In this article we cover the last decision area of the Scaling Up methodology: Cash. So far, we have covered Strategy – what a business offers, who its customers are and how much it should charge; People – what sort of people a business needs and how to organize them and Execution– how to get things done.
However, how can you ensure you have enough cash to execute your plans with sufficient flexibility to accommodate changes? When it comes to growing your business you need to pay close attention to how and when cash is produced. It is possible to fund growth by improving your operational cash flow, provided you take a disciplined approach and accelerate sources of revenue.
The main sources of cash available to young businesses are the entrepreneur’s own money, investment from business partners, friends and family, and external shareholders such as venture capitalist funds (VC). Commercial banks are unlikely to offer loans as they require years of operating history and consider young businesses to be too risky.
In the early stages of a business sales and marketing productivity will be poor, as most of your efforts will be focused on proving your offering and refining messaging. During this period you will also need to train people and invest in the business infrastructure, all of which will incur costs before contributing to revenue.
Bootstrap
It is possible to raise cash through your customers and to grow the business purely through revenue –operating in a bootstrap mode. MailChimp is a good example of a marketing software company that grew without external capital. Founded in 2001, MailChimp has always been profitable and has more than 12 million people and businesses around the world using its products.
Accelerate cash conversion
To bootstrap your business it is essential to keep operating costs low. Firstly, look at ways to eliminate inefficiencies and improve your business model. Can you reduce your direct costs to increase gross margins? Can you improve the success rate of sales and marketing teams?
Favourable terms
Secondly, review your contract and payment terms to find ways to shorten your cash conversion cycle. The cycle begins with sales and marketing – next a customer signs a contract and time is spent doing the work – when the work is complete you issue your invoice and wait to be paid – this can often take 60 days. Throughout this cycle you are incurring costs. The more you can accelerate this cycle, the better.
Advance payment
Can you ask for payment or part payment in advance of the work being done or offer discounts for payment in advance? Financial technology provider, FRS Global (now part of Wolters Kluwer), changed its contract terms so that customers pay a third of the contract value at the beginning and then the remainder in increments. This produces a much better cash flow profile – they get paid quickly to cover the sales and marketing costs incurred to win the contract.
Could you charge upfront for set-up costs and membership fees? For example, many Customer Relationship Management (CRM) software providers charge set up fees at the beginning of contracts to configure their systems and monthly membership fees to access their platforms. If you can get your customers to pre-pay, this will significantly improve cash flow and provide funds to grow the business.
Invoice immediately
Look for ways to improve the invoicing and collections process. Make sure you get your invoices out as soon as the work is done or the product is delivered, don’t wait until the end of the month. Start the payment cycle as soon as possible and ask to be paid within seven days of the invoice being issued.
Profitability vs cash flow
Most entrepreneurs don’t think of their accounting processes in a way that will produce value for the business. They see accounting as a necessity to comply with regulatory obligations. In addition to producing accounts to meet the reporting and statutory requirements we recommend producing the accounts to show clearly how the business is producing cash and profitability.
For most businesses, it makes sense to measure earnings before interest, taxes, depreciation and amortization (EBITDA). This is often equivalent to cash with a small time delay.
For businesses where EBITDA is not almost the same as cash, for example software businesses that are required to capitalize research and development expenses or businesses with significant capital expenditures, it makes more sense to use a free cash flow measure.
Labour efficiency and unit economics
A good way of telling how well the business will do long-term is to look at unit economics – what is the financial contribution of an incremental customer – think about the unit economics of each sales person and the contracts they win. This will tell you how quickly you can grow without external capital.
To grow your marketing and sales teams you need to know what financial return they are providing. What is the gross profit of the new contracts they win minus all the direct expenses incurred? Compare that to the cost of employing them. As a general rule, a sales team needs to generate three times its costs in order to generate enough cash to fund the business. Sales productivity, sales quotas, the cost of sales people, how much sales and marketing support is needed and other fixed costs all impact cash flow.
There is no point seeking venture capital (VC) money in the early stages of a business, as any investment would be wasted on inefficient sales and marketing processes. It is much better to wait until you have a proven business model and market opportunity. This is when VC capital can help to rapidly scale-up your offering.
Improve your equity story
Before seeking external investment, it is important to research the market and talk to your customers and potential shareholders to understand how they think about your business model, as this often throws up misconceptions which could prejudice their willingness to buy or invest. To improve your equity story, you will not only need to show good potential cash flows, but you may also need to communicate what you do in a totally different way.
Watch this video to know more about the Scaling Up methodology and do get in touch if you would like us to help you implementing it in your business.