Does your start-up need cash? One way to get it is to convince people who have it-- such as friends, family, angel investors, or venture capitalists-- to write you a check.
While some will do that because they like you or your idea, most investors won’t give up their cash unless you can convince them that you will return what they invested and much more in the not-too-distant future.
This leads to a little problem for your start-up. Given that you are burning through your savings fast and have no immediate prospects for getting a paying customer, how can you possibly convince an investor that you won’t burn through their cash if they give it to you?
You can’t convince them unless you do a good job of creating pro forma financial statements. At Babson College -- U.S News & World Report has ranked it No. 1 for entrepreneurship each year since 1996-- four teams of undergraduate students in my Foundations of Entrepreneurial Management course are trying to do that for their start-up projects.
In so doing, they are trying to answer four fundamental questions that investors ask before they will write a check.
1. What are the key assumptions of your business model? I have seen hundreds of business plans over the years and they always show the company losing money in the first one or two years and then going on a near-vertical growth spree that yields huge profits.
One way to screen out the more unrealistic of these is to ask questions about the sources of the key assumptions. Of those, one of the most important is how many people will buy your product, how much they will pay, and how frequently they’ll buy each year.
For that, you should not even begin to work on your spreadsheets until you have interviewed at least 100 people in your start-up’s target market. You ought to ask them to answer the question of whether they will buy your product with a score between 5= definitely and 1=never.
And when you prepare your list of key assumptions, you should assume that the people you interviewed are exaggerating. So you should discount the number who give you a 5 or 4 and assume that everyone else will not buy.
Based on this research, your key assumptions should show an investor how you estimated your potential sales. And if you are in a product business, key assumptions should also assume the level of inventory you’ll need and how that inventory will change as you make sales.
2. How much money will it cost to get this business started? If you have not started operations yet, you need to figure out how much capital you’ll need to get the assets your start-up needs to operate. If you are already operating, you will have to figure out which assets you need to add to get to the next level of growth the financing of which you are seeking from the investor.
If you are running a service business the start-up costs might include office rent, telecommunications, Internet access, utilities, computers, office furniture and supplies, employee salaries and benefits, marketing, insurance premiums and a 10% contingency in case things are worse than you originally thought.
For a product business you can add inventory to the list of things that you’ll need to get your business off the ground.
3. What are the sources and uses of cash to operate your business each week and month? Having a clear picture of the timing of cash coming in and going out of your business is essential. If you don’t have enough money to meet payroll every two weeks or to pay for your Internet access or your materials suppliers, your start-up could come to screeching halt.
So you should develop a forecast of weekly and monthly cash flows for your start-up. This will detail how much you will need to spend on items like salaries, office space, insurance, inventory, marketing, and all the other items. It will also make it clear when you expect payments to arrive from customers - if at all.
If you don’t expect paying customers in the first several months, investors need to know how their money will be spent each month.
4. When will the business break even? Unless you can convince investors that your start-up will sell its product or service at enough of a profit for them to get a return on their money, they will never write you a check.
The investor will get a return only if you can build the business to the scale where another company will buy it or its shares can be sold to public investors - a feat that requires your start-up to reach at least $100 million in sales and 30 percent annual growth.
But forecasts of such revenue levels are not persuasive early in a start-up’s development. But what you can do is help investors understand when your business will breakeven. One way to think about that is to calculate how many units of your product or service you will need to sell before your venture’s cumulative pre-tax operating profit equals its total start-up costs.
If those four spreadsheets can withstand the scrutiny of skeptical investors, your venture will be much closer to getting the capital it needs.