Finance Planning – Beware
Blog – Finance Myths
There are several finance myths that can mislead a company and in particular a startup.
For instance – “I can get a bank line whenever I need it” – WRONG.
Banks are not in the equity business and offer loans if there is a high probability of getting the money back. I have often seen a business plan that forecasted a bank loan early on in the company existence. Some even have the bank line in before the company profit is in sight. Most founders/entrepreneurs lack of experience can make it difficult to develop a relationship with banks. It may not be known that a bank loan requires at least two very strong sources to guarantee the loan. Cash generated by the company from their sales and revenue can be a good one but a small company can almost bet that one of the two has to be a personal guarantee. Even having the personal guarantee may depend on a FICO score.
Because cash is so important in even attempting a bank loan a business plan should be provided with a detailed use of the cash in the finance section. The cash flow schedule should show where the possibilities of the money will come from as the company grows. I have worked with startups and when they are ready to go for a backline, I have a suggestion for the cash flow schedule to add a line that says if the sources of cash to pay the loan are not happening, it will show where the loan payment has to come from. That could be a second mortgage by the founder on her house. You can bet in the request for the loan, details are expected showing how the cash is planned to be used. The banks will not be very happy if a substantial part of the funds are slated for staff compensation. There may be a shock for that loan that includes a clause in the agreement that says, if the company defaults on the loan, the bank will own all the assets, if there are any.
Here’s another one, “I will never pay 2 ½% per month for a loan” – this sounds good in principle before the company is faced with a negative cash potential and the number one priority is survival. If a company is in trouble a normal bank will have no interest in providing a loan. There are finance companies that will be interested for a high interest rate. The interesting thing is these companies may not require a personal guarantee, because although they have a higher risk the high rate is offset by the higher rate. So the solution to this is try to get the higher prices for the product or services to be able cover such a high interest rate. In others words have enough margin to consider the high rate is the cost of doing basis. Ironically I’ve seen founders use their credit cards with interest over 20%. One actually when the company failed, had to file bankruptcy personally because of all credit card balances
I like this one because it seems to give a comforting feeling to small companies with robust growth and startups. It goes like this, “My margin is so high that I will have no problem having the cash for my growth”. There are two problems with this, one, the higher the growth rate the more front end cash is needed and profit may not provide enough cash. But more important the profit margin in real dollars has to cover all the operating costs. For instance, if the revenue is $1 million the operating costs are $600,000, even with a 50% profit margin, ($500,000) the company could be in trouble losing $100,000. So even with great profit margins, the real margin dollars are more important to cover all of the operating expenses.
It may not be a myth with but the inexperience at times will provide revenue numbers that defy Guinness records. As an example, the revenue forecast that shows sales in year I at $50,000 and 25 million in year two. Sound crazy but I’ve seen examples close to this?
Again not a myth, but the inexperience entrepreneur may lack the practical aspects of getting started. Normally when paying for a service or for a manufactured product a customer can get an agreement like paying 30 days after the service or product is received. This will be unlikely with a startup that doesn’t yet have a credit record. I have worked with startups with a physical product and when planning the cash needed to pay for the product, the entrepreneur may not understand he may have to pay for expensive tooling and even worse, with no credit worthiness, he will have to pay upfront.
All of the above can really be helped if the entrepreneur starts out with an open mind and has a high priority for obtaining experience help from coaches, mentors and advisory boards.
Final last words, Banks do not become partners, and they will provide a serious of ratios, new to the entrepreneur, related to the balance sheet and profit and loss statement called covenants that better be covered, or the bank will close on the loan, even if payments are being paid.