Permanent link for Planning for Cash Flow on June 2, 2023
Cash flow is another important financial metric that founders should understand when determining how much money their startup needs. It refers to the amount of cash that flows in and out of your business during a specific period, usually a month. Positive cash flow is how businesses pay their bills, so predicting your cash flow is crucial to ensuring that your business will be viable.
Cash flows are normally presented on a cash flow statement, and a good financial projections template will have one that automatically fills in for you from your projections of revenues and expenses.
To calculate your cash flow, you need to know the inflows and outflows of cash for a given period. Inflows of cash can include sales revenue, loans, or investments, while outflows of cash can include expenses like salaries, rent, and utilities.
You can calculate your cash flow for each planning period (typically a month, a quarter, or a year) using the following formula:
Net cash flow = sum of inflows of cash - sum of outflows of cash
For example, let's say that your startup received $50,000 in sales revenue and $20,000 in loans during the month, and your expenses, including salaries, rent, and utilities, totaled $60,000. Your cash flow for the month would be:
Cash flow = ($50,000 + $20,000) - $60,000 = $10,000
A positive cash flow means that you have more cash coming in than going out during the period. This is what you want; it makes it possible for you to pay the bills. On the other hand, a negative cash flow means that you have more cash going out than coming in, which will lead to using debt (e.g. credit cards) to pay bills and might ultimately have to file for chapter 11 bankruptcy in the business. When your cash flow prediction is negative, you should go back to your assumptions about pricing and what is needed to achieve desired sales. You'll need to find ways to either increase revenue or decrease costs.
Trovata offers a lot more detail on how to predict cash flow before starting your business, and why it's important.
Posted by Thomas Hopper on Permanent link for Planning for Cash Flow on June 2, 2023.
Permanent link for Estimating Operating Expenses on May 26, 2023
Operating expenses are the second of three major sources of financial expenses in your business. Operating expenses are the ongoing costs of running your business, regardless of whether any product is sold.
To estimate your operating expenses, start by making a list of the items and expenses you will need to run your business. Then, research the cost of each item and expense to arrive at an accurate estimate. Be sure to include any recurring expenses, such as monthly rent or utility bills.
Here are some common types and categories of operating expenses that you should consider when estimating your startup costs:
Rent: This includes the cost of leasing or renting office space or a storefront.
Utilities: This includes the cost of electricity, water, gas, and other utilities needed to operate your business.
Salaries and wages: This includes the cost of paying your employees, including payroll taxes and benefits.
Marketing and advertising: This includes the cost of promoting your business, including social media ads, print ads, sponsored content, and travel to trade shows or key customers.
Supplies and inventory: This includes the cost of purchasing materials and supplies needed to provide your products or services.
Insurance: This includes the cost of insuring your business against liability, property damage, and other risks.
Professional fees: This includes the cost of legal and accounting services.
When estimating your operating expenses, be sure to include all related costs, such as taxes, shipping fees, and other related expenses. It's also important to consider any seasonal fluctuations in your expenses, such as higher heating bills in the winter.
Once you have estimated your operating expenses, you can use this information to determine your cash flow needs and create a budget for your business. You should aim to have enough capital to cover at least six months of operating expenses, and ideally a year or more.
Posted by Thomas Hopper on Permanent link for Estimating Operating Expenses on May 26, 2023.
Permanent link for Estimating COGS on May 19, 2023
In planning for and tracking the cost of doing business, we often find that it's useful to divide the costs into two categories: fixed costs and variable costs.
Variable costs are the costs that increase with number of units sold. If sell twice as much, our variable costs roughly double. For example, if you were making a single iPhone, you would have to spend money for one screen and one battery pack. If you made two iPhones, you would need to spend twice as much to have two screens and two battery packs. Screens and battery packs are part of your variable costs.
A major component of variable costs is your costs of goods sold, or COGS.
Estimating COGS will help you understand your business' financial variability, guide you in pricing strategy, and provide a basis for establishing investor confidence.
COGS for Product-based Businesses
For product-based businesses, COGS are sometimes referred to as the production costs, and are expenses that are directly related to the production and distribution of your product. These costs can include raw materials, labor, shipping, and packaging. Understanding your production costs is crucial to determine how much money your startup needs to operate and become profitable.
Calculating actual COGS is pretty straight-forward:
COGS = Beginning Inventory + Purchases − Ending Inventory
For entrepreneurs looking to start a business, this takes a bit more work. To estimate your future production costs, you need to add up all the direct costs involved in producing your product. These can include:
Raw materials: the cost of materials that go into your product, such as components or ingredients.
Labor: the cost of the workforce involved in manufacturing or assembling your product. May sometimes include the portion of sales labor directly attributable to selling each unit of a product.
Shipping and handling: the cost of transporting your product to your customers or warehouses.
Packaging: the cost of materials used to package your product, such as boxes or bags.
Once you have calculated your production costs, you can use them to determine the price of your product and the minimum amount of revenue you need to generate to cover your costs.
For example, if your production costs for a unit of your product are $20, and you want to have a gross profit margin of 30%, you would need to price your product at:
Price = COGS / (1 - Profit margin)
Price = $20 / (1 - 0.30) = $28.57
This means that you would need to sell your product for $28.57 to cover your COGS and earn a 30% profit margin.
Knowing your production costs is essential because it can help you make informed decisions about pricing, product design, and manufacturing processes. By understanding your costs, you can optimize your production processes and pricing strategy to maximize profits and grow your startup.
COGS for service-based businesses
While the costs of goods sold (COGS) are typically associated with manufacturing businesses, service-based businesses also have costs that are directly related to providing their services. These costs can include wages, supplies, and overhead expenses, among others. Understanding your service-based COGS is crucial to determine how much money your startup needs to operate and become profitable.
To calculate your service-based COGS, you need to identify all the direct costs associated with providing your services. These can include:
Wages: the cost of paying your employees who provide the services.
Supplies: the cost of any materials or supplies used to provide the services, such as software or cleaning supplies.
Travel expenses: if your business requires travel to provide services, such as a consulting or delivery service, then you need to account for expenses like gas, car rentals, or airfare.
Overhead expenses: these are the costs of running your business that are not directly related to providing services, such as rent, utilities, and insurance.
As with production-based COGS, once you have identified your service-based COGS, you can use them to determine the price of your services and the minimum amount of revenue you need to generate to cover your costs.
Posted by Thomas Hopper on Permanent link for Estimating COGS on May 19, 2023.
Permanent link for Estimating Startup Costs on May 12, 2023
As a founder, determining your startup costs can be both a daunting task and critical to your success. Startup costs include all the expenses you will incur to get your business up and running, including fixed assets, operational expenses, marketing and advertising, legal and professional fees, and more. Accurately estimating your startup costs is essential to ensure that you have enough capital to launch your business and keep it running until it becomes profitable.
To determine your startup costs, you should start by making a comprehensive list of all the items and expenses you will need to launch your business. Here are some common categories of expenses you should consider:
Fixed assets: These are the physical assets you will need to operate your business, such as real estate, computers, furniture, equipment, and vehicles. The value of fixed assets should be depreciated over each item's useful life and, where applicable, that depreciated value deducted from your tax burden.
Operational expenses: These are the ongoing costs of running your business, such as rent, utilities, insurance, and salaries. These expenses are deducted as you incur them.
Marketing and advertising: These are the expenses associated with promoting your business, such as social media ads, print ads, and sponsored content. These expenses can be deducted in the year they are incurred.
Legal and professional fees: These are the expenses associated with setting up your business, such as legal fees, accounting fees, and consulting fees. These expenses can be deducted in the year they are incurred.
For each item above, estimate your cost, being sure to include all taxes, shipping costs, and other related expenses. If you are unsure about the cost of an item or expense, research it and make the best-educated guess that you can. It's not important to have perfect estimates, but to have estimates that you can plan around.
After you have estimated your startup costs, you can then determine how much initial financing you will need to launch your business. Additional financing may be needed to cover post-startup operation of your business, until you're earning more cash than you're spending.
SCORE offers a nice financial projections template to help you get started.
Posted by Thomas Hopper on Permanent link for Estimating Startup Costs on May 12, 2023.
Permanent link for Founders get this wrong on May 5, 2023
Starting a new business venture can be an exciting but challenging experience. Entrepreneurs are constantly looking for money to run their businesses, and most feel the pain of not having enough money.
I find myself frequently advising entrepreneurs to test their business ideas early and often—to fail fast—and one of the earliest and easiest ways to test a new idea is to prepare a plan with detailed financial projections. It's a cheap way to figure out what you need to start your business, and what you'll need to keep it running. In this and several following blog posts, we will explore how founders can determine how much money their startup needs to achieve success.
1. Conduct Market Research
The first step in determining how much money a startup needs is to conduct thorough market research, as we've explored in past blog posts. Understanding the market, competitors, and customer behavior will help you estimate the costs associated with acquiring customers, launching products or services, and running your business. Market research can also help you determine how much revenue you can expect to generate in the first year of operations.
2. Determine Startup Costs
Once you have conducted market research, you can start determining the costs associated with launching your business. These startup costs are what you will spend before you start selling and delivering your product or service. Startup costs can include expenses such as legal fees, permits, licenses, rent, equipment, supplies, inventory, and marketing expenses. They can also include capital expenses like real estate, manufacturing equipment, furniture, and computers.
3. Estimate Costs of Goods Sold
Costs of goods sold (COGS), sometimes known as production costs, are expenses that are directly related to the production or creation of your product. These costs can include raw materials, labor, shipping, and packaging, and will scale directly with your sales volume. When you sell twice as many items, your total COGS will be twice as much.
While the COGS are typically associated with manufacturing businesses, service-based businesses also have costs that are directly related to providing their services. These costs can include wages, supplies, and travel expenses directly associated with delivering a service.
4. Estimate Other Operating Costs
In addition to startup costs and COGS, you need to estimate the ongoing operating costs associated with running your business. Operating costs can include salaries, wages, benefits, rent, utilities, insurance, taxes, advertising and marketing, and maintenance costs. These costs will vary depending on the type of business you are starting and the location, and they do not typically scale with the amount of goods sold.
5. Calculate Cash Flow
Cash flow is the amount of money that flows in and out of your business each month. Understanding your cash flow is essential to determine how much money you need to have enough cash on hand to cover expenses and pay bills.
6. Determine Break-Even Point
The break-even point is the point at which your revenue covers your expenses. The break-even point will tell you how much revenue you need to generate to cover your costs.
7. Finish the Financial Plan
Once you have estimated your startup costs, operating costs, cash flow, and break-even point, you nearly have a complete financial plan for your startup. Add projected income (a.k.a. profit and loss) statements to calculate profit margins and balance sheets for the first year of operations, and you're done! A detailed financial plan can help you make informed decisions about how to allocate resources and manage cash flow.
So what do founders get wrong? Too often, when they make their ask for investment--whether from angels or VCs, or at a pitch competition, or just for a bank loan--they haven't done the work above to know how much they need and when they need to spend it. Haje Jan Kamps has some additional insights for you.
Posted by Thomas Hopper on Permanent link for Founders get this wrong on May 5, 2023.
Permanent link for Should you start that business? on April 28, 2023
Starting a new business is exciting, but unless you have unlimited time and resources, you need to evaluate your idea before taking the plunge. Here are three crucial steps when evaluating a new business idea.
The single most important consideration is the market. Will your target customers pay for your product or service, and is the market big enough to sustain your business and its competitors?
Conducting market research is a crucial step to identify whether there is a need for your product or service in the market. Understanding your target audience's needs, preferences, and analyzing competitors in the industry can help you identify gaps in the market. This information is essential to ensure that your product or service is unique and valuable to potential customers.
Evaluate Your Financial Resources
Before investing in a new business idea, it's crucial to evaluate your financial resources. Starting a new business requires financial resources, and you need to identify how much money you will need to start the business and how much revenue you can generate from it. Create a financial forecast that outlines your expenses and revenue projections. Identify potential sources of funding, such as loans, grants, or investors. It's crucial to be realistic about your financial resources and ensure that you have enough money to cover your expenses until the business becomes profitable.
Test Your Idea
Testing your idea before launching a new business can help you identify potential issues and refine your product or service. One effective way to test your idea is to create a minimum viable product (MVP). An MVP is a basic version of your product or service that you can test with potential customers. You can also test your idea by creating a landing page and driving traffic to it through social media or online advertising. The landing page should describe your product or service and collect customer feedback. This can help you identify potential issues with your idea and refine your offering before launching the business.
Entrepreneur Magazine takes a deeper dive on this, and offers some good advice for evaluating your readiness as an entrepreneur with Is Your Business Idea Worth Pursuing?
Taking the time to evaluate your idea thoroughly can save you time and money in the long run. So, take a step back, evaluate your idea, and make an informed decision before starting your new business.
Posted by Thomas Hopper on Permanent link for Should you start that business? on April 28, 2023.
Permanent link for Failure Breeds Success on April 21, 2023
Startup failures and pivots can lead to success. Innovation—like starting a company—is fundamentally a learning process, so sometimes we have to fail in order to get better at succeeding. In fact, research shows that learning is optimal when decisions are successful about 85% of the time and fail about 15% of the time. At least, for certain types of learning.
It might be just coincidence, then, or it might be a good sign that we're good at learning as a society, that according to the Small Business Administration around 20% of small businesses fail in the first year. Startup failures provide valuable lessons to entrepreneurs, helping them learn from their mistakes and increase their chances of success in their next venture. In some cases, a startup failure can lead to a pivot that results in a more successful business model. Instagram, for example, started as a check-in app called Burbn but became one of the most popular photo-sharing social media platforms after pivoting. Similarly, Slack started as an internal tool for video game developer Tiny Speck. The company eventually pivoted to focus on Slack and rebranded as Slack Technologies.
Entrepreneurs who embrace failure as a learning opportunity, learn from their mistakes, and pivot when necessary can increase their chances of building a successful business. Some venture capitalists recognize the value of failure so strongly that they incorporate it into their investment strategy.
While failure is hard to accept, sometimes it's better than succeeding. Embrace your failures and just learn from them.
Posted by Thomas Hopper on Permanent link for Failure Breeds Success on April 21, 2023.
Permanent link for Product Cost Modeling, Target Markets, and Pricing on April 14, 2023
Entrepreneurs and intrepreneurs developing new products are inevitably asked "how much does it cost?"
To answer this, we need to distinguish between price—how much the customer pays—and cost—how much it costs you to put it in the customer's hands. We also need to distinguish between how much it costs right now and how much it will cost at volume.
If you're talking to potential customers, who are interested in buying, they really mean "what's the price, right now?" You'll need an answer for them, because you want them to buy. You need that market validation. So what's the right price? Ideally, it's a premium price point, but early price points should have no relation to actual costs. You're testing the market; not your operational efficiency.
If you're talking to potential investors or internal stakeholders, they usually want to know about the cost at volume. Volume is a bit tricky. You cannot possibly obtain an accurate cost estimate to produce a product design that doesn't exist yet in volumes you can only guess at, and at a manufacturing site that you haven't selected. But that's o.k.! You don't need to know the exact costs of every component; you only need to know which components of production drive the bulk of your cost, and roughly what those components cost at volume. What we're really looking for is just a fair estimate, at the highest volume that makes sense. If you're developing the next whiz-bang smartphone, where the total market is running around 1.5 billion units per year, you don't want to estimate volumes of 10 billion units per year. But around a hundred million a year could be the basis of a perfectly reasonable volume cost estimate.
Let's try an example of part of your operation. Suppose you're manufacturing your next-gen smartphone in China and shipping to the U.S. west coast once a month. Your product is small and you can fit 500 units to a pallet. Shipping rates for that pallet will probably run you around $1,000 (mid-2022 prices), or $2 per phone. When sales grow enough to utilize an entire 40-foot shipping container, you'll spend $10,000 but ship 20 pallets, or 10,000 units, lowering the cost per phone to $1. If you could reach volumes of around 120 million phones per month, you can buy the capacity of an entire container ship, which a google search or a phone call to a major shipper tells you will cost around $100,000 per day. With shipping times of around two weeks, you'd spend about $1.4 million per month to ship those parts, but the cost per part would be just 1 penny. When an investor or stakeholder asks you "how much will it cost," your answer should not be "$1,000 for a pallet of 500 phones;" your answer should be "we estimate 1 cent per phone at volume."
If your investors instead want to know how much it costs today, you'll of course tell them that at today's very low volumes, shipping costs about $2 each to port; just $500 per month.
One startup manufacturer I'm familiar with had a product where the bulk of the cost came from labor and certain metals in the product. That manufacturer's answer to "how much does it cost" assumed production would (someday) be someplace where labor was cheap and that volumes would be sufficient to buy an entire mine's-worth of metal production—this resulted in the lowest potential costs. In the present day, their actual costs were many times higher, with production in the United States where it was easier to manager during scale-up and with lower volume metals purchases.
This cost-volume relationship holds for just about every product or service that a business provides. The more you do, the more your costs are dominated by variable costs rather than fixed costs, and cheaper the variable costs get per unit.
For this reason, early-stage startups should (almost*) never be trying to sell into cost-conscious mass markets. You should be looking for the high-value customer segments, those who are willing to pay a premium price for a premium product or service. As your volumes increase, you can work on reducing costs and then reducing price while holding your margins (or letting margins slip while raking in large revenues, the way oil companies do). We'll cover this more in a future blog post.
* almost never: there are some great market opportunities in cost-conscious markets, where customers are under-served or not served and cannot afford current offerings. Startups can offer a lower-margin substitute with fewer features at lower prices, staving off competition from established companies while gaining market share. Examples include the early personal computer market, transistor radios, and shared mobility (e.g. Uber). Harvard Business Review offers some additional insight.
Posted by Thomas Hopper on Permanent link for Product Cost Modeling, Target Markets, and Pricing on April 14, 2023.
Permanent link for How to grow sales on April 7, 2023
Entrepreneurs often start out strong with a few hard-won sales, but rather than seeing the growth they expect, their sales often stall.
What strategies will work to grow sales? You have to understand your product and your markets, and improve your customer acquisition channels. You want channels that
- offer a high ROI,
- fit within your resource constraints,
- are already connected to your target customers,
- are suitable for the types of relationships you want to build (in particular: your customer's average customer lifetime value), and
- are scalable.
Kevin Indig compares some of the possible channels and identifies which work and which don't. His channels are:
- Affiliate Marketing
- Content Marketing
- Organic Social
- Product Virality
- Referral Traffic
- Word of Mouth
He argues that only ads, product virality, sales, and SEO are scalable. His article is thought-provoking and worth your time.
Posted by Thomas Hopper on Permanent link for How to grow sales on April 7, 2023.
Permanent link for A Model for Improving Your Business on March 31, 2023
Many businesses think of their biggest competitive advantage as being the "secret sauce" in their product or service. Established businesses often focus on their "core strengths," which invariably revolve around their main capital investments and maintaining a healthy ROA. In practice, though, a company's real competitive advantage is their ability to consistently adapt and improve how they do business.
Startups, as temporary organizations dedicated to the search for a repeatable and sustainable business model, do this constant improvement almost instinctively; there is no "right" way to do things, so entrepreneurs are always looking for some way to do things. One of the key steps in transitioning from startup mode to normal business mode is setting up the organization to continue to learn, adapt, and improve.
This is accomplished in four steps:
- Set up processes and tools that everyone can follow, then
- Make sure people follows the processes,
- Compare the results to what was expected and understand the causes for any deviation from expectations, and
- Finally, update the processes and tools.
Repeat this constantly, everywhere and at every level of the organization. Do whatever it takes to speed up this cycle of improvement. Most importantly, empower employees to perform this within their areas of responsibility by providing a process and tools to implement this change. The result will be better-quality products and services, at higher revenue, and at lower cost.
The simplest model to implement continuous improvement is the Plan, Do, Study, Act (PDSA) cycle developed by quality guru W. Edwards Deming.
Plan: Plan a test or a change that is intended to improve your business.
Do: Follow the plan
Study: Study the results, asking "what went right?" and "what went wrong?" Identify any discrepancies from expectations and understand why they happened.
Act: Act on what was learned in the previous steps, updating your understanding or adopting the change, and initiating the next planning phase.
While the main advantage to this process lies in institutionalizing the learning and improvement process that is naturally performed on an ad hoc basis in startups, business selling to other businesses will find an additional benefit. Many businesses require their vendors to be registered to the ISO-9001 quality management system standard, or one of the related industry-specific standards such as QS-9000, TL-9000, or AS-9100. Each of these standards requires companies to have processes in place for continuous improvement, and PDSA lays a solid groundwork for such processes.
Posted by Thomas Hopper on Permanent link for A Model for Improving Your Business on March 31, 2023.