The Real Risk to Starting Up

Over the years, I’ve read more than a thousand business plans for business plan competitions, investment or client acquisition purposes. By habit, I scan the first few pages of an executive summary and then turn my attention to the financial projections. If I don’t see a strong gross profit margin story, I lose interest in the plan.

My reason is simple. Lower gross profit margin companies are riskier companies to manage than higher gross profit margin potential companies. This is true for any size business operating in any industry from Silicon Valley to Apalachicola, Florida.

If you work hard to improve your company’s gross profit margin performance, your business will be less likely to end up in bankruptcy court. You’ll have more operating flexibility to survive harsh recessions or the sudden loss of a big customer. And, perhaps best of all, companies with higher gross profit margins than their competitors tend to be bought out for nifty premiums. That’s success.

Calculating your company’s gross profit is really easy. Simply add up all your company’s revenues or sales received during a period of time (usually over a month, a quarter or a year) and then subtract the direct costs associated with producing the goods or services sold. This calculation does not include advertising costs, sales commissions, accounting, legal, etc. If you sell candles on Etsy, cost of goods sold includes the wax, wick, fragrance, packaging and labor to produce and ship the candle.

Total Revenues – Total Costs of Goods or Services Sold = Gross Profit

Next, let’s transform your company’s gross profit number into a percentage, which is called a gross profit margin. To calculate your company’s gross profit margin, divide your company’s gross profit by your company’s total sales.

Gross Profit / Total Sales = Gross Profit Margin Percentage

You can compare a company’s gross profit margin performance to other industry competitors on a month-to-month, quarter-to-quarter, or year-to-year basis. If for example you want to start a hip beverage business, look to The Coca Cola Company or Monster Beverage Corporation for margin guidance. Both companies consistently deliver gross margins over 50%. Coke is usually about 60%.

An upstart beverage company limping along with gross profit margins in the 20% range just won’t cut it for long in the beverage industry. Sure, the company might stay in business for some time, but it will struggle because it won’t have enough extra cash flow to fund marketing, new product innovations or other business needs. And, when a company’s projected gross profit margins are too far below industry competitors, investors are hard to find.

Here are three ways you can use gross profit margin analysis to super-charge your business startup or Plan B turnaround:

1. Know your industry. Whatever you want to sell, learn what success looks like within your industry. If your dream is to produce custom-built motorcycles, check out Harley Davidson. Its gross profit margins range between 34% and 36%. Aim to beat Harley Davison!  If you want to market a consumer or beauty product, do everything you can to get your company’s gross profit margins to 60% to 65%; higher if you are selling perfumes.

2. Change product development priorities. To the extent that you have a long list of products or services you would like to sell but are short on cash resources, favor the higher gross profit margin opportunities first. Set minimum gross profit margin targets to guide new product or service development too. And never ever sell any product or service with a negative gross profit margin. Your purpose is to make money in business, not lose it on every sale!

3. Specialize at something.  Every business should offer at least one item or service that can be sold at a premium price to boost overall gross profit margin performance. Ideally, this special item or area of expertise becomes what your business is “known for.”  The simple objective is to pick one thing and do it really, really well. Build buzz around the item or service too. A diner can market its specialty brownie Baked Alaska; a graphic designer can become known for corporate logo design; a hair salon can specialize in correcting hair color nightmares. The goal here is to market something exceptional that customers will talk about and value.

Don’t despair if your company’s gross profit margin performance today is below your local competitors or industry averages. But do take steps to improve this important metric every year you are in business. Rework your product or services until you do.

In one way or another, every significant business problem that challenges startup entrepreneurs involves C-A-S-H. Entrepreneurs who are fearless and passionate about earning, collecting and protecting their company’s cash are going to stay in business longer than entrepreneurs who don’t appreciate its almighty significance to sustainable business operations – that is until it’s too late.

Managing cash is not the job of a company’s controller or its CFO. I believe it is the leadership responsibility of the company’s CEO or founder. Afterall, businesses go out of business when they run out of cash.

Here are some cash survival tips:

1. Fund more than your startup costs. Perhaps one of the more serious judgment mistakes startup entrepreneurs make is they scrape together just enough funds to “start” their business, but don’t secure enough funds keep the doors open until the company is sustainable. The situation is similar to starting out on a three-week mountain hike with only two days of food and supplies. Entrepreneurs who beat the odds of business failure are practical and risk-adverse. They don’t start out until they have enough resources in hand to reach one or more key milestones of financial safety, such as cash flow breakeven.

2. Invest low. Buy low, sell high. It’s the American Way. Unfortunately, too many of America’s small businesses today are “underwater.”  No, this doesn’t mean their businesses are the victims of hurricane flooding, but another form of financial catastrophe. They invested more cash in their businesses than they are worth on the open market.

The more cash you invest in your business, the more your company has to perform in order to earn a positive financial return on your invested cash. Successful entrepreneurs know that it is easier to double, triple or quadruple the value of a $10,000 investment than a $100,000 investment in a startup company. They also understand the harsh reality that just because you may invest $100,000 in a business doesn’t mean that anyone else will ultimately buy the business for the same amount or more.

3. Resist spending. Owners of enduring businesses barter, haggle, and question all potential expenditures. To save cash, they work out of their homes; test workers as part-time 1099 consultants before committing to full time employment obligations; favor Zoom over travel; make do with used equipment; and avoid making long-term financial commitments to landlords until their businesses achieve several milestones of consistent revenue generation and profitability.  These penny-wise entrepreneurs also don’t sell products or services to customers who don’t pay their bills on time.

4. First customer focus. Successful startup entrepreneurs direct all of their attention to securing their first paying customer rather than their first 1,000 customers. In practice, this means that if you want to create a successful fashion label and company, your first step is designing and producing a first garment for a first paying customer. Then build from there.

5. Adapt quickly to first customer feedback. Businesses that persevere into their second and third year of operations test, tweak, and test again. They would rather learn what their target customers are willing to pay for before investing in a big product launch, rather than after. Too often, first-time entrepreneurs are just too stubborn about their first product or service idea. They spend more and more on marketing or a different sales approach just because they couldn’t accept that the customer is always right.

When you make managing cash a workday priority for oversight, you’ll be less likely to face an all-consuming cash crisis that can crater an otherwise promising company. Take the time to do this well. Project your company’s cash requirements on a month-to-month basis. It will empower you to speak up for your company in the sophisticated way investors and lenders expect.

Seeking capital to start or re-invent a business can be intimidating. Fortunately, there are no absolutes. This means that turning to lenders or investors for business funding is never always good or bad, risky or rewarding, stupid or smart. Different business situations call for different funding remedies. What are the basics for beginners?

Most communities have a bank branch or two around every Main Street corner, so it’s natural for business owners to turn to a bank for a first round of business funding. Banks are the right place to go if your business can repay a loan within a specific period of time with a high degree of certainty. The consistency of a company’s profitable cash flow is a major factor in lender approval decisions, so startup companies that haven’t yet finished product development or developed a stable customer base won’t get a cheery welcome at a traditional bank. The language of lenders is stability, predictability and accountability, not disruption, hyper-growth, or unicorns.

Sources of debt financing include banks, equipment finance companies, factoring, commercial mortgage companies, micro-lenders and credit card issuers. And yes, because of the diversity of lenders in the small business market today, it pays to shop around for the best debt funding deal possible especially if the loan is to fund routine operations, purchase equipment, or develop real estate.

A key advantage of most debt funding is that it doesn’t reduce the founder’s ownership stake in the business. Provided owners repay the loan on time, lenders won’t question a company’s business plan or leadership team when company goals aren’t met.

My biggest gotcha warning with any kind of small business lending arrangement, including small business credit cards, is the requirement for all owners and sometimes their spouses to personally guarantee a loan. If a business is unable to pay the obligation, then creditors may turn to the owner’s non-retirement personal assets for payment…and they do!

Debt may also not be an ideal funding solution for companies that don’t yet have consistent cash flow. (Note: Cash flow is very different than revenues from sales) Even though debt may be less expensive than equity in terms of cost of capital, any blip in customer payments can make it hard for owners to make loan payments on a timely basis. Late payments always cost extra. A change in economic conditions can also cause lenders to withdraw small business lines of credit without much notice. It’s at these moments that business owners have to scramble for equity capital, if they can get it.

The primary advantage of raising capital from investors is freedom from a strict repayment schedule. Businesses are given time to develop their customer relationships and can re-invest the cash flow in more marketing, talented staff, partnerships, acquisitions; basically anything that can build the long-term salable value of the business. Business owners are also not personally obligated to pay back investors for any losses.

The downside of seeking equity capital is it’s not a source of fast cash and will take longer to obtain than simply maxing out a credit card (not ever recommended for any purpose). But the offset to the perceived inconvenience of giving investors time to ask a lot of questions is, once invested, they will roll up their sleeves to help entrepreneurs work through unexpected problems.

Equity capital is generally not a good funding fit for business owners who want to make every strategic decision without any oversight from a board of directors or a direct investor. It’s also unworkable for most business owners who want to keep family members on the payroll or one day want to pass the business down to their children. Eventually investors do want to get their money back. And when they become “tired” or lose patience, they can push entrepreneurs to sell before the founder is ready to really cash-out.

Admittedly, there is a strong bias among equity investors to back innovative technology companies that have high revenue and gross profit margin potential. However, there is significant investment activity in lower tech companies that sell the kinds of things that people eat, wear, or enjoy every day. A respected consumer sector investor once told me that, “Successful investing is not rocket science. The best opportunities are always easy to understand.” I agree with this assessment. It’s the owner’s job to make their plans as uncomplicated and efficient as possible.

At some point, most businesses need some sort of extra funding. The more you know about the process of raising capital the easier it will be for you to target good-fit investment partners when your company needs it most.

Last weekend I received an urgent call from a former business colleague who is a board member of a large, privately-held company. She’s also head of the company’s audit committee, which carries certain obligations for conscientious financial oversight.

She started this way, “Tell me if I am crazy or not…”

“You’re not crazy; never have been. But someone is obviously trying to get you to second-guess yourself and apparently succeeding. Tell me about it.”

Her situation was a classic; probably all too common in boardrooms. A CEO was pushing certain influential board members for fast agreement without supplying nitty-gritty transaction details.

The CEO relied on “just trust me, it will be fine” assurance. A signature was required to go forward. My colleague wanted to know more.

Years ago, in a different business life, I studied the specific situations that lead to disastrous business decisions in promising, mostly tech startups. The businesses were well-funded but eventually struggled because of a whopper of a mistake.

Many of the business founders admitted they made a crucial decision in a matter of minutes. They felt “caught off guard” by someone pushing for a fast answer—an employee, vendor, customer, competitor, etc. They went along with a recommendation, signed on the dotted line or took on the big lease because they assumed the person “knew better” or had more expertise to make the right call. In other cases, the founders caved to a manipulative warning that they’d “never get the same opportunity again.”  

When I asked the founders to tell me more about how they felt at the time they agreed to something they later regretted, they often said they were “pressured,” “distracted,” or intensely “frustrated.”  They also said they felt compelled to “just do something” without much thought about what else could go wrong from the move.

The next time you feel pressured to give a fast answer to anyone, consider the following tactics to help you be a better boss of your future:

Change the timeline. Probably the only decision that really has to be made on the spot is when a family member is in a hospital emergency room and someone has to make a decision about surgery. Outside of a medical crisis, I’ve found that whenever someone is pushing me for a fast answer it’s usually for the other person’s convenience or commission.

The very best way to extend the timeline to make a decision is to simply say, “let me think on it.” It’s simple and straightforward. Here, I’m not talking about ducking responsibility in a fearful way, but buying more time to gather facts, read the fine print of a contract, explore competitive options or speak to trusted allies.  After you announce your decision to delay, stop talking. Don’t let an awkward silence unnerve you. Be friendly, but firm. You do have a lot of choices in managing your company, including the choice not to be pushed into something you don’t really want or need to do.

Decide before noon. When is the best time of the day to make important decisions? In the morning! As the workday progresses, your resistance to bad employee behavior, outlandish customer requests and pushy salespeople goes down. It is at these times when we are more likely to “just give in” to make a problem or person go away. Entrepreneurs who work long hours have to be highly disciplined to avoid making big decisions in the late afternoon or evening hours. It’s like gathering up the will power to say no to a brownie or scoop of ice cream late in the day. It’s too easy to give in.

Clear the room. “Present bias” is the term behavioral scientists use to describe a situation in which a person’s willpower or resistance is compromised by something or someone who is present at the time a decision is being made. Judges often leave a courtroom before making important decisions. You can too. Send all salespeople and staff members out of your office so they don’t have the opportunity to compromise your better judgment.

Walk away from anger. When people don’t get what they want, they can make disparaging comments, name call, yell, or threaten an attack on social media. What should you do when someone attacks you in a hurtful, unprofessional way? Leave the room. Nothing good can come from talking to someone who is unable to listen to your point of view. Here’s one more tip. Don’t agree to meet with the person until enough time has passed for reason to prevail. And when you do meet, consider inviting a third person to the meeting to temper more angry flare ups.

“Phone a friend.”  When you have to make one or more critical decisions on matters that are relatively new to you, solicit at least one business colleague or advisor for an independent perspective. Ideally, try to find someone with “been-there done-that” expertise. You should never be too proud to ask for help, especially when you need it most. 

Share leadership. The more you want to grow your business, the more you must let go of the notion that you are the only—or even the most important—decision maker in your company. You can’t always be there to tell employees what to do, but you can teach them how to make decisions that represent your leadership priorities.  It’s too hard for a founder to consistently make really good decisions if you are overwhelmed by having to make too many decisions every day.

Expect adversity.  All business leaders have really bad days. One day a hacker may shut down your website. Another day, one of your oldest customers may file bankruptcy before paying your company’s bill. When nasty surprises occur, just say to yourself, “Hello adversity, I’ve been expecting you.”

You can maintain psychological advantage when you accept problems and setbacks as a normal part of business flow. Saying “Why me?” isn’t helpful. Better decision-making comes from not allowing adversity to gain the upper hand of your emotions and confidence.

If you’re planning to start a business with a friend, you’re in good company. About half of all startups are organized among friends, spouses or siblings.

So why have I witnessed so many friendships fold before the business itself?  I think British author William Blake got it right when he said, “It is easier to forgive an enemy than to forgive a friend.”

Underlying every solid friendship are expectations of a higher level of loyalty and understanding than found in work relationships. Friends count on their business partners to be supportive when family obligations interfere with business deadlines. Friends also expect their business partners to defend their actions to co-workers, customers, investors, and vendors, even if all reason says otherwise. When our friends or spouses let us down, resentments simmer in profound and potentially debilitating ways.

Here are four recommendations to help friends transition to successful business partners:

1. Agree on time and financial commitments. The typical startup business will take a lot more time and money to become profitable than anyone ever expects. This isn’t necessarily a sign of poor planning, but a reflection of the routine adjustments that are made as entrepreneurs learn more about their customers and competition.

Nagging problems, however, arise when one partner can commit more time or rescue cash than the other partner. It is these commitment imbalances, especially in 50-50 partnerships, that tend to create the most emotionally draining dissention.  

Prior to securing a domain name or printing business cards, partners should gain an understanding of the limits of each partner’s contribution to startup success. Pressuring partners to commit more money than they are able will create undue stress on the friendship and the business.

Also, discuss how long each partner can go without a salary before having to look for outside employment. If one partner can commit more time and money than the other, simply agree to add to the lead partner’s ownership stake and decision-making authority. Lastly, develop a structure when each partner can really leave the office without interruption or guilt.

2. Discuss “what-if” scenarios. The best functioning partnerships always start out fully aligned about their strategies and spending priorities. It helps companies move forward in a productive way. Without agreement, the business is doomed to disagreements on big issues and small issues. Partners are best served when they talk through a number of different nasty “what-if” scenarios. Try this question as a good discussion icebreaker: “What if we run out of money?” 

3. Decide who is ultimately in charge. It’s easy for two pals to compromise on friendly disagreements when not too much is at stake. But in an operating business, partners have their time, hard cash, and professional egos on the line. It’s completely unrealistic to assume your easygoing buddy will always be agreeable and supportive. What areas present the greatest risk for disagreement?  Simply stated, it is debt and decision-making authority. Can a partner take on debt on behalf of the company? 

Can a partner agree to a customer discount without consulting the other partner?  And last but not least, who decides an issue when partners can’t agree?  My recommendation to entrepreneurs is to (a) develop a board of directors with at least one independent member or (b) find an experienced businessperson to help the partners work through the tricky issues of job descriptions, budget priorities, and the need for decision-making collaboration.

4. Draft forward-serving agreements. Today you want to work in a startup; tomorrow you may not. The reasons for a sudden career plan change are more likely to be influenced by family issues such as an illness, a new baby, a divorce, a spouse’s layoff, or sudden family relocation, than concerns about startup viability. When one partner wants to sell out, quit, or reduce involvement, what happens?  If one partner wants to invest more money in the business, what happens? 

The best time to negotiate these complex issues is before any money goes into the business checking account. Hire a lawyer to help you craft two must-have documents: a partnership agreement and a stock purchase and sale agreement. Don’t start up without them!