"With Bobby, we had to start all over again. He had based his projections more on what he thought they needed to live on than on what he could actually sell. He justified them by looking at his record with his old employer, where he'd been selling computer-cleaning equipment worth $12,000 to $20,000 per unit. It never crossed his mind that it might be different selling computer supplies at, say, $40 per order.
"So I tried to slow his thinking down by making him focus as narrowly as possible. This was January 1992. I said, 'Let's take July. What can you do in July?' He said, '$20,000.' I said, 'There are 20 working days in a month. That's $1,000 per day. Is that realistic? Our average order is $40, so you're talking about 25 orders a day.' He said, 'Jeez, 25 orders.' I said, 'Right, in eight hours. Three orders an hour, with phone calls. That's an order every 20 minutes. For a whole month. Can you do it?' Maybe yes, maybe no. The point was to make sure we were dealing with reality. Then we worked forward and backward, month by month, until we had a year's worth of sales. What I wanted was reasonable projections, educated guesses.
"But it's the next step that I consider most critical, which is to determine gross profit. Once you have reasonable sales projections, you can break them down by product category and calculate the cost of goods sold [COGS], or, in service businesses, the cost of sales. You subtract COGS from sales, and you have your gross profit or -- expressed as a percentage of sales -- your gross margin. In my opinion, gross profit is the single most important number in any new business. It determines everything else about your business -- the amount of capital you need, the volume of sales, the overhead you can afford, the time it will take to determine viability, even viability itself.
"Say you're selling an item for $1 that costs you 90¢ to produce or to buy. Your gross profit is 10¢ per item, or 10% of sales. Suppose you need $5,000 per month to cover your overhead. To get it, you have to do $50,000 per month in sales. Now, let's say it takes you three months to collect your receivables. You'd have to put up more than $100,000 in cash to get the $5,000 per month you need to break even. That's usually not a viable business.
"And gross profit is the linchpin, the deciding factor. You have to pay all your expenses out of gross profit -- your salary, your rent, the phone bill, gas, electricity, photocopying, whatever. If your gross margin is 10%, you need $10 in sales for every $1 of expenses just to break even. If your gross margin is 40%, you need only $2.50 in sales for every $1 of expenses. That difference is crucial when you're working with limited capital. The higher your gross margin, the fewer sales you need to cover expenses, and the longer your capital will last. And, for most start-ups, time is survival.
"That was the most important lesson Bobby and Helene had to learn, and I made them do the math themselves. I took them through the steps. I showed them how to break down sales by category and how to calculate their cost of goods sold and their gross margin. We came up with a list of expense categories and determined their fixed overhead. With sales, COGS, and overhead expenses, they could work out the month-by-month income statement on their own. Then I took them through the process of doing monthly cash-flow forecasts, from which they could put together a cash-flow statement for the year. I did just enough with them to make sure they had the hang of it. The rest they did at home. With pencil and paper. No computers allowed.
"It's all part of the education process. When you write out your own projections by hand, do your own calculations, and work through the numbers for a whole year, two things happen. First, you begin to get a feel for the business. Second, you start to understand reality. You see that sales don't necessarily lead to profits, and that making a sale or earning a profit is not the same as generating cash. You get a sense of the connections.
"Of course, there is another important reason to do a business plan. It will give you a pretty good idea of the amount of start-up capital you need. The number comes off the cash-flow statement. In most cases, you will see cumulative cash flow getting worse and worse, month after month, until the business turns a corner and cash flow starts to improve. Now, I'm assuming that the business is viable on paper. If projected cash flow never improves, the business is not viable, and you should find something else to do. But if the business is viable, the amount of start-up capital you need is theoretically equal to the largest cash deficit on the statement. If you put that amount into the business, you should be able to avoid running out of cash -- in theory. In practice, I always increase the number by at least 50%. With Bobby and Helene, for example, it looked as though they would have negative cash of about $15,000 in their worst month. I told them the business would probably require an investment of $25,000, but they had to put in only $15,000 up front.
"There are two reasons for building in a reserve. First, things always cost more than you anticipate, and profits are always less. So, in fact, you probably will need more capital than appears on the projected-cash-flow statement. But there's also a psychological and emotional issue. It's one thing to put up additional capital down the line if you know from the start you might have to. You feel very different about it if you think you've already made the maximum investment required.
"Doing the business plan leads right into the next phase because you're learning what has to happen for the business to survive. With Bobby and Helene, I was breaking survival down into terms they could understand and numbers they could monitor. They were seeing the difference between selling cleaning supplies with a gross margin of 50% and magnetic media with a gross margin of 10%. They were beginning to understand how gross margin, credit, collection, and so on would affect their cash flow, and how cash flow would determine whether or not they'd last long enough to see if the business was viable in reality as well as on paper. They were finding out where they had to focus their attention to have a decent shot at succeeding.
