Don't underestimate costs and overstate cash-flow.
As anyone who has sat down to do a cash-flow projection of any complexity knows, modelling the movement of money into and out of a business is not as easy as might at first appear. Who knows when you will get paid for your first orders? Who knows how quickly suppliers will strike with invoices?
And anyway, everyone knows sales projections for start-ups are just so much confetti in the wind. To be able to say anything about your cash-flow which actually holds water, you could feasibly argue that you simply need to have been trading for a while.
A tempting approach, but almost certainly the wrong one. This is the kind of thinking that leads many small businesses to go belly up for lack of liquidity, in spite of the fact that they might be perfectly profitable on paper. For cash really is king in the land of SMEs: the biggest single thing that distinguishes a business which is going to make it from one which isn't is the capacity of the entrepreneur to manage the cash cycle from day one. Even when extinction isn't the result, the consequences of poor cash-flow management are extremely unappealing (see Turn that down order, p112). Much of the activity of the business can end up being financed by overdraft. Too often, further rounds of debt are incurred to meet interest payments and before you know it, the entrepreneur has arrived at the dismal and depressing situation known as 'working for the bank manager'.
If not, the entrepreneur may choose to dilute his or her stake, a cause of huge regret, since ownership has been such a driving force to date. The gut reaction understandably is: 'Why should I sell a great lump of my company to someone simply because he has a wad of cash? He hasn't worked for it. He doesn't deserve it.' The knee-jerk reaction is understandable but may have to cede to the force of necessity.
Lean times can catch everybody by surprise and your business is no different especially if it is one of those vulnerable to lumpy cash-flows, construction or shipbuilding, for example. And at least equity is committed money, bringing a confluence of interests between you and the investor: neither makes money unless the business prospers.
The best advice is clearly not to under-estimate your costs and overstate your cash-flow when sitting down to concoct your business plan. If the tip comes too late for some or simply isn't workable from day one, perhaps the best solution is performance-linked equity. In this case, an entrepreneur may yield, say, 60% of the company in return for cash, but will retain the option to buy back 20% if the company is profitable and targets are met. Thus both parties are happy: the investor gets an exit route with high returns; the entrepreneur funds the no-man's land of start-up through a temporary loss of control, but regains it if and when targets are met.
After all, it's better to be a smaller part of something than a larger part of nothing.
Sarah Gracie is a senior writer at Venture Capital Report.