As an entrepreneur, we are exposed to many risks and uncertainties. These risks generally fall into one of three buckets:
- Capital (Financial) Risk
- Market Risk
- Execution Risk
In this article, I want to focus on the risk that every entrepreneur has to contend with, and that is financial risk. As entrepreneurs we are faced with two kinds of financial risk – business financial risk and personal financial risk. Yes, we get two risks for the price of one business!
Examining the Business Financial Risk
Just about every entrepreneurial venture starts off under-capitalized. Before you can seek outside investment, you need to have developed a prototype of your product and proof of concept, if you’re selling a service and / or product. This takes time and money. This is the bootstrap phase of your business. This is where we ask “friends and family” for an investment or a loan to help us get our venture off the ground. Or we convince our life-partner to let us mortgage the house one more time to fund our latest crazy idea. This is the start of financial risk and financial pressure.
If we are fortunate enough to build our prototype and demonstrate proof of concept, we have to start building our team. This costs money. We still don’t have revenue. Top talent is expensive. Cheap talent is more expensive in the long run. We may still be too early for outside investment. Either we are not big enough or their money is too expensive in terms of the equity they require at this stage. Do we take a loan, max out our credit cards, mortgage the house (if you have one), close out the 401K, raid the kid’s tuition?
Forms of Financial Risk
Over time, as our business grows, we face different forms of financial risk. Our customers are a form of financial risk. Customers are looking to buy on credit, and we are looking to generate revenue so we extend credit pretty readily. All of a sudden we are facing a bloated accounts receivable and a skimpy bank account. What happens if our customer goes under and we don’t get paid?
We also face supplier risk. In times of financial distress, suppliers concerned about their own accounts receivable exposure may tighten credit and accelerate payment terms. You may not have that same luxury with your clients. Collecting in 60 days and paying in 30 days can drain your bank account pretty fast.
There is also banking risk. Banks generally like to lend in growing economic environments when businesses are making lots of money and really don’t need a loan. The worst time to ask a bank for a loan is when you really need money. In severe economic times, banks have been known to limit credit lines to amounts already borrowed and cut off your supply of oxygen (cash) when you can least afford it.
Leverage is another huge risk for any business. Leverage is simply the use of debt to grow the business. The problem with too much debt is, if sales take longer than expected to materialize, or if business in general slows down, your lender still expects to be paid every month. And if your business fails, you will generally still be personally liable to repay that debt. There is a place for debt in growing your business, however, that decision needs to be made very prudently and the proceeds from the loan managed very carefully.
Some businesses get very lucky and they take off immediately growing faster than their founders ever could have imagined. While this sounds really exciting, there is an element of financial risk when growth is too rapid, which is you may out-grow your capital. What could be more awful than running out of money while running a business that is growing at exponential rates? None of these scenarios are pleasant. However, in the life cycle of building your business you will encounter most, if not all, of these risks.
Exploring the Personal Financial Risk
Shifting gears a bit, while contending with all of these potential financial risks to your business, there is also the personal risk. If your business is experiencing a cash crunch and your struggling to pay your employees and vendors then guess who will go without getting paid? Yet, there is still mortgage / rent, car payments, grocery bills and children’s tuition to get paid.
None of this is meant to scare you, or dissuade you from pursuing your entrepreneurial dream. In fact, it is meant to encourage you to follow that dream. Knowing the risks that lie ahead of you and having a solid plan to manage your scarce capital and related risks makes all the difference between success and failure. The more disciplined you are in your approach to financial management, the better run your business will be and the more attractive you will become to investors or lenders as your business matures.
So, What is an Entrepreneur to Do?
So, what is an entrepreneur to do? Establishing some very simple protocols early in the life of your business is key.
- Know your numbers: What will it cost to build, sell, distribute, provide your product and / or service. Know your unit costs and your gross margin.
- Know how much capital you need to get to that first sale: Do a detailed plan. Once you have come up with the amount you believe you will need to get funded, double it.
- When you are starting out, allocate a certain amount funds to 90-day sprints: Have a clear set of goals and dollars available to fund those goals. Are you spending more or less? Why? What can you control? What can you Adjust? The earlier we figure out there is a flaw in our plan the earlier we can adjust before it is too late and we run out of cash. There is a very simple tool I have used with all of my businesses and my clients that I will be glad to share with you. A side benefit of this practice is that it creates a disciplined culture of accountability.
While none of this will guarantee your success, it helps tilt the scales in your favor.
