10 Joys Of Small Business Ownership

Don’t fret about those woes! For on a daily basis…

  1. You are building something greater than the sum of its parts.
  2. You set the mission, vision and values.
  3. You define the right people, right roles, and right rules.
  4. You will push constantly to explore and learn to think outside your comfort zone.
  5. You will often fall, but consistently stand up stronger… usually.
  6. You will grow leaps and bounds professionally and personally.
  7. You will come to understand the wisdom of those you admire, and fear.
  8. You are pursuing your dreams and will pity those that lack the courage to pursue theirs.
  9. You have no limit to your possible successes.
  10. You are the driver of your destiny.

I’d also like to emphasise that none of these items are directly focusued on the immense financial wealth of which we all hope. Over time wealth may or may not come, but the common factor amongst all great entrepreneurs is the primary importance of personal satisfaction regardless of monetary riches. At times–and during all stages of business–progress can require a certain amount of financial masochism and sacrifice, yes, but always should you be proud of what you’ve done, where you’re headed, and excited for the treasures of the next day.

Offering Developers Startup Equity, A Dialog

I have this conversation about once a month, generally by a well-intentioned dreamer new to the software space who doesn’t understand why I¬†can’t accept projects for equity. I may be exaggerating slightly, but it sure feels this way… ¬†ūüôā

Preston: Hi Bill, nice to meet you. How can we help you develop your online venture?

Bill: I have a unique web startup opportunity worth $4B and am accepting HTML experts to implement it.

Preston: [immediately suspicious of the phrase “HTML expert”] Ok, you have my attention. What’s the business plan?

Bill: It’s essentially a combination of eBay, Facebook…

Preston: [senses where this is going]

Bill: …Slashdot and TheSuperficial.

Preston: It’s a news and auction site for celebrity social networks?

Bill: No no no, it’s more like Google meets MySpace.

Preston: Like.. Orkut?

Bill: Kinda, but simpler.

Preston: [completely confused] Back to the business plan part for a minute. Could you tell me about the nature of the business? Is this an ad-based site?

Bill: No.

Preston: Ahh, ok. Some sort of subscription thing then like Salon or TheOnion?

Bill: No way. Users hate paying for stuff. It’ll affect our bottom line. We’re going to keep it free for everybody. And green. We should probably add a database of sites using ecological products. And videos, of course.

Preston: [now confident of where this is going] Let me restate the question. Where did that $4B figure come from?

Bill: YouTube was bought out for $18B. Google will be all over this after we capture 10% market share.

Preston: [completely ignores the issues with those two sentences] I see. To be completely honest, I should share a couple general thoughts. [brings up telephone script #4 from personal wiki] We haven’t talked about budgets at all, but I assume this is an equity-share idea, and I’m really honored you thought of us. There are a lot of great people out there, and I’m happy and thankful to have stood out. Unfortunately, we’re not accepting equity-based projects at this time for two primary reasons. First–and again all in frank honesty–we have the technical, business and other resources to implement these things on our own without external partners. We have a lot of great ideas, and it makes the most sense for us to pursue them internally. Secondly, it’s our goal to treat employees the way we all want to be treated: with respect, recognition and great benefits. That comes with cash flow requirements we just can’t meet with equity-heavy relationships.¬†I’m going to email you some contact information for other resources you may want to follow up with directly, and I think you’ll find that reputable software engineering shops will share these two sentiments in common as a matter of prudence. We look forward to working with you in the future, however, and we’ll keep in touch periodically to check up on you!

[exchange of pleasantries]

The Three Types of Start-Ups

At OpenRain Elite Web Software we’ve seen all the popular combinations of startup business models when evaluating new projects. Here is a breakdown of the three most common startup models based on financial structure, the pros and cons of each, and recommendations on which one to choose for your new venture.

 

1) The Pop-Start

The pop-start–short for “popular startup”–is the stereotypical venture capital (VC) or Angel backed venture wherein an initial product prototype is created with a small angel fund, pitched to investors once (barely) operational, and subsequently funded for $1M+ in a second, third etc. round to fund growth to a profitable status. As each round is collected, additional personnel are generally hired immediately to kick off additional production development in a (hopefully correct) high-velocity direction.

Pros

  • Should you raise enough in your initial rounds and find the right people, you’ll be able to keep the company operational in the early growth stages without incessant worry on keeping positive cash flow, which, depending on the idea, may not be possible.
  • Fast growth once the big investment dollars roll in.
  • A minimum of personal risk since only the initial angel round will likely come from close ties.¬†

Cons

  • Tons of investor pitches and marketing/sales-speak on vaporware which will drive technical people insane.
  • Legal issues from the get-go. Expect difficult negotiations with second round investors and costly legal fees.
  • You’ll have to put up cash for airfare, lodging, marketing materials, legal fees etc. up front for possibly dozens of remote meetings. The costs add up fast.
  • Large amounts of constant pressure from investors.

This is for you if…

  • Your idea requires a substantial capital investment to get off the ground, such as $100K in federal licensing costs or $500K in manufacturing equipment for a first line of production product.¬†You legitimately need this funding to get off the ground, and the amount is too large to put up yourself.
  • Your exit strategy is getting bought out by Google for $100B.
  • You can afford the risk of working on this full time, with little (or no) compensation up front and no gaurantees on a second round of funding.

 

2) The Weekend Warrior

The proliferation of online services for company creation has allowed many dreamers to create legitimate legal business shells in free time for hundreds of dollars. The weekend warrior start-ups are those who believe in the idea, but cannot financially afford to quit day jobs.

Pros

  • Low risk. If the company fails, you still have your day job.
  • Low cost. You still have the income from your day job, so eating small operational costs should be easy. If you’re supporting a large family on a single income, this may be your best option.

Cons

  • Making progress is painfully slow since it’s an “in my spare time” project.
  • People will not take your business as seriously since you are not committing your livelihood to it.
  • The logistics of getting things done off-hours can be challenging, such as finding the time for calls during business hours without interfering with your day job. ¬†

This is for you if…

  • You can only commit yourself to working nights and weekends.
  • You cannot accept large financial risk.
  • You do not require large capital investments to reach financially sustainable operation.
  • You can accept the fact that progress and growth will be slow.

 

3) The Self Serve

Self Serve businesses are full-time owner operated organizations which grow based on their own performance, rather than external investment. They are self-funded, full-time ventures which put the responsibility of success squarely on the owner(s) since there is often no formal governing board. OpenRain’s web development business started this way, and continues to be entirely self funded.

Pros

  • No pressure from investors.
  • Full-time personal investment gives you time to put operations in order.
  • Will be taken seriously by potential clients/customers.

Cons

  • Self-funded. This can be mitigated by limiting personal credit exposure, but there’s no getting around the fact that initial operating costs will need to come out-of-pocket, and losses may personally bite you regardless of the precautions you take.
  • Personal pressure to constantly generate income since your personal income will be determined by the performance of the company.

This is for you if…

  • External funding is not appropriate or necessary for your idea.
  • You (and you business partners) are comfortable operating the entirety of a business amongst yourselves, our are able to invest in quality people to fill in the holes as soon as possible. Technical work, finances, marketing, sales, human resources, operations and 8000 other miscellaneous tasks will crop up needing¬†someone’s¬†attention. And that someone is you.

Financial Primer For Self-Funded Startups, Part 1

You’ve considered starting your own business–ExampleTech–and have pondered the initial investment, opportunity costs and personal risks.¬†Here’s a brief financial primer on what you need to understand before taking the big leap, and key issues you’ll need to grok for¬†after ExampleTech begins operations.

My big leap is OpenRain, for which I manage financial planning and performance amongst a bagillion other things, so I frequently receive questions on the financial aspects of forming and operating a company. This failure-based example assumes ExampleTech uses accrual accounting as opposed to cash-basis accounting.

Understanding Your Initial Investment 

When you start the company books, the first type of financial statement you’ll need to understand is the balance sheet. The balance sheet is a snapshot of the company’s finances at a particular moment in time, and aggregates all the company accounts into one single formula which always remains true..

Assets = Liabilities + Equity 

Once you¬†invest in the company, that money becomes a company asset, and is no longer yours. You are only given claim to this money by an equivalent amount of equity. The company is a living, breathing entity, and is considered to a be a distinct taxable entity by the Internal Revenue Service (IRS) if you have formed an LLC (ExampleTech, LLC), S or C corporation (ExampleTech, Inc.). Even if you choose to do business as a sole proprietor (John Doe “doing business as” ExampleTech), which is not a distinct taxable entity, you should mentally consider your¬†initial¬†personal investment gone forever!¬†Don’t event think about mixing personal accounts with business.¬†ExampleTech accounts belong to ExampleTech and are maintained separately from your personal finances. Period. ¬†It’s company money now, not yours, so get over it.¬†You’ve invested $10K in ExampleTech to get it off the ground.

$10K Assets (cash) = $0K Liabilities + $10K Equity (ownership)

Since, the company has purchased $6K of equipment using $1K in cash and $5K on a credit card with an $8K limit (this will be important later). The balance sheet now looks like this..

$15K Assets ($9K cash + $6K equipment) = $5K Liabilities (credit card) + $10K Equity (ownership)

Where did these numbers come from? We have $15K in assets because we started with $10K in raw cash, spent $1K of it and received $6K of equipment in return. The difference is on the credit card as a $5K liability. Some interesting observations…

  • You (John Doe) still have $10K of ownership equity even though the company only has $9K of cash in the bank. It would not be possible to cash out 100% of your initial investment without liquidating (converting to cash, a.k.a. selling) the equipment.
  • If you bought the equipment out of¬†warrantee¬†and it breaks on day 1, ExampleTech will be down the $6K in equipment assets but would still need to pay off the $5K credit card liabiltity. The loss would come out of cash and leave the balance sheet looking like this: $4K Assets (cash) = $0K Liabilites + $4K Equity (ownership). Oops. On the plus side, you would realize what the term “equity-funded venture” means.
  • All book equity is held directly by you, the owner. This is a tremendous advantage over private equity venture capital (VC)-based start-ups, because you are the only person who cares about the eventual return on equity (ROE) investment. By using short-term debt instead of long-term equity, your creditors couldn’t care less about ROE as long as you’re making payments on time, so ExampleTech’s decisions remain yours to make.

ExampleTech is now ready to operate, and opens its doors with a slick new job for ClientComm.

Understanding Cash Flow & Income

After 1 month of operation, ExampleTech has performed and delivered $8K of services to ClientComm. Only $3K in credit card¬†expenditures¬†was need to complete the job. ClientComm has been invoiced and “the check is in the mail”, which should arrive and clear within 2 weeks. ExampleTech is now moving on to a much bigger project for MegaComm.¬†Here’s your current balance sheet..

$23K Assets ($6K equipment + $9K cash + $8K accounts receivable)
=
$8K Liabilities (credit card: $5K initial equipment + $3K ClientComm job)
+
$15K Equity (ownership)

Note that you’ve increase your equity 50%, which is now $15K up from the $10K you started with. Woohoo! Here’s the ExampleTech income statement for the previous month..

Income
ClientComm: $8K

Expenses
Office equipment: $5K
ClientComm production expenses: $3K

Net income for period (last month): $8K (income) – $8K (expenses) = $0K

So in your first month you not only purchased reusable office equipment, but broke even! (That’s pretty awesome, go grab a beer!) Armed with $23K in assets and a renewed sense of self-confidence, you’ve signed MegaComm to a new¬†deal worth $40K which will only cost $10K to deliver.¬†You immediately start MegaComm production by writing a check for the $10K in materials and production costs.

..And you’re about to realize how you just screwed up.

To your¬†surprise, you receive a call several days later that your check has bounced due to “insufficient funds”. What you forgot to consider is perhaps¬†the most important aspect of financial management for the start-up phase of a self-funded new business: cash flow. Your cash flow statement for last month defines the raw dollars going in and out of ExampleTech during the given period, and looks something like this..

Cash at period start: $10K
Equipment investment: $1K
Net cash flow: -$1K
Cash at period end: $9K

Remember the $6K of equipment you purchased before you opened your doors? It’s only represented as $1K on the cash flow statement because $5K was put on credit, and creditors have not required ExtremeTech to pay out. The $3K shelled out for ClientComm production isn’t represented here at all because you chose to finance the entire amount with credit.
Thus, your bank only has $9K of raw cash even though your balance sheet showed you at $23K of assets, which also includes accounts receivable: money that has been counted as income on your income statement but has not yet been collected. Accounts receivable did not contribute to your cash flow statement since no money actually exchanged hands during the period, even though the job is completed! The cash flow statement will not reflect the ClientComm job until you..
  1. Cash the ClientComm check (which you really need), or
  2. Pay the credit card bill.
ExampleTech was cash flow negative¬†last month¬†despite having positive income, a non-intuitive but not infrequent business¬†occurrence. Being cash flow negative isn’t in-and-of-itself a problem, but puts you¬†in a short-term pickle because you don’t physically have enough cash for the materials, and your credit is already maxed out at $8K. You’re looking your next big client square in the face but don’t yet have the assets to pull it off, and you’ll be scrambling for the extra working capital to push forward rather than getting actual work done.

In Summary

Self-funding your company comes with the perks of directional freedom, less time pressure and fewer legal complications at the cost of pressure to stay cash flow positive from day 1.¬†The self-funded company cannot grow–let alone survive–without an early, consistent trend of positive cash flow as we’ve just demonstrated. ExampleTech won’t have much wiggle room for strategic ventures and operational improvements until these numbers provide an ample financial buffer.

Next

We’ve glossed over quite a few important details such as taxes, loans, interest,¬†accounts payable and, of course, paying yourself. So if you’ve found this information helpful and would like to see more content on the practical financial aspects of start-ups, let me know you’d like a Part 2 and the specific topics you’d like to know about!