than 10 or so percent of sales, you’re not done. Either you have underestimated your costs or expenses, or you have an unusually strong business. It’s almost always the former.

Hint: No matter what industry you’re in, if your pretax profits are more than 15 percent, then I suggest you subtract 15 percent from your projected profits and add that amount back into operating expenses as marketing expense. Having profits too high usually means you aren’t projecting all your expenses. And marketing is where most people underestimate expenses. And besides, in a real business, well-spent marketing expenses are better than profits because they grow your business, which makes it more valuable over the long term.

3. Startup costs

Make a list of expenses you’ll have to pay before you start. Common startup expenses are legal expenses, website development, logos, signage, fixing up a location, computers and so on. Then make a list of assets you’ll need. Those are things like vehicles, equipment, furniture, startup inventory and starting cash in the bank.

The cash in the bank is the toughest. If you go back and look at your running profit and loss, that will give you an idea. You have to have money to support your early losses. Read the next step and then revisit it.

4. Understand cash flow

Unfortunately, making a profit doesn’t mean you have cash in the bank. The biggest problems here are the business-to-business sales, which typically mean you get paid a month later; and product businesses, because normally they have to buy things to sell before they sell them. If you’re a business that paid two months ago for what you sell today, and is going to get paid for that three months from now, then cash flow is both critical and unintuitive. You’re going to need money in the bank (you can call that working capital) to handle running expenses while you wait to sell stuff and get paid for it.

On the other hand, If you’re selling to people who pay immediately in cash, check, or credit card, especially if you’re not putting money into buying and keeping products, then cash flow is more predictable.

If you have no idea, and you do have business-to-business sales and inventory, then look at templates, or software, or books, or tutorials, or somebody who can help you. Don’t take cash flow for granted, even if you expect to be profitable. Ironically, some of the worst cash-flow problems come with high growth rates.

5. Review and revise regularly

Yes, you should forecast for 12 months and the two following years; but no, don’t expect your forecast to be accurate. They never are. You do the financial forecasts so you can set expectations and link spending to sales, but that’s just the start. Review your results every month. Compare actual results to what you had planned. And make corrections.

Final thought: all financial projections are wrong, by definition. We’re human and we don’t predict the future accurately. So don’t expect accuracy. Go for plausibility, and then follow up with regular plan versus actual analysis, review and revisions. We call that management.

(Image: Nicolas McComber/Shutterstock)

Are You Planning to Sell Boxes or Hours?

Angel investment, Bootstrapping, Starting a Business, Venture Capital, , ,

All of these are just “in general” points. There will always be exceptions. But still, it’s good to understand the huge difference between service businesses and product business. Selling hours has advantages, but selling boxes does too. And there are huge differences, things I think you need to understand.

My wife and I spent several years working on converting our business planning business to “sell boxes, not hours.” It took a long time, but eventually that worked. But we started with a service business, and it was only after several years of that business that we started to convert it to products. Here are some of the standard tradeoffs.

  1. Service businesses take less capital to start. Particularly professional service businesses, like consulting, graphic design, landscaping, bookkeeping … you don’t have to buy products to sell, or materials to build products. You need credentials, yes, and a computer, and in most cases a website. But you’re not worried about design, prototypes, packaging, inventory, channels of distribution, and all that.
  2. Service businesses are harder to grow. With a product business you sell more and you make more money. Succeed with online marketing, open up a new channel, and you can build more of those things. Product businesses usually – obviously not if a lot of hand labor is involved – scale up. On a classic service business, though, to double sales you have to double your payroll. That’s what investors call a “body shop.” Classic service businesses can be great businesses for the owners and workers, but they’re rarely good investment opportunities for outside investors.
  3. Investors like Product businesses. I’ve been spending a lot of time lately looking at pitches for our angel investment group, and evaluating businesses for some major business plan competitions. Investors like product businesses because you can lever up, and scale. And you can sell a product business – the whole business – to somebody else. And you can make sales while you sleep. And of course, to make this perfectly clear …
  4. Investors don’t like service businesses. It’s the body shop problem. The assets walk out of the door every night. The assumption is that they don’t scale. Sure, there are exceptions.
  5. Web service businesses act like product businesses, without the inventory drag on cash, or the problems of physical distribution. A web service can scale up, if it’s designed correctly, and go from 100 to 1,000 to 10,000 without needing a lot of hand labor or human intervention.

So what? I think it’s good to know. Service businesses start up all the time with only a few thousand dollars of initial investment. All you need is that first good client, and off you go. There is less risk. It’s easier to get from nowhere to covering costs.

But if you want to go big-time, or if you want to build a business you can sell, build products or web-based services.  Sell boxes, not hours (or a web app).

(Image: Quang Ho/Shutterstock)

Not the Customer’s Job to Know What They Want

Business Ideas, Business Stories, Business Strategy, Venture Capital, Web/Tech, , , ,

There was a nice short video on TechCrunch the other day, quoting Mark Zuckerberg, John Doerr, and two other industry leaders on how much the iPad has changed “everything.” I picked it up because of what John Doerr says near the end.

http://player.ooyala.com/player.js?deepLinkTime=02m46s&embedCode=kwZnh5MTrZtMPzfZVRRMNSLo3_EsC71X&videoProviderCode=11amo6qGw2oucN78pR-BYbDpCESk&width=480&deepLinkEmbedCode=kwZnh5MTrZtMPzfZVRRMNSLo3_EsC71X&height=290

The video snippet I’ve embedded here skips directly to my favorite part, at 2:45, very near the end, as John Doerr talks about Steve Jobs saying what market research has done for the iPad. Jobs says:

It’s not the consumers’ job to figure out what they want.

I like that. As we turn increasingly to polling and research for answers, the problem is that people don’t often say what they really think, and quite often don’t even know what they really want. One kind of leadership, to me, is leading people instead of asking people. You take a guess. When you guess right, you win big. Guess wrong, you lose.  Is it possible that this is also called entrepreneurship? What do you think?

Pitching Your Business: How Not to Answer A Tough Question

Business Mistakes, Business Pitch

Imagine a meeting room in a hotel. You’re an entrepreneur talking to five potential investors. You present their new business with a slide presentation. This is your pitch.

The pitch goes perfectly well until it gets to the financial projections. They’re bad.  They are embarrassingly over optimistic. They cast doubt over the entire presentation.

So, when the investors question the financials, how do you respond?

The wrong answer: blame the financials on the outsider who did them. Take no ownership and no responsibility. Do you realize how bad this makes you look?

The right answer:  Acknowledge the problem and ask for as much information as the investors are willing to give you about what’s wrong with them. Promise a thorough revision as quickly as possible. If you can – use good judgment, this might not be appropriate – suggest that unrealistic financials are a lot easier to fix than poor product-market fit or a less-than-stellar management team.

Isn’t it obvious why one is better than the other?

(Image: istockphoto.com)

5 Ways to Make Your Projected Profits Realistic

Business Financing, Business Plan Contest, Business Plan Marathon, Business Planning, Venture Contests, , , , ,

I’m well into my business plan marathon again this year, in Houston today looking forward to judging the Rice Business Plan Competition, one of my favorites.

Regarding business plans, instead of just complaining (again) about unrealistically high profitability projections, today I have some specific suggestions. And this has nothing whatsoever to do with the six excellent plans I’ve read for my part of the judging today. dollars

But, as my mother used to say: “if the shoe fits, wear it.”

The underlying problem is that projecting high profits doesn’t usually mean you have a great business plan. It almost always means that you’ve underestimated expenses or direct costs. It’s usually a bad thing, rarely a good thing.

So here are those concrete suggestions:

  1. Compare your projected profitability (net profits or pretax profits as percent of sales) to standard industry profiles. The most well-known source in the Annual Statement Studies published by Risk Management Associates (RMA). These will give you standard profitability rates for more than 700 common types of business. I searched the site for information business, narrowed it down to software publishing, and I was offered a download for $120. Oxxford Information Systems competes with RMA with more profiles for more different types of business. And Business Plan Pro bundles the Oxxford Information profiles with a searchable database linked to the ratios table [disclosure: I’m the conceptual author of Business Plan Pro and my company publishes it.] And there are other competitors in that market. Standard profitability isn’t that hard to find.That doesn’t mean that I recommend your projected profits always match some standard industry profile. Not at all. What it does mean, though, is that you should know what profits are reasonable for similar industries, and don’t project huge profitability that’s 5 or 10 times higher, in percent of sales terms, than the standards. That kills credibility.
  2. Compare your projected profitability to results of publicly traded companies in your industry. You don’t need an exact match, but you should know how different your projections are, and you should satisfy yourself on why they’re different. The publicly traded companies tend to be larger and more established than new startups. Sometimes a startup is so new and innovative that it is much more profitable than industry leaders; but that’s rare. If you don’t know where to find financial reports of publicly traded companies, start with Yahoo Finance.
  3. Do a good web search to see if you can find comments on blogs or in interviews where entrepreneurs talk about actual profits in real businesses like yours. Maybe you’ll find somebody who might be a competitor. People give a lot of information away these days, in blogs, and on the web.
  4. Try to find somebody with actual experience in a similar company. Use social media, use your mentors, talk to the nearest business school or chamber of commerce. Get somebody to tell you, from real-world experience, what kind of profits are likely.
  5. If all else fails, remember that across the real world of business, normal profits run about 5, 10, maybe 15 percent of sales. If you’ve done your best and it still shows 30 percent or more, take a good look at your payroll, headcount, and marketing expenses. When it doubt, add marketing expenses to take your projected profits down to a credible level.

Is this you? Does your business plan project profits way above standard levels? That doesn’t make your plan look better. First, make it credible. Only then are the numbers really interesting.

(Image: Elnur/Shutterstock)

Finding Your Financing: Is Angel Investment Realistic?

Advice, Angel investment, ,

I was talking to a group of determined entrepreneurs, a food business boot camp in Corvallis, Oregon, and finishing up on business plans when one of them asked me:

What do you recommend for getting angel investment?

I recommend that unless you have a good investment opportunity, you don’t waste your time. cash pile

What’s a good investment opportunity?

  1. First, it has to be something scalable, defensible, that can grow. That means it’s either a product business, or one of those web services that scale easily. Can you add sales without adding employees? That’s a good clue to scalability.
  2. Second, you need people on board with experience in startups. It’s tough if you’re just beginning, but investors worry about risk and nothing reduces risk like having some experience. If you haven’t been involved in a startup, it’s really almost impossible to get investors to take a chance on you. Look for partners or team members who’ve had some startup experience. Ironically, having failed with a startup isn’t always bad; failure is better than no experience at all.
  3. Third, you need a believable exit strategy. And you need to be able to convince investors you really want that. Investors don’t want just a small piece of a healthy growing business; they don’t make money unless that business wants to be sold in a few years, meaning it gets acquired by a larger company, and investors get to convert their ownership back into money.

The hard part, as a speaker talking to entrepreneurs, is entrepreneurs want encouragement. But then when I think of how much time and effort some people spend trying to get investment that’s never going to happen, I try to just tell the truth.