How startups should think about money
What’s taught in school about how to finance a startup is wrong. Here’s a better way.
Summary
In this story, I compare 3 different models startup financing that shaped my thinking as my startup matured over the past 3 years. These models were:
- The Entrepreneur’s Model
- The Engineer’s Model
- The Freelancer’s Model
I examine each of these models through the lens of my personal experiences as an engineer turning into an entrepreneur.
When I was in grad school, I was studying systems engineering which (according to Wikipedia) is:
Systems Engineering — an interdisciplinary field of engineering and engineering management that focuses on how to design, integrate, and manage complex systems over their life cycles
Being an interdisciplinary field, I was able to sign up for a few classes outside my area of focus. And since I was building my startup at the time, I decided to sign up for an entrepreneurship class.
The Entrepreneur’s Model
If you’ve ever taken a college-level entrepreneurship class, you probably know the basics — estimate the size of the market, figure out which segment/niche you’d want to focus on, and then do a 1- to 3-year projection of your growth.
Most people call this projection the infamous startup J-curve or “hockey stick” graph:
It’s called a hockey stick graph because of its shape — it dips down as more expenses and capital are needed to build the business. But then, it’s expected to go back up as you gain more traction with customers.
When I was first introduced to this graph, I asked:
“How can the money be negative?”
In my head, I was pretty confused. I’ve only ever seen money be negative on my credit card statement — meaning that some kind of credit was used to cover those initial expenses.
But how could a startup take on any loans when it had such high uncertainty?
My professor answered:
“It’s not actually going to be negative — you’ll have to get investments, loans, or try to bootstrap to cover those costs.”
Bootstrapping— building a company from the ground up with little or no outside cash or support (i.e. using personal savings and, if possible, first sales).
At that time, here’s what I had understood: in order to start a business, you must be prepared to owe someone — be it an investor, the bank, or yourself.
So, most of the class was aimed at conducting market analysis to reduce business risks and uncertainty so that we could go on to pitch this data to potential investors.
Although the market analysis techniques were helpful, I couldn’t help but think something was wrong with this investment-first model.
The Engineer’s Model
After grad school, I decided to work on my business full-time and use my personal savings to cover my expenses.
I gave myself a budget and said:
“I give myself 6–8 months to get my business to a sustainable level. X amount of money is what I need for that time.”
Here’s what that looked like in my head:
As you can see, I had a safety margin between my blue soft-cap of 6 months and my green hard-cap of 8 months while my expenses over time are in red.
In the beginning, my expenses were small but grew sharply as I committed more and more cash to the business. But then, it started to plateau as money ran out. This results in the S-curve that’s common in engineering and project management.
S-curve — a graph that shows the cumulative effort of a project, typically cost or person-hours, plotted against time.
This model worked fine in the beginning. But as I approached the upper limit, I began to make compromises just so that I’d stay under budget.
I started working every day of the week, and I’d go 2 or 3 weeks without leaving my apartment. My schedule was packed to the brim with customer interviews during the day followed by coding right after dinner until just past midnight.
After those 8 months, I finally ran out of money. Having failed my mission, I packed my bags and went home. Then I had a massive burnout that, even today, I’m not sure I’ve truly recovered from.
The engineer’s model had such a finality to it — beyond this line, there is nothing. And because that was my model, I did everything in my power to bend the curve to meet the ceiling.
But I should have thought to bend the ceiling, not the curve.
The Freelancer’s Model
Instead of getting a normal job to cover my expenses, I decided to try freelancing with my software development skills.
I got my first client through my roommate, whose Ph.D. advisor was looking for someone to update some in-house software their lab had developed.
So I said, “$200 to fix this small, somewhat pressing bug for now. Then later, we can make the milestones bigger, if you’d like. This way we can all get used to working with each other.”
For that first bug fix, I estimated I could do it in an hour or two, but I asked my client for a week just in case I hit any unexpected roadblocks. For me, this one-week agile sprint approach was something I was familiar with, given my software development background.
Sprint — (agile software development) a set period of time during which specific work would be done.
After a couple of projects, here’s what my finances started to look like:
Though most of my projects have only taken a few hours so far, I have a rule that any project should be possible to complete in a one-week sprint. This meant that my maximum expense was fixed to a week’s worth of coding (blue line) while my actual expenses should always remain below it (red line).
And although there were gaps between the milestones, the value of each milestone increased as each step unlocked a new value built on the previous milestones (green step curves).
With the Freelancer model, there was no limit overtime to the amount of value I could produce for my customers.
I was willing to do anything I could under a week, and I was okay with risking not being paid for my work. That’s why the Freelancer model drastically changed the way I thought about my personal and startup financing.
Comparing the Models
In the Entrepreneur’s model, my thinking was “How much money do I need to start serving customers?”
I’ve found that this way of thinking doesn’t really work in practice because it’s set up such that investors come before customers, which simply isn’t true. All the investors, mentors, pitch competition judges, and accelerator advisors I’ve come across would certainly agree that customers should always come first.
But too many budding entrepreneurs (myself included) have had trouble trying to follow this mantra because the most pressing concern for a startup is its initial scarcity of resources.
After all, how can we solve problems for others if we can’t solve our own?
In the Engineer’s model, my thinking was “How do I stay under my budget ceiling?”
This model is better than the Entrepreneur’s model because, at the very least, it gets you started on solving your customer’s problem right away. But, it has an expiration date and a lot of harm can come out of making unhealthy compromises as the expiration date approaches.
Looking back, it was an over-eager approach to take on a lot of unnecessary risks.
But in the Freelancer’s model, my thinking became “How much higher can I fly above the cost floor?”
Though seemingly subtle, this vastly changed the way I thought about any of my entrepreneurial endeavors. By doing everything in small week-length bursts, I didn’t mind losing any effort I put into a project.
This, combined with the revenue for each project, made my risk pretty much negligible. I also managed to my efforts more targeted and effective compared to the Engineer’s model. I also didn’t have to depend on unnecessary stakeholders, unlike the Entrepreneur’s model.
Key Takeaways
Although the Entrepreneur’s and the Engineer’s model have their place in large-scale projects, the Freelancer’s model is the best way of thinking for startups because it allowed me to reduce risk and focus my efforts on the things that actually mattered.
A mentor of mine once told me:
“Pick up laundry, not capital.”
That’s why I became a freelancer in the first place. So far, it’s the best way I’ve found to truly understand value-based pricing. And if you’re trying to start a business, becoming a freelancer is how I recommend starting.
Have startup questions that keep you up at night? Interested in using engineering tactics in freelancing or entrepreneurship? Like my writing? Please leave a comment with a topic you’d like to read about!
