Friday, May 18, 2007

Lesson #20 - Don't let Good Money follow Bad

Let's face it - being an entrepreneur and starting a new venture is not too dissimilar to being a gambler. There are so many elements in gambling that make for great analogies, but none more relevant than the old saying "don't let good money follow bad".

One of the most challenging decisions of an entrepreneur (and a gambler) is to walk away from the table and accept their losses. You never know if your losses where due to bad planning, bad execution or just bad luck - but there comes a point where you lose faith in your ability to turn your luck around, and you just need to stop.

I have been involved in multiple ventures (including ones I was the CEO) that raised millions of dollars around solid business plans, great management and a clear idea on the market opportunity - but never seemed to turn the corner and reach cash flow positive. So they continued to raise capital, round after round, hoping their luck would change. They always insist that success is just a matter of time and money. They rarely are able to accept that maybe the business plan wasn't flawless after all, and maybe they need to change their game plan ... or maybe, just maybe .. they need to fold and walk away from the table.

Here are some of the warning signs that in hindsight were obvious but difficult to accept nonetheless.

1. Sales Cycle - To me this is probably the most accurate way to determine if there are problems ahead. There are many factors that determine a sales cycle including the sales person, the product, the price and the buyer. But when you boil it down, the biggest factor that determines a sales cycle is market demand. If there is no real market demand for the product, the company will have a long road to reach success. I have seen a lot of startups close sales where there was no real market demand - but the sales cycle was brutal, they had to jump through hoops, and ultimately the sale wasn't profitable. I know what you are thinking - "what about million dollar deals... they always have a long sales cycle". Yes, big deals can take longer - but remember we are talking about startup companies, not established companies with a track record. If you are a startup, and think you are going to close big six digit deals - then you definitely need to rethink your business model.

2. Proactive Operations versus Reactive Operations - Here is another great litmus test to see if your venture is gaining real momentum, or you are operating in denial. Proactive operations is where the CEO has to actively push operations - referring back to the business plan almost like it is an unfulfilled prophecy. Reactive Operation is where the market is pushing the company - the phones are ringing, opportunity is knocking and customers are demanding product. The difference is obvious when you are looking outside-in, but sometimes is difficult to see when operating in a vacuum. Every company when it first opens its doors will operate in proactive operations for a little while, but if you are still proactive in Year 2 - there is a problem.

3. Gross Income per Employee - Here is a great way to measure the health of a company. So many of these early warning signs are subjective, but this is a clear cut number. Before you use this test - you need to wait until the sixth month of sales (which could mean you're 12-18 months into operations). At six months of sales, total up gross income for the past 3 months (total sales minus total cost of goods for the last quarter) and divide it by one month payroll.

Here is the equation:
X = (Gross Income for last quarter) / (Monthly Payroll)

So for example, let's say I did $120,000 in sales in the last three months. And my cost of goods was $20,000. My gross income for three months would be $100,000. If my monthly payroll is $33,000 then my number is 3.

Here is the scale to determine the health of the company (and whether you need to make changes)

Less than 1 - If you number is less than one then you need to make changes NOW. You are upside down, and your cash burn is way to high. The first suggestion is to cut payroll immediately. Your company could be doing well, but your staff is too big to support.

Between 1 and 3 - This is the danger zone. Most startups are in this zone during the first year or two of operations because they are in growth mode and in early stages of sales. However, you can't survive in this zone for a very long time. If you have capital in the bank to help with cash flow and sustaining operations for 12 months, then you are reasonably healthy, but if you don't have the cash to fund 12 months of operations - then you need to consider reducing overhead or really hustling on sales.

Between 4 and 7 - This is a healthy state. You may still have cash flow issues due to accounts receivable and investing in growth - but overall you have turned the corner in validating there is customer demand, now you just need to focus on scaling the business.

Over 7 - You are a rock star - prepare for an exciting journey - you clearly have the lion by its tail.

Hopefully, you can look objectively at your business and ask the hard questions to really determine if you are heading the right direction. One of the greatest strengths (and greatest weaknesses) of an entrepreneur is their blind-faith in their idea - and the willingness to fight until the bitter end.

Just remember that success usually follow failure, but only if you have the courage to make the necessary changes.