Undercapitalization is one of the top reasons why startups fail, but the good news is that you can increase your likelihood of success with proper business and financial planning.
After 21 years in business, I have yet to hear an entrepreneur complain that a startup was overfunded. Excess cash and liquidity is usually not one of the major challenges faced by new owners. Startups often come up against unexpected problems and delays, both of which tend to push back the point of positive cash flow, causing a further, unplanned drain on working capital.
Planning for contingencies and "what ifs" is an important part of the preparation process. My first piece of advice is to always focus on writing a meaningful business plan – one that conservatively plans for fixed and variable expenses as well as a realistic ramp up of sales and the contribution margins they produce.
My starting point for incorporating startup contingencies is 25 per cent. I try to bake that into both planned costs and planned timelines toward goals. Nothing goes exactly as expected. Since you don't know what you don't know, 25 per cent is a reasonable buffer.
Further more, avoid the "if I build it, they will come" syndrome. Overnight successes are usually based on years and years of hard work and innovation. Being at the right place at the right time normally takes networking, planning, late nights and risk taking.
For those who need to raise money to start their businesses – which is most of us – adding contingencies can be discouraging. It increases the amount you need to borrow or the number of shares you need to sell to raise equity, or both. Most startups want to keep debt low and remaining ownership high. I get it. However, borrowing or raising a little extra to cover the unknowns reduces risk for all parties.
Raising capital for a startup is hard – raising follow-on capital when you are still 90 days from positive cash flow because you missed some targets is really, really hard. At that point, you are going back to the investment or debt well, having missed your own timelines. It's not fun. It's better to have the breathing room up front.
Writing a business plan also gives you hard budgets to live by and to track yourself against. The name of the game for a recently funded startup is to achieve your milestones while preserving capital. Until you start making money, you are losing it, and that can't go on forever. There is a place between making money and losing it – it's called break-even – but that is such a fine line it can hardly be considered an accomplishment.
If undercapitalization is one of the top reasons for startup failure, you need to plan for it in advance. Financial projections buffered with some wiggle room will go a long way. Once you've opened your doors, be as thrifty as you can while continuing to meet your goals. Once you get consistent, positive cash flow, you will be out of the woods and ready to try new things to move to the next level.
Chris Griffiths is the Toronto-based director of fine tune consulting, a boutique management consulting practice. Over the past 20 years, he has started or acquired and exited seven businesses.