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Ask SCORE: Three questions every small businessperson should ask themselves
Three questions every small businessperson should ask themselves
1st Question-Where can I get start up funding?
2nd Question-How can I make a profit regardless of conditions?
3rd Question-How can I plan an exist strategy?
By Richard N Walton
Asst District Director, SCORE, W Md.
Adjunct Faculty Member, Frostburg State University
I believe that good answers to these three questions will go a long way toward making your business startup successfully, operate profitably, and provide you with an income in later life to enable you to live comfortably in retirement. But you do need to ask yourself the three questions and act on the information that you get. Let's take them one by one.
1. Where can I get startup funding?
This is the first question most entrepreneurs ask when they seek counseling at SCORE (I have been a SCORE counselor for nearly 10 years). The assumption usually is that no matter what his or her past credit history has been, the new business idea is so good that it will overcome any negative information that may lie in one's credit report.
This is simply not true. Past credit history does matter, particularly where there is no present business history, as would be the case in a startup. Not only that, but current banking relationships matter as well. You cannot have a personal account that periodically has an overdraft and expect to qualify for a business bank loan. What's more, thinking of a bank as a funding source from the start for all your financial needs raises another issue, which is that the entrepreneur is expected to have some financial stake in the venture. Without it, the chances of getting someone else to fund it 100% are very slim. So what to do? Here are some guidelines.
1-A Prepare a business plan that tells your story in the most favorable light, without exaggerating any facts or figures. Most especially, even if on a minimum basis, sales that show customer acceptance of your product or service will go a long way toward making your case. Be sure to include information about your management team (no one likes to think of a credit worthy business as being run solely by one person). And include financial information, how much capital you are prepared to or already have invested in the venture.
1-B Make a thorough search of all potential sources of funding, whether equity or debt (stock or loans) and of course, grants. Sources could include family and friends, clients, suppliers, and of course, banks, finance companies, angel investors, government agencies, or even private companies. The key is to make a thorough search and to understand what the criteria are for obtaining financial assistance from each.
1-C Make a thorough review of your own personal credit history and fix up any errors that may appear on your report. Open a bank account for the venture, and make sure that it is operated properly. Get to know your banker and show him or her that you are enthusiastic and capable in your industry, and in the field of management generally, specifically entrepreneurship and entrepreneurial finance.
Then start working your list with energy and determination, while at the same time continuing to work on your business venture. Remember that a venture that is in the process of starting up is typically a much better bet than one that has not produced or sold anything.
The next question is:
2. How can I make a profit, regardless of economic conditions?
The answer to this question involves the use of several financial tools, each of which will be familiar to your banker and will show that you understand the mechanics of financial management.
The first tool is Breakeven Analysis, which shows how much sales volume is needed overall given the cost structure, to show a profit. That is top down analysis. But even more important is bottom up analysis in which every product or service that the company is going to provide can be shown as either a profit maker or a loss maker. The simple concept underlying Breakeven Analytics is this: Selling prices must be set so that the cost of producing the product or service (known in accounting speak as the variable cost) yields sufficient revenue (across all products) to meet the non production costs of business operation (known in accounting speak as fixed costs, or more generally, overhead costs). These calculations must be made before the business starts operations, and checked regularly to ensure accuracy in their computation. Any product that yields insufficient revenue to meet its variable costs and allocated fixed costs must be adjusted, either by increasing price or reducing cost. Using this tool both in startup mode and regularly thereafter (costs do change over time) will enable the manager to focus effort on products and services that yield the most revenue and profit to the business, regardless of economic conditions. If revenue declines, cost must decline in order to remain profitable.
A second tool, Ratio Analytics, will show not only total costs but how specific elements of cost affect profit. Ratio Analytics are based on the ratio each cost element bears to revenue. At a breakeven level, (when costs equal revenue), the ratio of costs to revenue is 100%, that is costs equal 100% of revenue. To make a profit, costs have to be less than revenue. This is much easier said then done, if you operate with Ratio Analytics. If you know how much each product should cost, then you know the ratio of costs to selling price for each product. Whether sales revenue is going up or down, managing the ratio of costs to revenue will ensure that in good times, cost ratios will not exceed those that have been previously set, and in bad times, cost ratios must be reduced as revenue reclines. Once again, using a financial tool such as Ratio Analytics will show how to operate profitably, no matter what the economics conditions are.
The third tool we will be using is Cash Flow Analytics. This is simply stating from available cash, deducting expenses as they are incurred (typically variable costs, such as production) or contracted for (typically fixed costs such as rent and utilities), and adding income as it is received. The Cash Flow Cycle can be projected into the future, which would include estimates of sales and costs, and the resulting flow of payments in and out of the firm. Cash Flow Analytics are based on assumptions of the behavior of costs as revenues over time, and must therefore be adjusted as the underlying assumptions are either confirmed or shown to be inaccurate. The critical nature of this tool is that it represents the company's health that is either being improved or being negatively impacted by its operating history. And it enables management to see trouble coming in advance of its arrival, thereby enabling the firm to take corrective action in time to prevent financial collapse. Once again, we have the ability through the use of these three tools, to operate profitably from the start, to make mid course corrections as needed, and to see how our financial structure will look in the future from the standpoint of liquidity, that is the ability to pay bills.
The third question is
3. How can I plan an exit strategy?
This question may seem way premature to the startup venture, but nevertheless it is crucial to consider it in the beginning, primarily because how the firm is structured will either make exit strategy (also known as harvesting) either easier or more complicated.
A very early decision might be whether there are family members who could be considered as candidates for taking over the business in the future. If so, a process by which the transition to a new ownership structure can be facilitated by such strategies as an earn out (by which the business earning are used to pay the former owner over time).
If no such opportunity exists, then a sale could be envisioned, under which either the firm (or perhaps all or a large part of its assets) could be sold. The usual way such a transaction would be valued is in terms of the earnings a new owner might anticipate receiving after the purchase, and whether these will be sufficient to provide a favorable return on his or her investment. If the new owner can earn $50,000 (net) per year, a 10% ROI would require an investment no larger than $500,000.
Businesses can be sold or liquidates, closed down, broken up, merged or acquired in a number of ways. Or they can go public, if the earnings are high and growing, and the business is in an attractive market with a solid market share. To the entrepreneur who now wishes to exit the firm, careful consideration should be kept in mind at all phases of the economic cycle. One of the best times to be selling is when you are making money, such as in good times, and one of the worst times to be selling a business, is in the bad times, when you are not making money. And yet, just as this type of thinking seems to prevail in the stock market, more people want to buy when prices are high, and sell when prices are low, precisely the opposite of what good management practice would dictate.
The exit strategy should be developed well in advance of its implementation, but a careful eye should be maintained for opportunities that may arise before the initially projected date. Excellent business conditions make for high enterprise values, and while you may not want to leave while the party is in full swing, that is exactly when you should leave, because the best deal are typically available under those conditions.
Always be sure as well to take legal and accounting advice for possible problems or tax implications of any sale or other planned exit.
Whether at the beginning, the middle, or the end of an entrepreneurial career, careful thought and planning can get you the funding and make it produce profits for you while you are in business, and set the stage for a comfortable and secure retirement in later years.
Mr. Walton teaches Entrepreneurship and Quality Management at Frostburg State University. He is also Assistant District Director for SCORE, Western Maryland, and the President of ERMACORP, a Hagerstown based Management Consulting Firm. He may be reached at 301-462-9850, or by email to Richard@ermacorp.com.
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