Entrepreneurs who start their own companies will hit a point when they need outside financing to continue their businesses. After years of working out of a garage, sleeping on a couch, and eating ramen noodles, an entrepreneur might be tempted to seek far more money than he or she needs to take a business to a new level. Accepting either too much or too little money can doom a business startup and limit its growth and development. A few simple guidelines can help an entrepreneur to do the best business growth planning and to determine how much money he or she should seek in an all-important seed financing round.
The entrepreneur’s first step should be to determine the business’s monthly “burn rate.” This is the amount of money the business needs every month to sustain its operations, including paying salaries, rent, equipment and raw material costs, and administrative expenses. Financing sources will be more impressed if salaries and expenses are held on the low side of industry standards because this will show that an entrepreneur is sensitive to managing and controlling costs and expenses.
The entrepreneur should then determine if that burn rate will stay the same or increase or decrease over a subsequent two-year period, and he or she should make adjustments for those changes. This will give the entrepreneur a picture of the necessary funding to sustain the company for twenty-four months, and that number should be the financing target.
An entrepreneur who accepts financing for anything less than this amount will quickly find himself or herself seeking additional financing too soon after closing an initial financing round. This will distract a startup business from developing and growing the substance of its business. Conversely, an entrepreneur who takes more than is needed for a two-year period risks giving away too much of the company at an early stage of its growth and development. This risk is best demonstrated by a hypothetical.
Assume that a startup company needs $10,000 per month, or $240,000 to sustain and grow its business over a two-year period (i.e. 24 months times $10,000 equals $240,000). It also determines that its business has a value of $960,000. This suggests that $240,000 would be enough to buy 25% of the business, which leads the entrepreneur to sell 25% of the business to investors in the financing and to retain the other 75%. Assume further that the investor likes the business so much that he offers to double the financing to $480,000 in exchange for a 50% ownership of the company. This gives the entrepreneur the $240,000 he needs to run the business, plus a spare $240,000 emergency fund in the bank.
Suppose that after two years, the company is then worth $20 million. At this point, the entrepreneur can sell 25% of the business for $5 million rather than $240,000. If the investor accepted more money than he needed from an investor before this growth, he will have given away all that extra potential value at a very low price instead of keeping it for himself to sell at a later time. That $240,000 emergency fund comes at a very high price.
Remember, running a business successfully does not need to be complicated. Keep it simple!
For more information on business analysis, business planning, and ways to grow your small business profitably, please check out our website www.portalcfo.com.
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Manny Skevofilax is a consultant and speaker that helps his clients successfully navigate the challenges of growing their businesses profitably. Since 2003, Manny helps businesses enhance their results by using his experience in strategic planning, financial statement analysis, operations, organizational development, and team-building. His consulting firm, PORTAL CFO Consulting, Inc., has attracted clients from diverse industries in the United States and abroad.
Manny can be reached at 410-808-3441 or via email at manny@portalcfo.com.