Table of Contents
Financing Your Startup
Different ways through which you can finance your business:
- Bootstrapping: personal savings
- CrowdFunding: the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.
- Friends and family
- Incubators and accelerators
- Angel investors: simple to understand investors since these guys are wealthy individuals who like to to invest their personal funds in startups. It’s usually a more informal setup with these investors as they will likely make choices based on instinct and interest rather than analytics. This can be a great option for startups who may have a tough time getting any traction from other types of investors.
- Venture Capital (just mention a couple of venture capitals in egypt like V-lab ): this type of situation is different than an angel in that it is an organization of investors. Usually, this type of investor isn’t as interested in the early stages of a startup and prefers to see some return before they get involved. They like to make deals where they know they will get a return, so they can be turned off by too much risk. However, they are more likely to invest a larger sum of money, but typically require ownership and to be placed in a decision-making position.
- IPO: One of the most important financial documents that you will need as an entrepreneur is an Income statement. Basically, income statements are documents that state how much income, or losses, you made.
So basically, to calculate your income you simply subtract your revenues from your expenses.
Step 1: Assume Sales Unit
- Determine the quantity you will assume to sell for one month, try to be realistic in your assumptions
- Set the price per unit for each month,and try to estimate based on market research
- To get revenues, multiply sales unit* price
Calculate your total revenues. Revenue is the money you collect without subtracting the costs
Step 2: Calculate the cost of goods sold. These are called variable costs, meaning that the value of the costs will vary according to your level of production such as labor wages and raw materials.
Step 3: Subtract the cost of goods sold from the revenue
The number you get is called the Gross Profit. You can transform the gross profit into a percentage of your revenues by dividing it by the revenues and multiplying that by 100.
So if your revenues are equal to 100, and your cost of goods sold = 50, your gross profit=50. The gross profit margin, or the percentage, would be 50/100*100 = 50%.
Step 4: Calculate your operating expenses. These are also called Fixed costs because their values are fixed regardless of your level of production. Such costs include marketing, research and development, and rent . administrative
Step 5: Subtract your fixed costs from your Gross Profit. The number you get is your net profit./income
Now that you know the components of an income statement, you need to be able to estimate your financials for future periods of time.
How to overcome overstating profit?
- Do not understate cost; take into account all costs, even indirect ones like office rent and supplies
- Put realistic forecast for sales
- Account for Depreciation Expense
- Deduct organizational costs/initial investment
- Do not forget to deduct taxes
- Start with expenses, not revenues. When you’re in the startup stage, it’s much easier to forecast expenses than revenues. So start with estimates for the most common categories of expenses as follows:
- Utility bills
- Phone bills/communication costs
- Legal/insurance/licensing fees
- Advertising & marketing
- Cost of Goods Sold
- Materials and supplies
- Direct Labor Costs
- Customer service
- Direct sales
- Direct marketing
Here are some rules of thumb you should follow when forecasting expenses:
- Double your estimates for advertising and marketing costs since they always escalate beyond expectations.
- Triple your estimates for legal, insurance and licensing fees since they’re very hard to predict without experience and almost always exceed expectations.
- Keep track of direct sales and customer service time as a direct labor expense even if you’re doing these activities yourself during the startup stage because you’ll want to forecast this expense when you have more clients.
- Forecast revenues using both a conservative case and an aggressive case.
If you’re like most entrepreneurs, you’ll constantly fluctuate between conservative reality and an aggressive dream state which keeps you motivated and helps you inspire others. I call this dream state “audacious optimism.”
Rather than ignoring the audacious optimism and creating forecasts based purely on conservative thinking, I recommend that you embrace your dreams and build at least one set of projections with aggressive assumptions. You won’t become big unless you think big! By building two sets of revenue projections (one aggressive, one conservative), you’ll force yourself to make conservative assumptions and then relax some of these assumptions for your aggressive case.
For example, your conservative revenue projections might have the following assumptions:
- low price point
- two marketing channels
- no sales staff
- one new product or service introduced each year for the first three years
Your aggressive case might have the following assumptions
- low price point for base product, higher price for premium product
- three to four marketing channels managed by you and a marketing manager (Read my column on paying employees during the startup stage to learn how you can afford a marketing manager.)
- two salespeople paid on commission
- one new product or service introduced in the first year, five more products or services introduced for each segment of the market in years two and three
By unleashing the power of thinking big and creating a set of ambitious forecasts, you’re more likely to generate the breakthrough ideas that will grow your business.
- Check the key ratios to make sure your projections are sound. After making aggressive revenue forecasts, it’s easy to forget about expenses. Many entrepreneurs will optimistically focus on reaching revenue goals and assume the expenses can be adjusted to accommodate reality if revenue doesn’t materialize. The power of positive thinking might help you grow sales, but it’s not enough to pay your bills!
The best way to reconcile revenue and expense projections is by a series of reality checks for key ratios. Here are a few ratios that should help guide your thinking:
Gross margin. What’s the ratio of total direct costs to total revenue during a given quarter or given year? This is one of the areas in which aggressive assumptions typically become too unrealistic. Beware of assumptions that make your gross margin increase from 10 to 50 percent. If customer service and direct sales expenses are high now, they’ll likely be high in the future.
Operating profit margin. What’s the ratio of total operating costs–direct costs and overhead, excluding financing costs–to total revenue during a given quarter or given year? You should expect positive movement with this ratio. As revenues grow, overhead costs should represent a small proportion of total costs and your operating profit margin should improve. The mistake that many entrepreneurs make is they forecast this break-even point too early and assume they won’t need much financing to reach this point.
The main sources for the assumptions used in the cash flow forecasts for a start-up will be:
Entrepreneur experience – there is no substitute for experience of running a small business. Some of the assumptions will be based on “gut feel” and instinct. A cash flow forecast produced by an inexperienced entrepreneur has to rely much more heavily on other sources.
Market research into key aspects of sales and costs – e.g. seasonal fluctuations in demand, average selling prices and quantities in the market, typical gross profit margins, the lead-time between marketing campaigns and orders etc
Suppliers – a great source of information on costs and also the timing of payments. What are the industry norms for paying suppliers in the market?
Advisers – it makes sense for start-ups to get help from advisers when putting the cash flow forecast together. The advisers might be from Business Link or other government-funded agency. It could also be the local bank manager or accountant – whose help is particularly useful when it comes to making sure the forecasts are complete & mathematically sound.
Businesses can either be financed by equity or debt.
Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders’ percentage of ownership decreases.
There is no promise to repay the investment like in a loan arrangement, nor is there an interest component.
There is, however, a cost to equity capital. In order for investors to agree to invest in the company, they expect to earn an acceptable return that justifies the risk of the investment. That return varies over time and across industries as investors compare the potential upside, the potential risks, and the risk-reward profile of investment opportunities other than the given company. If the company fails to meet these return expectations, investors can share their ownership interest and move capital elsewhere, reducing the value of the company and hampering future efforts to raise capital.
Equity investors are owners of the company, which means they have significant upside should the company prosper in the future. The cost to their capital is a floor, not a ceiling. That higher upside is required to reward investors for the increased risk of equity financing, which excludes collateral and pays equity owners last in a bankruptcy situation.
Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates.
Lenders have no claim to a company’s profits outside of the original financing agreement. The upside for lenders is capped from the onset of the transaction at the interest rate, but their downside is also mitigated through loan covenants, collateral requirements, and a senior position to be repaid should the company face bankruptcy.