Building a company from the ground up is one of the most challenging things one can do. In the early stages, the nitty-gritty of finance may be one of the last things you want to focus on. Still, it’s something to hone into for pushing past short-term survival and grow into a profitable company.
As a seasoned finance professional and entrepreneur, Spark Centre Finance Advisor Peter Mandl knows how crucial finances are in entrepreneurship, and he’s sharing his Top Finance Tips that all startups need to hear.
You’ve decided you’re going to start a new business. You’ve invented “a better mouse trap”, identified an underserved market/customer need or have insight on a new and emerging trend (maybe the next “pet rock”!). If it’s a technology-based product or service there are key considerations for planning and executing your business strategy. These considerations have been formed from many years of participation in numerous science and tech-based startup companies (semiconductors, biotech). Some were successful, others, well, not so much.
The nature and complexity of your underlying idea, product, science, technology, etc. will likely determine the funding style of your business.
You must decide whether you want to build a “lifestyle” business or one that requires and attracts outside investment capital.
A “lifestyle” business is one that is generally self-funded (typically by founders and family), grows organically (by reinvesting its profits) and usually has modest market share and revenue goals. A successful lifestyle company can provide a comfortable “lifestyle” for the founders and family and is usually firmly in the control of the founders and family. Company owners typically don’t intend to sell the business to convert their gains into cash.
However a new business based on any sufficiently advanced and complex science, technology, idea or service almost always requires a meaningful amount of outside, third-party capital investment (usually equity-based and in the millions of dollars). These startup businesses must have an exit strategy (e.g. initial public offering, company sale, secondary offerings etc.) for investors to realize their capital gains. These businesses must also have a compelling financial story, target and aim to dominate global markets. They are usually high-risk ventures based on new, disruptive products, services, and business models (think Tesla, Facebook, Google, Uber), and they have complex and sophisticated financial arrangements and governance models. And unfortunately, they often fail (you don’t normally hear about these).
If the nature of your business requires significant outside third-party investments, especially from professional investors (e.g. venture capital, VC), expect to have a new boss (the Board of Directors, or the VCs). If successful, the rewards can be tremendous and life-changing (career-wise, personally and financially), but as a founder, expect to work at it 24/7.
As you evolve your business plan and strategy, in the early days you’ll likely fund your ideas with personal savings or assistance from family and friends. You may be able to build your first Minimum Viable Product (MVP) using this type of funding, however, for most very advanced technologies, you’ll need Angel or Venture Capital funding.
Angels can provide some modest financing, but for companies with serious capital requirements (semiconductors, healthcare, biotech etc.) VCs are usually the only source of realistic funding. VCs specialize in specific industries, focus on specific stages of company development (e.g. seed, Series A, B, C, etc.) and have domain experience and knowledge. Their pool of investable capital has been raised from clients (high net worth individuals, family offices, institutions etc.), and has promised a return in 5-7 years. VCs look for the “home run”, the company that provides a return of ten times the money invested.
What startup company attributes do smart angels and VCs look at when making their investment decisions?
- A founding executive team. Ideally, the founding executive team “has been there, done that”. The executive team has prior experience in startup, fundraising, building a team, operations execution and (hopefully) an exit. Ideally, the executive team should be in place or contingent to be in place upon financing. The exec team should also include CEO (Chief Executive Officer) leadership, a CTO (Chief Technology Officer)/expert in the technology, service or product, a CFO (Chief Financial Officer) to manage invested funds and possibly a CMO (Chief Marketing Officer) for sales and marketing.
- A large addressable market. This usually means a market opportunity of hundreds of millions of dollars, allowing for the possibility of tens of millions to hundreds of millions of revenue in the future (say 5 years), depending on market share. Such opportunities are desired because the costs involved in developing any sufficiently advanced technology are often in the millions to tens of millions of dollars.
- Disruptive, novel, protected (i.e. patents) technology, product, service, business model etc. You must have a “secret sauce” — a competitive advantage or differentiator from existing products. To overcome barriers to entry, often a tenfold advantage in some product attribute is necessary such as special features, speed, performance, and cost/price (but competing on price is often not the best strategy).
VCs understand that any business plan, financial projections etc. is your best guess at the future, and likely too optimistic. VCs will often say the composition of the exec team is a key determinant of their funding decisions because they know an experienced team will likely be better equipped to manage the evolving risks, and setbacks and maximize the probability of success.
Investors look for a compelling financial story — one in which they leave with substantially more money than they put in (your risk profile is high, so they are looking for a big return). VCs are looking for that tenfold return. Given that much of an investment decision is based on subjective factors, it’s essential that your financial projections make sense.
Your financial projections are based on a multi-year financial model. Your model should make realistic assumptions about revenues, costs, profitability, margins, etc. (easier said than done I know). Note the often-quoted truism “it’ll take twice as long, cost twice as much … and then more”. Your financial model should be similar to your comparable companies.
A “comparable” is a similar company in your industry at a similar stage of development. Your financial model and projections are measured by financial metrics such as gross margin, profit margin, cash margin, the number of employees, operating expense per employee, revenue per employee, investment capital vs revenue and more. Most comparable companies will have “similar” financial metrics. I’m of the opinion that comparable companies are bound by the same “business physics”. That is, the revenue and cost constraints are likely to be similar across companies in the same industry. What sets you apart and drives your success is your “secret sauce”. If
you think you are an outlier, you better have a convincing story to tell investors. For new businesses in emerging industries that lack “comparables”, it becomes all about the founder’s “vision” (and your ability to convince investors to bet on that vision).
There are many financial model templates available online but many focus only on the income statement, and/or cash flow (admittedly cash flow is the most important concern). Due to their generic nature, most templates fail to provide a comprehensive structure to identify and capture the key costs and expenses for entrepreneurs and fall short in projecting actual real-world expenses.
“Starting a new business is an exciting and challenging endeavour. It’s a lifestyle choice.”
A more comprehensive financial model is based on accounting principles and generates accounting-compliant income, balance sheet and cash flow statements. The core of such a model consists of a general-purpose operating expense module, surrounded by a customizable, company-specific revenue module and technology development expense/cost plan.
In my experience, for an IP or technology-based business, employees are a key asset. The number of employees required for IP, technology or product development is a key driver of development costs in the early years of the new business (and hence typically drives the initial investor financing required). There is a general relationship between projected revenues and the number of employees to achieve those revenues (study your comparable companies). When the business becomes profitable, cash flow positive and enters the self-sustainable operating phase, there is a general relationship between ongoing operating expenses (G&A, R&D, S&M) and sales revenue. All these relationships can be used to build a realistic financial model that makes sense to an experienced investor. Such a tool is extremely valuable to project cash flow and investment needs. For fundraising purposes, annual time resolution over a period of 3-5 years is suitable for an investor presentation. If time resolution is extended to monthly and historical accounting data is incorporated, the financial model can also be used as an operational tool assisting with budgeting, monthly financial projections and investor reporting. While powerful, such a financial model does require an in-house experienced financial person with accounting and finance training.
Starting a new business is an exciting and challenging endeavour. It’s a lifestyle choice. I’ve had the good fortune to participate in multiple startup companies. Most didn’t work out but one was a “home run” and went public on the NASDAQ exchange. Luck and timing are important. But you can “make your own luck”. Prepare to work hard, move fast and hire the best (especially if you land US venture capital). You’ll always be under tremendous pressure to deliver results before the cash runs out!
Peter Mandl is a seasoned finance professional, technology executive, entrepreneur and Advisor to Spark Centre clients who transforms great ideas into sustainable commercial advantage. To learn more about Peter Mandl and other Spark Centre Advisors click here.