Last column, I introduced the second pillar of startup and broke it down into 5 key areas of understanding. Here’s a short refresher. The second pillar of startup is building the product or service. In order to reach its full potential, you must first understand your value prop, the competition, how you’ll differentiate, the technology necessary, and the minimum viable product. To catch up, read it here.
It’s Time that We Talk Startup Financials
Given that your business will not be making revenue in the first 3 to 12 months in operation, dependent upon the idea, it’s critical to understand where you’ll be getting the money to fulfill the initial obligations of starting a business. On top of that, you have to wrap your head around the economics of the business to determine if your idea can become a profitable business.
When reflecting on the financials of your startup, I encourage entrepreneurs to break it down into 4 key topics:
- Investment to start
- Economics of the business
- Financial management
- Exit strategy
Let’s dive in.
Investment to Start
Almost all startups will require an unknown sum of money to fund the beginning of operations and to build the product/service that you have imagined. For each business, the amount of capital needed will greatly depend on the type of product/service and the costs associated with the building.
For a consulting business where minimal development is necessary prior to launch, the investment to start and bring the product to market will be low. For most tech companies that require significant amounts of time to develop the product, initial capital required tends to be high.
Regardless, there are four ways that you can obtain the money:
You and your co-founder(s) invest the money needed to get the company off the ground
For one of the new companies that I’m starting, we determined that we needed $5,000 to get it running. To preserve our equity in the company, we each invested then used the amounts as a means to determine our equity stake in the company.
If you’re planning to self-invest, be sure to let your co-founder know before welcoming them to the team and extending equity in the company. You don’t want to get into a situation where co-founders are arguing about equity at the early stages of your startup. This can lead to animosity that impacts your ability to add value to the business each and every day.
2. Friends and Family
You and your co-founder(s) can attempt to raise money from your friends and family by extending them a very small portion of the company’s equity. If they believe in you and your idea, their early investment could be returned in multiples in the future.
3. Angel Investors
A third option to obtain your startup financials is identifying angel investors in your industry or network and attempting to raise money from them. Angel investors are high net worth individuals who decide to invest their money into other entrepreneurs with the hope of earning a return. Most of the time, these individuals have been entrepreneurs at some time in their life as well.
4. Venture Capital Firms
Your final and most difficult option is raising a round of investment from a venture capital firm. While vc’s will have the most money to invest, significant preparation is required and they will take the largest equity stake from your business in an effort to justify and protect their investment.
As with anything in a startup, there are pros and cons to each option.
The more financial risk you personally assume, the less equity you sacrifice and the greater personal reward you receive if the company succeeds. The less financial risk you take on, the more equity you give to another party, and the less you benefit in the long run.
Before deciding which is best for you, it’s important to read, research, and speak with others who have been through it in the past.
To date, I have not raised money from any outside investors as I have been lucky enough to pool the money needed together with my co-founders. Bootstrapping is a more gradual process to building your startup, but it ensures your control over the direction of the company and profits in the short and long term. I have interviewed many entrepreneurs and there is no right answer to the question of whether one should raise money or attempt to fund it themselves. Each situation is unique.
Self-reflect on the investment necessary to start your business and fund it until it begins earning revenue.
- What are the startup financials being used for?
- Do you know how much it costs to register with the government and state?
- Do you want a safe net for unexpected events?
Hint: Don’t forget to include your own salary if this is your sole source of income.
Economics of the Business
As an economics and math major, I have a stronger preference towards understanding the economics of the business before diving in. Regardless of your background, taking the time to consider various economic factors about your startup will allow you to better understand the startup financials of your product or service.
When I refer to economics of the startup, I am speaking about three distinct characteristics: the type of good that your product/service is, the unit economics of each sale you produce, and the long term potential of your idea.
Types of Goods
In economic terms, goods are separated into a number of distinct categories which each have their own characteristics. For a deeper understanding of each type of good, refer to a great resource for everything economics.
Depending on which category your type of product/service falls into will also greatly impact its supply and, more importantly, demand as the business grows.
For example, you may create a business whose product is a luxury good meaning that it has a higher ticket price and consumers will spend more time researching before they buy. In strong economic times, your product and startup will boom. However, if the market shifts downward, demand will also follow in suit significantly as well.
On the other hand, if your product/service is identified as a necessity good, you may actually see an uptick in harsh economic times. As can be seen in the link above, there are many types of goods that your produce/service may fall into. Understanding the impact of supply and demand within your given market will prepare you for outside economic factors.
- Self-reflect on the type of good that your product/service is.
- How will your product/service perform in good and bad economic times?
- Will it be able to survive or will you perish?
Unit economics is an understanding of every cost that goes into the production of your product/service. Understanding the unit economics of your startup is useful because it allows you to properly and precisely target your desired profit margins.
Let’s look at an example. I’m the owner of a manufacturing company that sells our products directly to the consumer. I know that in order to produce 1 unit of the product, it costs me $25.00. In that $25.00, I am paying for the raw materials, the labor, the quality assurance, and the shipment to my warehouse.
Once it is in my warehouse, I then have to pay a small fulfillment cost to have it picked, packed, and shipped to the customer. That costs me $2.00. My final cost is actually shipping the product to the customer which is $5.00.
In total, it costs me $32.00 to produce and ship my product to the end user. Knowing the almost exact cost of each unit produced allows me to set the correct retail price to target my desired profit margin.
Let’s say that I want a 50% profit margin. That means that in order to achieve 50% of the retail price, I must double my total cost to a price of $64.00. When I sell one unit of my product, I receive $32.00 in profit.
These are unit economics. When you understand them, you gain the intelligence to pinpoint areas of your production that can become more efficient to increase your profit margins.
- Self-reflect on the unit economics of your startup
- how much does it cost to product 1 unit of your product/service?
- what gross profit margins are you targeting on 1 sale?
- where can you decrease costs in your production to increase profit margins?
Hint: Industries tend to have similar profit margins due to the similarities of operations and the product/service that they are offering. After understanding your production costs, research the industry average for gross profit margins to determine where to price your product. If you are way off, it’s clear that your production costs need to be adjusted.
Long Term Potential
In economics, all theories eventually predict the outcome of a situation in the short term and the long term. When discussing a market where businesses are created and thrive, economic theory for competitive markets tends to reach a point where all profits are distributed evenly between the competition.
When studying the long term outcome of monopolies, we see a different result where 1 firm continues to own a majority stake of the market. Establishing a monopoly like business is extremely difficult to achieve as there is an endless amount of competition in most markets around the world.
When starting a new business, it’s important to understand where your firm may end up. If you are able to develop a monopoly in a given niche in the short term, there is potential for you to dominate that market in the long run as well. There will be many factors fighting against you, but anything is possible.
- Self-reflect on the long term potential of your startup.
- Are you entering an overcrowded market where you’ll constantly be fighting for profits?
- Could you focus your target market a notch deeper to reach the potential of a monopoly?
To Be Continued…
Given the longevity and importance of this section on startup financials, I’ll be cutting this column short. In the next column, I’ll get back into startup financials and explain the importance of financial management and an exit strategy.