A detailed look at how a successful entrepreneur guided a couple through various start-up pitfalls.
Helene and Bobby Stone had a fledgling business idea, the dream of economic independence, and a work ethic at least partly fueled by desperation. What they didn't have was what every great company builder relies on -- the street-smart grasp of what separates successful businesses from unsuccessful ones. That's where Norm Brodsky came in
They were just friends going out to dinner, two couples who liked to get together over food to chat about life and children and the ways of the world. One of the couples, Bobby and Helene Stone, suggested they eat someplace cheap this time. The other couple, Norm and Elaine Brodsky, were happy to oblige. Not that money was an issue for them. Norm Brodsky had made and lost and made again more money than he could count. The founder and CEO of Perfect Courier, a three-time Inc. 500 company, he was working on his sixth start-up, which -- after three years -- looked like another strong contender for the list.
The Stones lived in a different world, augmenting Bobby's salary with income from a tiny home business that Helene ran out of their basement in North Bellmore, N.Y. That evening in January 1992, Bobby told Norm and Elaine that he'd been laid off from his job as a computer-equipment salesman, a job he'd had for more than 14 years.
"He was really distraught, as you'd expect," Norm recalls. "He was angry. He said he'd never work for someone else again. He said he was going into business with Helene, selling computer supplies out of their home. He was all gung ho because he thought he was a great salesman. Helene was more concerned with figuring out how they were going to live.
"So I said, 'Look, Bobby, if you need any help, I'd be glad to sit down with you.' I was just thinking I'd give them a little advice. Of course, it turned out they needed a lot more. They needed a whole education.
"And that proved to be the most interesting aspect of this whole thing. I mean, you get to my age, and you start to wonder how much you can teach people about business. Can you take a middle-aged couple who aren't businesspeople, who know nothing, really, about creating a successful business, and show them how to do it? Or do you have to learn from experience? I wasn't sure. It's taken me a lifetime to learn what I know about business. I didn't learn it from a mentor. I certainly didn't learn it in school -- and remember, I have degrees in both law and accounting. I had to unlearn a lot of the stuff I'd been taught in school. And how much of business is instinctive, anyway? How much do you learn as a kid before you're even aware it has anything to do with business at all?
"I didn't know, but I was curious to find out."
Bobby and Helene Stone recall the dinner somewhat differently. "Norm asked me what I was going to do," Bobby says. "I said, 'I'm going into my own business.' He said, 'Do you have a business plan?' I said, 'No. . . . "
Helene interrupts. "That's not true. That's not what happened. You said, 'What's a business plan?"
"Yeah, right, I said, 'What's a business plan?' And he said, 'A business plan is what you expect to do.' I said, 'What do I need that for?' He said, 'You need it so you'll know if you have a viable business.' I said I was pretty confident we had a viable business. I mean, the business had been going for seven years with just Helene and her assistant, Paula, working part-time out of our home, and no one doing sales. And I think I'm a pretty good salesman. How could we not have a viable business? So I'm saying one thing, and she's saying something different."
"You bet I am," says Helene. "I'm saying, 'This man is nuts.' I'm saying, 'Norman, there's no money. We can't even pay our bills. We're looking for a home-equity loan to pay off our biggest supplier.' Bobby says, 'You're being too negative.' I say, 'Bobby, you don't understand this. You look only at the sales. I'm looking at the dollars.' So Norman says, 'Look, do me a favor. Don't do anything rash. Bring all your paperwork to my house, and we'll sit down and see if you have a viable business here."
And that's how it all began.
* * *
Get a Grip on Your Emotions and Decide on Your Goals
Ask Norm Brodsky the single most important piece of advice he gives to people starting a business, and he'll talk about preserving capital and maintaining gross-profit margins. "But I don't begin with that. I begin by asking them their goals. I'm very big on setting a reasonable goal and trying to reach it in a reasonable amount of time.
"The truth, of course, is that the initial goal of every business is to survive long enough to see whether or not the business is viable. I don't care what business you're talking about or how much capital you have. You never know for sure if a business is viable until you do it in the real world. But viability is just a step on the way to somewhere else, and I want to know where somewhere else is. I want to hear what people have to say. What I'm listening for are goals that can't be achieved by business. Or goals that will get in the way of the business. Or goals that are totally unrealistic given the particular business they're looking at. I'm listening for what's really motivating people. Usually, it's something emotional.
"Take Bobby and Helene, for example. They told me they wanted to earn a living out of the business. Fair enough. But Bobby wanted something more. At that moment, what he wanted was revenge on his old company. Well, that's normal, but it wasn't going to get him anywhere except maybe to burn some bridges. Revenge had nothing to do with Bobby and Helene's long-term goal, which was to become financially independent and never be in this situation again. So, by identifying the goal, we were able to get those emotions out of the way.
"Of course, once you've decided on the goal, you come right back to the issue of viability. I told Bobby and Helene, 'Look, I don't know if you have a real business here, and I also don't know if you can run it like a real business. But first we have to see if it's even worth trying. We have to be sure that, on paper at least, it looks as though you have a shot at making it work.'
"So I asked them to bring over whatever information they had about their sales, costs, and expenses for the past year or so -- in other words, everything they'd taken in, plus their receivables, and everything they'd paid out, plus their payables. I told them we'd sit down after dinner and go over it."
Helene Stone says she was ready to explode by the time they cleared away the dinner dishes. "I came on like gangbusters," she says. "I couldn't wait to attack, because Bobby was really pissing me off. I'd been saying for months that something was wrong, but this man wouldn't listen to me. I knew Norman would listen."
"In reality, she didn't accept that I was coming into the business," says Bobby.
"That's true. I'm thinking maybe Norman will tell him to go out and get a real job."
"And I'm thinking we have a great future in this business," Bobby says. "So I start to tell Norm about all my projections and my marketing plan, and he doesn't want to hear it."
"What he said was, 'Bobby, shut up," says Helene. "Then he looked at me and said, 'What do you have?' I spread out my work and started explaining it. He said, 'I can read. Calm down.' He sits there, writing stuff down, asking us a question now and then, adding up numbers, and going, 'Uh-huh, uh-huh. Very interesting.' Like a doctor. I say, 'Norman, what is it?' He says, 'Here. I'm going to show you that your assistant, Paula, made more money last year than you did."
"Actually, he asked me to read it," says Bobby. "He said, 'Look at this. These were your sales for the year, and these are all your expenses except Paula. You subtract one from the other, and here's what you get. Would you please read that, Bobby?' I said, '$10,000.' Norman says, 'Right, $10,000. OK, now look over here. This is the total you paid Paula. What does that say?' I said, '$15,000.' He said, 'Do you understand what that means?' I said, 'I think it means we lost money.' He said, 'Very good."
"But Norman never told us to fire Paula," says Helene. "He said, 'I think you have some decisions to make.' He said, 'Look. The business appears viable on paper. But you do have to reduce your expenses, and you're also going to have to put some capital into the business. I don't know how much yet, but it will be a substantial portion of your savings. Are you willing to do this?' He's talking to me."
"Because the money would have to come out of her savings account," Bobby says. "The decision was between putting her money into the business or having me go out and get a real job."
"Yeah, and I didn't know at that point. I had a lot of question marks. I was drained. That was all I could take for one night. So we went home and went to bed. The next morning, I woke up and said to him, 'Paula goes.' And he said, 'Yeah, she has to.' And I tell him, 'Go do it. I can't do it.' It was too upsetting. I'm hysterical crying. Because this was just done to him, and now I'm doing it to someone else."
"I felt terrible," says Bobby. "I said, 'Paula, I'm really sorry. It has nothing to do with you or your performance. We just can't afford to have both of us in the business.' She was upset and hurt, but she didn't get angry. I think she knew. She said, 'If you ever need me again, call me."
"She left, and he and I were both hysterical crying," says Helene. "A part of it, I guess, was reality smacking us in the face. Here we are, just the two of us in our basement by ourselves, and now what? I felt like I was in mourning. He went off to clean out his old office. Finally, I said to myself, 'OK. This was a decision. Letting Paula go means you're in it for the long haul.' But I have to say I was going on blind faith. I was very anxious. It was clear we didn't know what we were doing. We just had to hope Norman did."
* * *
Make Sure You Understand What Cash Flow Is and Where It's Going to Come From
"Everybody is scared going into their first business," says Brodsky, "everybody with any sense, that is. That's one reason you need a business plan. It helps to demystify the process. It takes some of the emotion out of the situation.
"The problem is, you can't create a business plan unless you understand cash flow, and people starting their first business seldom do. They confuse cash flow with sales or with having money in the bank. They believe that to be successful, all you have to do is generate sales. In fact, what you need is the right kind of sales. The wrong kind can drive you straight into bankruptcy.
"To avoid that, you have to realize, first, that your capital is limited. I don't care who you are. Nobody starts a business with unlimited capital, not even IBM. So the whole idea is to make sure, number one, that you have enough capital to begin with, and number two, that it will last long enough to determine whether or not the business is viable. By viability, I mean the point at which the business is generating internally the cash it needs to pay its bills. It can survive on its own. A business plan is essentially your best guess as to how you're going to get there.
"Now, understand, when I say business plan, I don't mean anything elaborate. What I'm talking about is a modified, down-and-dirty income statement and cash-flow statement, real simple. I just want a reasonable expectation of sales by month for a year. That's what I asked Bobby to give me. What he came up with was ridiculous. He was way overoptimistic, which is typical. People on their first business venture are always overoptimistic -- at the same time they're scared to death. It's weird, and it's also dangerous, because it leads them to make bad decisions about how to spend their limited capital.
"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.
"I should say that Helene was finding it out. She learned very quickly. Bobby took a little longer, but then, he had more obstacles to overcome."
* * *
Helene Stone recalls mainly the anxiety and the tension of the first year. "We fought every day, every single day," she says. "I was so angry at those people for taking our livelihood away. And he just sat there on the couch in our basement."
"I was there -- that was the big problem," says Bobby. "For the longest time, she resented that I was just physically there and not at a job. She kept bringing it up. 'I want you to get a real job.' I said, 'What's a real job?"
"Not just me," says Helene. "Our family, our friends. They kept bringing it up, too."
"She was so anxious. She kept saying, 'What do we do when the severance runs out? What do we do when COBRA runs out?' And meanwhile, our son was getting married. I mean, there were so many emotions besides the business, so many emotions that flowed back and forth between us. It was unbelievable."
"And that was where Norman came in," says Helene. "Because we were so totally stressed out. Overwhelmed is the word I'm looking for. All these things were happening, and we still had a business to run."
"Norman put it back into perspective, and we needed that every month," says Bobby. "At least once a month."
"Norman would look over the numbers and say, 'OK, here's why your month was so low.' It was always the gross-profit margin."
"And he'd admonish me," says Bobby. "He'd say, 'You can't keep taking these low-margin sales. That's why your average gross margin for the month is only 32%."
"One sale he kept making at 9% gross margin," says Helene. "So Norman made me the keeper of the margin. If a sale came in under 20%, Bobby had to ask me if we could afford it. A lot of times, I said no."
"It took me a long time to grasp," says Bobby. "I'd have a chance to get a $3,000 order at 13% gross margin. That's $400 in the bank. I'd say, 'Look, I can get sales, and you're telling me not to? How is this business ever going to grow if we're turning away sales?' I just couldn't understand how a sale could jeopardize the business. It went against everything I'd learned for 14 years. I mean, I really want to get the sale."
"I'd bring it up with Norman, and he almost always took my side," says Helene. "I'd say, 'Norman, Bobby's out of focus again. He's off on another tangent. We have to get him back on track."
"It took me about nine months to grasp it," says Bobby. "Then, one day we're meeting, and Norman says, 'You know what, Bobby? You have a salesman's mentality. Not that it's all bad. But to make everything work, you have to have a businessman's mentality as well.' That was the lightbulb going on. I thought, 'Yeah.' It made sense. It had a very big impact on me."
* * *
Recognize the Sales Mentality Before It's Too Late
There are times, Brodsky says, when he thinks it's a miracle that anyone starting out fresh manages to stay in business. "You make so many mistakes. You get no good advice. It's so easy to get off on the wrong track.
"Take the salesman's mentality, which almost all entrepreneurs have when they first go into business. They want to see sales go up every month, every day, every hour. I myself didn't care about anything except our weekly sales figures. My investors were the same way, and many of them were accountants. You think they ever asked me about profits? All they wanted to know about were sales.
"That's the sales mentality. It's the idea that you should focus all your attention on making sales. With established companies, everybody talks about earnings, past and future, but with new companies, it's all sales. And it's very dangerous, especially when you're operating out of your basement on a shoestring.
"Why? Because sales do not equal cash, and cash is what you need to survive. You run out of cash, you go out of business. End of story. Look. It all goes back to the fundamental reality that you are working with limited capital. If your gross profit is not enough to cover your expenses, you have to dip into your capital to make up the difference. You dip too much, and pretty soon you run out.
"So here, in my opinion, are the two most important rules for every new business. Number one, protect your capital. Spend it only on things you are certain will generate positive cash flow in the short term. Number two, maintain the highest monthly gross-profit margin you are capable of achieving. Do not go after any low-margin sales.
"Now you may think these rules sound simple enough. Believe me, it takes discipline to follow them. It's very easy to go off on tangents, mainly because of the sales mentality. Here's Bobby Stone, for example, who was trained for 14 and a half years to think only in terms of sales. He'd never even heard of gross profit. His only job was to sell as much as he could at the prices he was given no matter how much, or how little, gross profit he generated.
"Now he's in business for himself, and he's having a bad month. In his business plan, he projected $20,000 in sales for the month. That's his break-even point. He's in the last week, and he's done just $10,000 in sales. He starts getting desperate. He calls up sales reps until he finds one who will buy $10,000 worth of supplies if Bobby will come down on price. They negotiate, and Bobby gives him a good deal. Bobby's happy. He's made his goal. He's moving a ton of product. He comes in and says, 'We did it. We hit our number for the month.'
"So what has he really done?
"One, he didn't break even. The price he negotiated left him with a 10% gross margin on the sale. Breakeven is $20,000 at a 40% gross margin, or $8,000 in gross profit. He has sold $10,000 at 40% and $10,000 at 10%, for a total of $5,000 in gross profit. The margin is 25%, not 40%. That isn't enough to cover their expenses. He's short $3,000, which has to come out of capital. Five more months like this, and they'll run through the entire $15,000 they put in.
"Two, he's wasted his time. He should be using his time to go after high-margin customers, which generally means smaller-volume customers. So we have another rule: spend your time developing relationships with your highest-margin customers. Let the low-margin customers come to you, and then negotiate the price up.
"That leads to a third point, because now Bobby has tied up $10,000 in one customer. What if the customer can't pay or takes too long to pay or will pay only after dozens of threatening phone calls -- on his nickel? It's a risk, and the risk is greater because it's a single customer. Bobby has taken a gamble without knowing it, and it comes straight out of the sales mentality. Commissioned salespeople never worry about getting paid.
"Don't get me wrong. I don't want to crush the sales mentality. I don't want to change Bobby's entire way of thinking. The sales mentality is wonderful -- provided it's balanced. Just because you have it doesn't mean you can't grasp the other parts of the business. You have to grasp them, or you won't survive. You'll make too many costly mistakes -- just to avoid having a bad month. I'm saying it's better to have a bad month, even a series of bad months, than to let your gross margins slide.
"Believe me, I know how hard this can be, especially if you're a salesperson. But it's important. Why? Because of your goal, your real goal, the one you decided on before you did the business plan. Bobby and Helene wanted financial independence. The question was, Would this business get them there? Their real goal was to find out.
"The sales mentality gets in the way of the real goal by substituting a short-term goal, making a sales target, for the long-term one: determining viability. So what if you have a series of bad months? Those results could be telling you something -- that the business isn't viable, or that you're not capable of selling at a high enough gross margin to achieve your goal. If so, you should pay attention.
"The usual alternative is to delude yourself with a series of high-volume, low-margin months. It's easy. You just drop your price below your competitors', and you can make all the sales you want. You'll think you're doing fine. You won't run out of cash as long as your sales keep rising and you can collect before you pay. Trouble is, you also have more payables than you can handle. You're bankrupt, and you don't know it. All of a sudden, you hit a couple of bad months, your cash disappears, and you lose everything. It happens all the time.
"The way to avoid that fate is to stay focused on your real goal, to follow the rules and watch the numbers. If you watch closely enough, a picture begins to emerge. You can actually see what's going on. You can feel it. The picture gets clearer, and the feeling gets stronger, until you realize that you're going to make it -- or that it's time to try something else."
* * *
Helene Stone says her first breakthrough came the day after the couple received Bobby's last severance check, about four months into the business. "I was so terrified," she says. "I was projecting the world would end. Then the check came, and I woke up the next morning and said, 'Bobby, we're still here! It's daytime again! Life is going on!' That was actually a big hurdle for me."
"The truth is, we didn't really know where we stood until the end of the first year," says Bobby. "Because we were subsidized. We had my severance pay. We had some other things coming in. We were going to lose it all, a $30,000 subsidy. We were going to be totally on our own."
"And Norman had warned us," says Helene. "He had told us from day one, 'You'll do fine the first year. The second year will be the hardest.' We had to see if we should even keep going. Were we a real business? Could we earn a living from it when you took out the subsidy? So we sat down with Norman at the end of 1992 and reviewed the whole year. And we figured out we would have been short by about $5,000."
"But he felt strongly we could make it," says Bobby. "He could see we were progressing. We were focused. We were getting the right margin, increasing our customer base. He said, 'If I didn't think you should go on, I'd tell you right now.' But it was scary. The second year was definitely the hardest."
"It was, but it wasn't," says Helene. "I was better by then. We were still eating, still paying the bills. I started to relax a little."
"You also realized I was here to stay," says Bobby. "It took a good year for her to accept I wasn't leaving."
"We really had just one big crisis in the second year, when we had two very bad months, back-to-back," says Helene. "For me, it was like impending doom. I thought, 'Omigod, we're out of business.' Norman had warned us that something like this might happen, that we might run out of cash. I called him. I said, 'Norman, it's here. What do we do?"
"Yeah, and he said we had a choice," says Bobby. "We could put up the $10,000 we'd held in reserve, or we could go without salary for two months. It wasn't so terrible."
"Well, that's true, I guess," says Helene. "Because Norman had prepared us."
"Plus, by then, we had a fairly good grip on the business," says Bobby, "because we'd been tracking it month by month for a year and a half. We'd been watching the sales and gross margins by product category. We'd been following about 10 categories of expenses. I think I grasped it very well after a year or so, but each piece was a revelation. Like creeping expenses. Norman said, 'As a business grows it's normal to have creeping expenses. Just be aware of them. Sometimes you can't help it.' But now I realized, 'Gee, I'm going to have to make a lot more sales to cover these expenses."
"I'd say things really started to get better toward the end of the second year," says Helene.
"Middle to end of 1993," says Bobby.
* * *
Learn to Anticipate and Recognize the Changes in Your Business
Norm Brodsky says he has learned over the years that it's a big mistake to let yourself get too relaxed in business -- to ever start thinking you're out of the woods and safe and secure. "I'm not just talking about start-ups here. I mean companies of any size, at any stage of development. Because fundamental shifts occur in business, and they can be good or bad.
"Look, a business to me is like a living thing, and living things change. People change. Trees change. So do businesses. They may change because their customers develop different needs or because they start selling to another type of customer or because a new competitor enters the market. There could be dozens of reasons. But those changes occur, and you may not be aware of them at first. They are often hidden. If the changes are bad, and you're not on top of them quickly enough, they can destroy you.
"I had that in mind when I got Bobby and Helene to start tracking their numbers. I wasn't thinking only about their immediate survival. I wanted them to see from the beginning how a business changes, so they'd recognize the shifts that were bound to happen later on. But I had another purpose as well. After all, this business wasn't going to be a start-up forever. So we were also figuring out what it would take to get them to the end of the start-up stage.
"How do you know when you're no longer a start-up? Listen to me: critical mass. If your business is viable, and if it survives, it will eventually reach what I call critical mass, and when it does your whole situation will change. Because critical mass is a threshold, a very significant one. It usually depends on some key factor in your business hitting a certain level. The factor may be the size of your customer base. It may be the number of active accounts you have. There are probably 10 different types of critical mass. But however many variations there are, they all translate into the same thing for every business: break-even cash flow. I don't mean breakeven on a profit-and-loss basis. I'm talking about getting to where the cash you generate each month is enough to sustain the business and allow it to grow without your having to go outside for new investment.
"That is the major turning point for any new venture. Before critical mass, a business is a fledgling enterprise surviving on external capital. It still has its umbilical cord. After critical mass, the business is a freestanding, self-sustaining entity capable of making its own way in the world. It's your next goal after you determine viability. The challenge is to figure out where the goal line is.
"With Bobby and Helene, for example, we figured out that their critical mass has to do with their customer base -- specifically, the number of regular customers they have. We saw that, over time, customers tended to stick with them and reorder supplies almost automatically. Some customers might have to be nudged with a fax or a phone call, but that's about all it takes. So, once you have a broad enough customer base, you know you're going to get enough sales to break even.
"The question was, How big a customer base did they need to get there? Well, if you know that regular customers reorder at more or less regular intervals, you can translate the number of customers you have into a specific volume of sales. That is, you can predict how many sales you're going to get from this customer base over a given period of time -- say, the next year. Not that you'll get the same sales from this group month in, month out, but the good months will tend to offset the bad ones.
"So we could predict the sales, and we could also predict the cash flow those sales would create. Because we knew Bobby and Helene's gross margins; we knew their expenses; we knew how long it took them to collect their receivables and pay their bills; we knew their bad-debt ratio.
"Once you establish the correlation between cash flow, sales, and some other factor, you can determine critical mass very easily. You simply work backward. With Bobby and Helene, we knew the monthly cash flow they had to have, on average, to make their business self-sustaining, and we could translate that figure into average monthly sales. Then we just calculated the size of the customer base required to produce those sales. That's their critical mass. As soon as they reach it, they won't be depending on Helene's savings to bail them out anymore. They'll just have to maintain their customer base, assuming there's no fundamental shift in the business.
"Of course, critical mass is going to be different for different businesses. Take my storage company, CitiStorage, a very simple business. We store boxes for law firms, accounting firms, anyone who needs to save records for an extended period of time. With CitiStorage, I define breakeven a little more broadly. I want to generate as much cash flow as I need to pay all my bills and still have enough left over to keep improving the business -- build new storage areas, put up additional racking, and so on. In my case, the key factor turns out to be the number of boxes I have in my warehouse. When I hit a certain number of boxes, I'll know I have a real, ongoing business that can continue to grow without outside monies.
"Now, there's an important point about all this. I'm saying that, after critical mass, growing the business becomes a matter of choice. That is clearly a huge change from before -- a predictable one, and a good one, but a change that has major consequences. It opens up a whole world of possibilities that you couldn't even think about during the start-up phase. As long as you're surviving on external capital you really have to focus on building the business you started to build. You have to be very careful, for instance, about experimenting with new products or services, at least until you've expanded your basic business as far as it can go. You can't afford to experiment. You don't have the time or the money. It goes back to those rules I talked about, all of which stem from the fundamental fact that you're living on limited capital. You have to do everything you can to reach viability before your capital runs out.
"Take away that fact, and the whole picture changes. You're no longer playing with your savings or with bank loans or with capital from other investors. After critical mass, you're living off your own internally generated cash. You have profits to put in the bank. You may decide you want to invest some of them back in the business, and I think you should. It's important to explore new avenues, especially if you have a strong customer base. You might even take on some additional debt, which you can pay off out of profits. Yes, it's a little more risky, but you have the luxury to take more risks, to try some experiments, because you're playing with your own money. If you invest intelligently, you have the chance to help yourself and your customers and strengthen the business. And because you've reached critical mass, you can take the chance without putting the business in jeopardy.
"Not that you can get reckless. Unfortunately, many entrepreneurs do become reckless when they hit critical mass. Often they get there by some combination of luck and instinct, without ever understanding the dynamics of their business or coming to grips with the sales mentality. They make it anyway, and the sales mentality runs wild. A whole new set of emotions comes into play. The fear fades, and they feel excitement, elation, enthusiasm bordering on euphoria. They throw caution to the wind. They want to jump on every new opportunity that arises.
"And if your basic business is strong enough, you can get away with that for a while. Sooner or later, however, you're going to wind up in trouble unless you stick to the rules and stay on top of the numbers. Because the numbers help you balance your emotions. They keep success from going to your head. They remind you that, while your cash may be self-generated, it is not unlimited, and it can still run out.
"So you have to keep yourself from getting carried away. You have to learn how to avoid making emotional decisions. Listen, that's a very long process, but it's important. Because in business, you have to try to be objective, to be as clear as possible about what you're doing and why, and about what the likely consequences will be. You can use the tools of business to help you do that, to help you gain perspective. In the end, you may decide to go with your emotions anyway, but at least it's a choice.
"And that's pretty much where Bobby and Helene are today. They have a bunch of choices to make. How fast do they want to grow? How big do they want to get? Do they want to keep working at home? Do they want employees? It's up to them. I just hope that, by now, they have the tools they need to make those choices wisely."
* * *
Helene and Bobby Stone are sitting on a couch in the basement of their Long Island home, which doubles as the headquarters of Data-Link Associates. The basement has two sides and two separate offices, one for each of them. At the moment they're on Bobby's side, which is neat as a pin. There's a stereo nearby, and along the walls are shelves with cassettes and CDs individually labeled and arranged in alphabetical order. Both of the associates look relaxed and comfortable in their jogging suits. They should be. They ended last year with total sales of $482,000, up from $162,300 in 1992. Their gross margin on computer supplies held steady at 39%. They're in good shape.
"It's funny how things have changed," says Helene. "A few months ago Bobby asked me, 'What would we say if I was offered my old job back?' I said, 'Absolutely not.' I never want to be at anybody's mercy again. Why should we give our talents away? We're smart enough to take care of ourselves. Besides, I think we have more security now than we ever had before."
"Anytime you work for someone else, it's total insecurity," says Bobby. "It really is -- especially the way things are today. Look at all our friends who've been laid off. I said to her, 'That will never happen to me again.' And I felt very good about it."
"One thing Bobby always said, and he turned out to be right about it," says Helene. "He said, 'Security is not the job. It's the confidence you feel in yourself. . . . "
"Yeah, I said, 'There's no such thing as job security anymore. The only security is your own sense of self-worth and your knowledge about how to earn a living."
"Even when he was working for someone else, he said it," says Helene. "I always thought it was just one of his optimistic little sayings. But you know what? It turned out to be true."