Basic Business Finance Concepts for Entrepreneurs with Non-Finance Backgrounds
Operating Capital, Bank Debt, and Equity Financing.
Finance is my least favorite aspect of business. Financial terminology makes me glaze over. It all seems so trivial in the grand scheme of executing your vision for your company. Unfortunately for myself and other entrepreneurs who feel this way, it’s a very important aspect of business and you must understand at least the basics. Below are a few of the most important financial concepts that a startup founder should understand.
Please note that I in no way consider myself an expert on business finance. I am sharing things that I’ve learned based on my specific experiences. Finance is a complex topic and every situation is different. My hope is to shed some light on a few basic concepts for those who have no experience in this realm. Always seek advice from a professional before making critical business decisions in an area you do not fully understand.
One of the main goals of every business is (or should be) to become cash flow positive. Bring in more cash than you spend and you will continuously build a cash cushion in your bank account. This is how Apple was able to amass nearly $150 billion in cash. The problem most companies run into during their early days is that they must spend more money than they make in order to get their business off the ground.
So, how can you spend more money than your company is able to generate? The answer: you must find money elsewhere. There are two main ways to secure operating capital for your business. You can borrow it or you can sell equity to an investor. Either of these options can provide you with the capital you need to get over this initial hump and become cash flow positive. The challenge is to figure out at what point in time your business will generate enough net cash to enable you to operate without financed capital. Then figure out how much financed capital you need to get to this point. I emphasize net cash because you can run a profitable business that doesn’t pad your bank account. Net income (or profits) also include the value of non-cash assets such as inventory, which isn’t very helpful when you need to pay for things. Net cash is actual hard cash in the bank and every company needs a sufficient level of cash to operate.
A wise friend of mine once told me that if you plan on building a successful business, then giving up equity for cash is by far the most expensive form of financing. While this is true, sometimes it is your only option. If you are fortunate enough to be able to borrow money from friends/family or a bank, and you are ok with the added personal financial risk, then this is your best option.
There are two main ways to finance cash for your business from a bank. You can obtain a revolving line of credit or a term loan. The difference between the two options is important (and something I literally learned last week). A term loan is basically the same thing as a mortgage or a car loan. The bank gives you X amount of money and you make monthly payments over a specified amount of time until the loan is paid back in full. A revolving line of credit is used to make large purchases with plans to pay back the money in full relatively quickly. Between the time you draw money on your line and when you pay it back, you typically are required to make monthly interest-only payments. For example, say you have a client who wants to buy 100,000 products from you. To fulfill the order you must produce 100,000 products specifically for this client and it will cost you $200,000. Your client will pay $400,000 upon delivery of the order. You draw out $200,000 from your line of credit to create the products with a plan to pay off the line in full once you receive payment from the client.
A line of credit is not meant to be used for operating capital. If your business needs to finance operating capital from a bank, then you need a term loan. A term loan can be used to cover operating expenses (Salaries, rent, utilities, R&D, etc) while you are working towards becoming cash flow positive. Once a company is able to generate enough cash to cover operating expenses, it can pay off the term debt. This is how a company becomes financially independent.
A revolving line of credit is less of a crutch than a term loan and more of a tool to extend your purchasing power. A RLOC will allow you to pounce on opportunities that you otherwise wouldn’t be able to capitalize on. You will most likely need a line of credit for the life of your business. I would recommend securing one as soon as possible and upping the limit as frequently as possible.
Raising operating capital by selling ownership in your business is a reasonable alternative to bank debt. There are many different ways to structure an equity deal, but I am going to focus on the simple math involved in determining value and ownership. In order to trade equity for cash, you and your investor must agree on a current value for the company and how much cash you want to raise.
There are two important valuation numbers: pre-money value and post-money value. Pre-money value is the current value of your company and is somewhat arbitrary. There is no standardized way to determine the current value of your company. Your company is worth whatever value you and your investor can agree on (hence the importance of negotiation). Post-money value is the current value plus the amount of cash invested. For example, say you agree that your company is worth $4,000,000 and you raise $1,000,000. Your pre-money value is $4,000,000 and your post-money value is $5,000,000. This concept is important if you are negotiating percent ownership with your investor, because your investor’s percent ownership is based on the post-money value.
So you have a $4 million pre and a $5 million post. For simple math, say your company has 4,000,000 shares of common stock and you and your partner each own 2,000,000 shares. The transaction will unfold like this:
- Based on the pre-money value of $4 million with 4,000,000 shares outstanding, each share of common stock is worth $1.
- You will create (out of thin air) 1,000,000 new shares, worth $1 each, and trade them for $1,000,000 cash from your investor.
- Now there are 5 million shares outstanding, each worth $1, making the total value of your company $5 million.
- You now own 2 million of the 5 million outstanding shares, taking your percent ownership from 50% to 40%. The total value of your shares remains the same. Your investor owns 1 million of the 5 million shares, or 20% of all outstanding shares (which are worth the amount invested).
When negotiating with an investor it is more important to concentrate on what you believe the current value of your company is and how much money you need, rather than what percentage ownership your investor will own at the end of the transaction. If percent ownership is an important deal point for your investor, then it is imperative that you understand how the math works, so you can back into numbers you are comfortable with. This is a very simple example, meant to explain the math behind a simple equity transaction. There are a number of other important things to consider when negotiating a transaction like this, but that is an entire topic on its own.
God that was miserable. Hopefully it helps.