|(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:
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:
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:
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.