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This impacts long term financial strategy as well as ability to negotiate and set up basic cost structures within the company.
Blame it on business school drop outs, or general lack of exposure to financial principles for building that great idea. It’s a growing trend and even professionals outside financial institutions working with startups have taken note.
Angel Investor and chairman at HDI company, Mark Schwartz told us, “Most companies don’t have people that are finance savvy other than knowing what to put in a term sheet for an initial capital raise.”
Startups forgo hiring a controller to manage the books and create financial reports because of “lean principles.” But even if you aren’t a finance major or don’t employ one, it is every chief executive’s responsibility to understand basic finance principles and how they can affect your business’ bottom line.
Robyn Gould, senior associate at Cooley LLP, a law firm that works closely with start-ups, has also noticed this trend:
“A growing number of our startup clients have developed the most cutting-edge, disruptive technologies, but struggle with determining their monetization strategy and preparing financials for investor pitches – skills that are critical for their ability to raise capital and build a successful business. We hear about startups ‘pivoting’ all of the time – often the most important pivot can be in a company’s monetization strategy. Accordingly, understanding the financial principles underlying such decisions is essential to being able to make these shifts.”
To help get all you new and hoping-to-be CEOs started on the right financial footing to ensure confidence from your team and your investors, here are seven basic finance terms that every good entrepreneur knows. We’ve also included a few additional resources to brush up on your Finance 101.
Net earnings and net income both fall under the “bottom line” description. You may hear people talk about “affecting the bottom line” of the company and this is simply any action that may increase or decrease the company’s net earnings, or overall profit. The term “bottom” is in reference to the typical location of the number on a company’s income statement, below both revenues (top line) and expenses. Needless to say, this is an important term to know.
Gross margin is expressed as a percentage and represents the percent of total sales revenue that a company keeps after subtracting the cost of producing its goods or services. The higher the percentage, the more the company keeps on each dollar of sales (that will eventually go toward paying its other costs and obligations). In simple terms, if a company’s gross margins are 25 percent, for every dollar of revenue that is generated, the company will retain $0.25 before paying its overhead, which includes salaries, rent, and more.
A fixed cost is exactly what is sounds like, a cost that does not change with increases or decreases in the volume of goods or services that are produced by your company. These costs are obviously the easiest to predict and plan for. Rent, salaries, and utilities all usually fall into this category.
Variable costs are just the opposite. They can vary depending on a what a company is producing (such as Amazon Web Services usage), and as a result are much harder to forecast.
The “equity versus debt” comparison may seem silly to some, but you would be surprised at how many people I have come across who have no idea what either really means. Equity is simply money obtained from investors in exchange for ownership of a company, while debt comes in the form of loans from banks that must be repaid over time. Both are necessary for growth, with their own pros and cons. Equity versus debt is a critical decision for any entrepreneur and it is important to know the difference as the future of your business may depend on it.
Leverage can be interpreted a couple different ways. In the financial world, leverage is most commonly known as the amount of debt that can be used to finance your business’ assets. In simple terms, the amount of money you borrowed to run your business. The balance you want to strike as an entrepreneur is that of your debt and equity. If you have way more debt than equity, you will be considered “highly leveraged” aka “very risky” to potential investors.
Capital expenditures are any items purchased by your business that create future benefits. Basically, if something you bought is going to be useful to your business beyond the taxable year in which you purchased it, capitalize the item(s) as assets in your accounting. Examples include computers, property, or acquisitions.
Concentration is simply the measure (usually a percentage) of how much business you are doing with a specific client or partner. Relying on one or a couple of clients and partners to do business is a prime example of over-concentration. This is a losing strategy for any business because if something goes wrong with those limited relationships your business will be in serious trouble. Focus on keeping low concentrations for your accounts and investors will be impressed.
Looking for more info? Here are some resources that you can use to get up to speed on your financial terms and concepts:
“The Intelligent Investor” by Benjamin Graham: This is The Bible to many investors as Graham was a mentor to Warren Buffett. What better way to think like an investor than learn from one of the all-time greats?
Wall Street Journal: If you don’t read it already, start. Every investor reads the Wall Street Journal, and staying up on markets is beneficial to any type of entrepreneur.
Bootstrap Finance: The Art of Start-Ups by Amar V. Bhide: Bhide has done a few very insightful pieces on entrepreneurial finance. This one is in the Harvard Business Review. I highly recommend checking them out.
Financing Options: Convertible Debt by Fred Wilson: Fred has written several in-depth posts as part of his MBA Monday column. His insights from the VC perspective are invaluable for any business leader.
The U.S. Small Business Administration has a wealth of resources including articles such as: Estimating start-up costs, Developing a cash flow analysis; Borrowing money for your business; Preparing financial statements, and more.
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Thank you. TiA.