Last night I lectured on this topic to my entrepreneurial capstone class at Purdue. It is possibly the most basic question for any startup looking to raise capital, but it is often not approached correctly. In my experience most entrepreneurs take a wild guess at their number.
The correct approach is to look at your cash flow projections and determine it from there. For a new startup the goal is to get to breakeven and beyond. For later stage companies the projections may address strategic growth milestones. Either way, the cash flow proforma is the most important financial statement available to you.
If there is one thing I have learned in my entrepreneurial law practice it is that:
Your proforma should address the month by month inflows and outflows of cash based upon your revenue model(s) and cost projections. Your goal is to find out where you bottom out. That bottom out number is the base for the capital needed.
I have never seen a startup hit its first year projections. Entrepreneurs who do their homework should be able to be within 5% or so of their cost projections, but revenue projections are much harder to hit. Even with the best market research, strategic risk, random risk, dumb luck and unfortunate events cause revenue projections to miss their mark.
Most business plans build in contingencies for variable costs (or certain key fixed startup costs) based on revenue milestones being missed. Take these contingencies into consideration when determining how much capital you will need.
A few other thoughts:
1. Know your A/R model. Whether you require payment up front or a long pay cycle will make a huge difference on your cash flow projections. Also, if your business model carries a lower realization rate on A/R, build in that strategic risk factor into your projections.
2. Know your inventory model. This is especially important for manufacturing and distribution companies.
3. Get an operating line of credit from a bank. This is extremely helpful for those payroll weeks where the company is short on cash. This happens to nearly all early stage start ups, and that is what lines of credits are intended to protect.
4. Plan for taxes. Whether your company is a C-Corp or a pass through entity which is making tax distributions to owners, you need to figure these amounts (both as savings and payouts) in your cost projections. I see a number of early stage business plans that do not consider tax distributions in their cash flow proforma.
5. Prepare for reserves. If your startup cash projections tell you that the business will bottom out at a negative $150k in month 7, do not plan to raise $150k. Determine the risks associated with your model, look at the revenue projection contingencies, and determine an appropriate dollars amount above and beyond the cash bottom out number to hold in reserves. Any sophisticated private equity investor will want (and expect) you to carry reserves.
The key when raising capital from angel or private equity investors is to be able to clearly explain why you need the money you are asking for. Use your cash flow proforma and refer to your sources and uses and be confident about how much you need.
~~~~~~~~
See also:
Changes To Accredited Investor Standards
Entrepreneurs Must Understand Cash Flows
Entrepreneurial Law - Developing a Good Business Model
Funding Law - Presentations to Investors
Funding Law - Investor Impatience
Random Thoughts on Private Equity
Funding Law - Know Your Numbers
Entrepreneurial Law - Proof of Concept & Proof of Scale
The correct approach is to look at your cash flow projections and determine it from there. For a new startup the goal is to get to breakeven and beyond. For later stage companies the projections may address strategic growth milestones. Either way, the cash flow proforma is the most important financial statement available to you.
If there is one thing I have learned in my entrepreneurial law practice it is that:
Employees care about salaries
Managers care about margins
Banks care about net income
Entrepreneurs care about cash flows
Managers care about margins
Banks care about net income
Entrepreneurs care about cash flows
Your proforma should address the month by month inflows and outflows of cash based upon your revenue model(s) and cost projections. Your goal is to find out where you bottom out. That bottom out number is the base for the capital needed.
I have never seen a startup hit its first year projections. Entrepreneurs who do their homework should be able to be within 5% or so of their cost projections, but revenue projections are much harder to hit. Even with the best market research, strategic risk, random risk, dumb luck and unfortunate events cause revenue projections to miss their mark.
Most business plans build in contingencies for variable costs (or certain key fixed startup costs) based on revenue milestones being missed. Take these contingencies into consideration when determining how much capital you will need.
A few other thoughts:
1. Know your A/R model. Whether you require payment up front or a long pay cycle will make a huge difference on your cash flow projections. Also, if your business model carries a lower realization rate on A/R, build in that strategic risk factor into your projections.
2. Know your inventory model. This is especially important for manufacturing and distribution companies.
3. Get an operating line of credit from a bank. This is extremely helpful for those payroll weeks where the company is short on cash. This happens to nearly all early stage start ups, and that is what lines of credits are intended to protect.
4. Plan for taxes. Whether your company is a C-Corp or a pass through entity which is making tax distributions to owners, you need to figure these amounts (both as savings and payouts) in your cost projections. I see a number of early stage business plans that do not consider tax distributions in their cash flow proforma.
5. Prepare for reserves. If your startup cash projections tell you that the business will bottom out at a negative $150k in month 7, do not plan to raise $150k. Determine the risks associated with your model, look at the revenue projection contingencies, and determine an appropriate dollars amount above and beyond the cash bottom out number to hold in reserves. Any sophisticated private equity investor will want (and expect) you to carry reserves.
The key when raising capital from angel or private equity investors is to be able to clearly explain why you need the money you are asking for. Use your cash flow proforma and refer to your sources and uses and be confident about how much you need.
~~~~~~~~
See also:
Changes To Accredited Investor Standards
Entrepreneurs Must Understand Cash Flows
Entrepreneurial Law - Developing a Good Business Model
Funding Law - Presentations to Investors
Funding Law - Investor Impatience
Random Thoughts on Private Equity
Funding Law - Know Your Numbers
Entrepreneurial Law - Proof of Concept & Proof of Scale
Powered by Compendium
Comments for Funding Law - How Much Money Does Your New Business Need?