 (Seventh part of a series,
and of an upcoming book entitled Natural
Enterprise)
In a traditional start-up, your
advisor or accountant works with you to project your cash flow. To do
that they'll take your forecast revenues and expenses, and adjust them
for the normal collection period and payment period, and then add in
the up-front and ongoing capital costs (premises, equipment,
intellectual property etc.) They'll then tell you you need at least
three types of financing:
- Capital financing, secured by your capital assets and
repaid over the life of those assets,
- Working capital financing, secured by your receivables and
inventory, its balance rising and falling with those assets, and
- Seed capital, usually secured by personal assets, to cover the one-time
up-front costs of starting up, hiring staff etc. before operations begin.
Financing basically has two forms: debt, which carries a fixed interest
rate and is usually repaid according to a set schedule, and equity,
which may or may not pay dividends, and which carries with it the
rights and benefits of ownership, including a share of the after-tax
profits of the business. There are some hybrid forms of financing that
offer creditors the benefits of both debt and equity, especially in
high-risk situations.
Most financing for new and entrepreneurial businesses is extremely
expensive, requiring effective rates of return of 10-20% and even 30%
in some cases, and creditors often demand a say in how the company's
money is spent, and reserve the right to demand repayment of their
investment at any time. No surprise, then, that the relationship
between entrepreneurs and their lenders/investors is often adversarial and
anxiety-provoking.
These investors, the people with the money, don't particularly care
whether entrepreneurs want or need their money or not. They have
low-risk, low-return alternatives for their money, and they are able to
demand very high returns from businesses that want them to take a risk.
That's how they made their money. Bankers offer more reasonable rates
but simply won't accept any risk at all, and will routinely sink
businesses by cashing in loans or jacking up interest rates the first time the security or cash flow of
the business fails their very stringent tests.
Although it's popular to blame banks and investors for torpedoing and
gouging small businesses, and there are
some predatory practices out there, the root problem of entrepreneurial cash flow is more often the way
entrepreneurial businesses are launched in the first place. Borrowing
money or issuing equity before you start a business may allow you to
launch the business faster, and give you more room for error, but it's
an unnatural, costly and stressful way of establishing an enterprise.
Natural
Enterprise differs from traditional business (even traditional
entrepreneurial business) in two critical ways:
- Where the traditional business develops its product, mass
produces it, and then advertises to create demand for the product,
Natural Enterprises start by identifying unmet customer needs,
developing customized solutions, then delivering to the pre-qualified
customers, and marketing virally.
- Where the traditional business has a hierarchical
organization structure and common shares, with control of the business
often wielded by corporations or people other than those who run it,
Natural Enterprises are flat and unincorporated, controlled equally by
their members.
These differences have important implications for how the business is
financed. Let's take a look at the three types of financing that
traditional businesses use, and see how Natural Enterprises handle them.
Seed
Capital: This is the most difficult and expensive type of
capital to raise. It is used for purposes like set-up of premises and
tooling of equipment, development of prototypes, initial advertising,
promotion, legal and professional services, licenses and similar
start-up costs. Most of this money is spent before the company begins
receiving any cash from product sales. These costs are almost always
under-estimated, and actually represent start-up losses that many new businesses
never recover from. Financing
organically is the process of minimizing or even eliminating
these losses. This can be done by:
- Doing your own research and legwork thoroughly in advance
(rather than paying others to do it), meeting with potential customers,
prequalifying and taking advance orders (and if possible, deposits) for product before you start
up, so that you know what,
and how much, will sell and at what price -- no wasted out-of-pocket
expenditures need be incurred, no unsaleable product need be made, and
some customers may be persuaded to advance funds for first shipments of
products in return for a one-time price discount.
- Growing more slowly: Reinvesting the profits from one
month's sales to finance the operations of the next month, so that the
business literally 'pays for itself'.
- Allowing the enterprise's partners to choose their own mix
of up-front investment. Depending on how each partner values their
time, some partners will prefer to invest lots of time doing the
upfront research, while others who value their time more highly may
prefer to provide some seed capital to the enterprise in return for a
lower personal time investment.
- Drawing on the community: There are a lot of people in
every community who have money invested in low-return securities, who might be
persuaded to invest some of it in a local community-based business that
they know has been well-researched (and which they can personally help
to make successful) and which will also give them a higher return than
fixed-income securities. In some jurisdictions credit unions may offer
preferential terms to local enterprises. Some communities even have
financial co-ops, non-profit member-owned Natural Financial Enterprises that provide
short-term loans and financial advisory services to local enterprises.
- Viral
marketing: Letting your customers market your product for you,
instead of paying for expensive advertising.
- Budgeting carefully: In many cases you can save up-front
cash by doing things yourself, using professionals you know (sparingly)
as advisors instead of paid suppliers, deferring discretionary
expenditures, making do with smaller, fewer, or without, and still run
a professional-looking business. Women seem to be inherently better at
this than men, which is borne out by their superior survival rates as
entrepreneurs.
Capital
Financing:
Leasing instead of buying allows you to amortize the
costs and the cash
outflows over the same period as the revenues, so you need no
'long-term' capital
loans. Or, as with seed capital, an older, cash-rich partner may choose
to contribute capital
assets to the enterprise in exchange for investing less hours into it,
so the cost of capital to the enterprise is very low but the
ROI to the
investing partner is better than he or she can get in the bank.
Working
Capital Financing: Receivables can be sold or 'factored' to a
bank on a revolving short-term
basis, essentially converting these assets into cash that can be used
to pay current liabilities to suppliers. Inventories in most
entrepreneurial businesses are negligible,
since most such businesses make products to custom specifications and
on a
just-in-time basis -- the inventory is only bought or made when it has
already been sold, so the customer effectively finances it.
There are many other creative ways of funding the business when it
cannot be financed organically. With a cautious spending strategy,
and reinvestment of profits, most Natural Enterprises shouldn't need to
borrow often, or for long periods, or have to give up equity at all.
It's been said that many entrepreneurs fail because they don't 'pay
themselves first'. Many small businesses that are profitable on paper
are, in fact, losing money, because the entrepreneur doesn't pay
himself or herself a reasonable wage, or reinvests their salary back
into the business. When the entrepreneur can no longer afford that
luxury, the business quickly runs out of cash, the bank seizes and sells the
assets, and the entrepreneur's 'back wages' and reinvestment are lost
forever. This is an important cautionary lesson for entrepreneurs,
whether theirs is a Natural Enterprise or not.
Here's a story of two businesses in the same line of business, one that
made some classic start-up mistakes and failed quickly and
spectacularly, and another that succeeded primarily by using organic
financing and other Natural Enterprise techniques. The first business I
described in the chapter on Avoiding
the Landmines: A
client of mine bought the North American rights to a new technology
that would extrude a rugged, colour-fast plastic that could be used in
decking, fencing, and other outdoor applications. He spent a fortune
setting up the manufacturing plant. Problem is, he did this in the
1980s, when plastics were distrusted as 'cheap', wood was
cheap, and creosote in pressure-treated lumber was not yet known to be
a carcinogen. The big box building stores wouldn't give him the time of
day. Being 10-15 years ahead of the market cost him his life
savings.
Jump ahead 15 years. Another entrepreneur did his homework on the market and competition very thoroughly, recognized
the unmet need, and bought the North American rights to a very similar
product. He got the European distributor to set up and finance the
North American manufacturing plant for him, repaying them from his
royalties on sales. He spent virtually nothing on advertising, relying
on viral marketing from satisfied customers and installers, and an excellent rating of
the product in Consumer Reports.
Essentially all he did was attend Home Shows in convention centres to
show off samples of the product, hand out lists of local satisfied
customers, and take orders from qualified installers and box stores who
couldn't get the product fast enough. The market was ready, and he had
a multi-million dollar, very profitable business, which he and his
partners own 100% outright, with not a single
penny of debt, nor a single penny of his own money involved.
Know of other successful stories or creative financing methods that
have kept entrepreneurial businesses out of the clutches of absentee
shareholders, usurious lenders, predatory investors and bankruptcy
trustees? If so, please let me know, and I'll acknowledge them in my
book.
Like most of the lessons of Natural Enterprise,
this isn't rocket science. It's simply a combination of common sense,
drawing on the experience and know-how of others, learning quickly and
inexpensively from your mistakes, doing your homework, and being
constantly creative. Being in debt is the scourge of most consumers,
the cause of much grey hair and divorce and wage slavery, so it's not
surprising that it's also the cause of failure and stress and
unhappiness for many entrepreneurs. The best solution to debt is not to
get into it in the first place, and, if you have to borrow, do it with
no strings attached and repay it fast.
As Mom always said, "Don't spend money you don't have". It's an
essential lesson for entrepreneurs. It wouldn't be a bad thing if a lot
of troubled big companies and governments paid heed as well, instead of
relying on us taxpayers to pay for their financing folly.
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