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You’re chasing the dream… running your own business… but what you don’t know could really come back to bite you.
And what you really need to know is this…
Why do some startups fail?
In startup circles, this question is as common as “Why is the sky blue?” Common sense prevailing, one of the main reasons startups fail is that they run out of cash.
While no one aims to burn through cash at an alarming rate, a lack of basic financial literacy definitely contributes to the bloodletting.
Looking at the other side of the coin, you can ask, “Why do some startups succeed?”
As co-founder and managing director of Barbara Corcoran Venture Partners, Phil Nadel writes, “We find there is a direct correlation between the depth of a founder’s knowledge of the company’s key performance indicators (KPIs) and the company’s success.”
Your financial data has a lot to tell you. But, first you have to develop a baseline fluency in order to be able to answer the following money questions:
How quickly will you burn through the money you have right now?
The experts at Appster point out that first you need to know the difference between burn rate, the rate at which your startup is consuming money, and runway, how long this money will last at the current burn rate.
Roughly speaking, your average monthly burn rate is your annual burn rate divided by 12. (Although average is seldom the norm. Once you have a year’s worth of data, you may also want to examine the peaks and valleys in terms of which months were above or below average).
In turn, your runway is calculated by dividing your current cash reserves by the average burn rate. The number of months you have in your runway gives you your zero cash date — which most viable startups hope to avoid.
There’s also a difference between gross burn, the sum your business consumes every month, independent of revenues, and net burn, your consumption rate offset by your monthly revenue.
According to most experts, you should ideally have 12 to 18 months of runway.
How much does it cost you to make the product or service you sell?
Just as your burn rate is to your runway, your costs of goods and services (COGS) is to your revenue. If you make a physical product, COGS includes the materials, labor, shipping and all of the components that go into making, selling and delivering the product.
If you’re building software, it’s more labor-driven in terms of development hours and talent costs. The difference between your revenue and COGS is your gross margin on your product or service.
While it may be understandable for margins to be lower in the early years of a company, over time, gross margins should increase. However, the ultimate size of the margins will vary by several factors, including industry.
Another way that startups attempt to control costs and generate margins is by applying the principle of minimum viable product (MVP) so that the first generation is just enough to meet the basic needs. Bells and whistles are added later.
How much does it cost you to make each sale?
According to forEntrepreneurs.com author David Skok, the cost of acquiring a customer (CAC) has to be less than the lifetime value of the the customer (LTV).
In this formula, CAC is equal to your total sales and marketing spend (including salaries) divided by the number of customers acquired. LTV represents the gross margin your business earns throughout each customer lifetime.
For startups with one-time or recurring fees, calculating LTV is pretty straightforward. However, the math gets a little harder when you have to factor in costs like product development and customer support. For example, Skok estimates that a SaaS startup would need to generate a LTV three times that of the CAC.
Time is also a factor with the ideal rate of cost recovery being approximately 12 months.
What’s the difference between your growth rate and your profitability?
Entrepreneur and investor Mark Suster writes, “VC investors seldom value profitability if it comes with slow growth.”
In a perfect world, you’d be making money and growing. However, in startup land, there’s often a trade off. For instance, some companies may take a short-term hit to their profitability by staffing up in order to drive long-term growth.
Turning a profit is only one part of the story. Growth is one of those holy grail metrics. It means that the market demand for your product or service is continuing or poised to expand.
If your growth is rapid and sustained along with your profitability, you may also need to start investing in glitter and unicorn feed.
But which do you put first? Right now it’s sort of a chicken-and-egg argument. You can find experts on either side of the equation.
Where can you find the building blocks for this information?
The bulk of your answers will come from your financials. The best way to get the right information from your finances is to use small business accounting software and integrated apps and to work with an accountant to ensure you’ve set up your processes and benchmarks properly. Some of the main reports you’ll want to review on a regular basis are your balance sheet, income statement and cash-flow statement.
Market research complements your financial data by telling you about your customers and your competitors. Industry trends are easily researched online or through paid third-party vendors. Direct information on your customers comes from speaking with them, which means your sales team is a wealth of first-hand knowledge. You can also study what your customers are saying and doing online, especially through social media.
Will your story be a suspense-filled thriller or a fantastical journey? Some things are a matter of fate, but your KPIs, not so much. The more you know, the better you control the narrative and avoid any unwanted plot twists.
The advice we share on our blog is intended to be informational. It does not replace the expertise of accredited business professionals.
A version of this article was originally published on the Startup Nation blog.