Go fund yourself: The power of working capital for start-ups
For years now, the largest corporations in the world have been looking to extract as much efficiency out of the way they manage their cash so they can use that cash to self-fund new investments.
In fact, this is such a massively important source of funding for large companies that there is a huge banking industry that exists to support it that is almost completely overshadowed by investment banking and trading desks.
But somehow these cash management strategies are virtually unheard of in start-up circles. All of the talks seems to revolve around venture capital and equity funding. And with this comes a huge interest in valuations and creating models to calculate them.
Nobody talks about optimizing the cash-flow of your start-up. But if you really understand this and do get it right, you might not need any outside investment at all.
Let’s start with a quick lesson on what is referred to in finance and accounting as working capital.
Working capital is not complicated, it is basically just the funds that you need in order to run your business on a day to day basis.
It is essentially a combination of these three things:
- What you get paid for selling whatever it is that you are selling
- What you have to pay in order to make whatever it is that you’re selling (rent bills, salary payments, tax, and anything you have to buy)
- The value of any inventory you haven’t sold yet
Think of it as a cycle that looks like this:
Buy raw materials / pay developers to write code >> Create finished product >> (hopefully) Sell that product >> Collect funds from people who bought it
His working capital cycle is really important because this is where you will spend all of your cash: creating your product and trying to sell that product. And this is also where you will earn your cash back by collecting cash from sales. (hopefully with some profit on top)
Notice that venture capital is nowhere in this cycle!
So what about venture capital?
Venture capital and debt funding only come into the picture to plug holes in this cycle.
Here are a couple of situations where that might actually be necessary:
- You want to start a company that has very high start-up costs (for example, machinery that costs a lot) — you have no choice but to raise funds just to get this cycle going
- You have a business model that is losing money on an on-going basis with the hope of turning a large profit at a later date (think Facebook as someone who already did this and Uber and Tesla as two that are still on the journey) — since you are not getting enough cash to pay for your costs, you need an injection of new capital every so often to keep the cycle going.
But here’s the thing — most of us are not building the next Uber that needs to blitz the world before somebody else beats them to it just to turn a profit.
The vast majority of people are looking to scale up in a relatively lean way, testing their assumptions as they go and looking to earn a profit as soon as possible.
And if you are building something sustainable from the ground-up like this, you shouldn’t even be wasting your time thinking about venture capital or valuations.
You should be focusing on getting your working capital cycle right so you never need any outside funding at all.
How to go fund yourself
So how can you actually go about doing this?
Think back to the cycle, you essentially have three important activities at the core of your business:
- Making Payments — for salaries, raw materials, tax, etc.
- Managing your Product / Inventory
- Collecting Cash from Sales
Traditionally, businesses would follow this order as they would have to buy big batches of raw materials, turn those materials into a finished product, and then finally sell them to the end customer.
With products like cars or washing machines, this whole process takes a long time and you need lots of funding to cover costs while you wait to be paid. But that’s not the way it has to work anymore!
With digital products and even many simple physical products, you can actually turn this cycle upside down:
- Collect sales up-front: crowd-funding or any other form of pre-ordering works great here. You are essentially giving a small discount to anyone who will buy your product ahead of time. (but this discount will be less than what you would be paying if you gave away equity or took out a loan!)
- Delay payments as long as possible: now I don’t mean here that you should refuse to pay suppliers or workers, but you should think about how you are making your payments. If you responsibly use a credit card, you get about an average of 45 days of free credit where you don’t have to pay anything. Or if you are working with B2B suppliers, they may extend payment terms as long as 90 days. Obviously, you need to always pay on time to avoid any penalties, but never pay early! Later on, when you are in a more profitable position, you might be able to get very attractive discounts to pay early, but at the early stages, you will want to hold onto your cash as much as you can.
- Keep your inventory to the bare minimum: many people will be tempted to buy a lot of products to get discounts, but flexibility is king when you are starting out. The last thing you want is to have all of your cash tied up in a bunch of product that no one is buying! Work with local manufacturers who may cost more, but will keep your up-front costs down. And if you are building software products, keep releasing and shipping rather than investing in building complicated features you’re not sure customers will want!
The key to all of this is that you should aim to hold onto your cash longer and get paid quicker.
That is the bottom line.
Always remember this cycle and think about how you can structure your business so that you are the one who is holding onto the cash.
Whether or not you have some kind of loan or equity financing that got this cycle started doesn’t really matter all that much — the real action in your company is in producing and selling your products and optimizing the working capital cycle that goes along with it.
And if you get this right, you can minimize the amount of outside cash that you have to put into your business or hopefully even go fund yourself!