by Norm Brodsky
That was the most important lesson Bobby and Helene had to learn, and I made them do the math themselves. I took them through the steps. I showed them how to break down sales by category and how to calculate their cost of goods sold and their gross margin. We came up with a list of expense categories and determined their fixed overhead. With sales, COGS, and overhead expenses, they could work out the month-by-month income statement on their own. Then I took them through the process of doing monthly cash flow forecasts, from which they could put together a cash flow statement for the year. I did just enough with them to make sure they had the hang of it. The rest they did at home. With pencil and paper.
No computers al owed.
It was al part of the education process. When you write out your own projections by hand, do your own calculations, and work through the numbers for a whole year, two things happen. First, you begin to get a feel for the business. Second, you start to understand reality. You see that sales don’t necessarily lead to profits, and that making a sale or earning a profit is not the same as generating cash. You get a sense of the connections.
The other reason to do a business plan is to get an idea of the amount of start-up capital you need. That number comes off the cash flow statement. In most cases, you wil see cumulative cash flow getting worse and worse, month after month, until the business turns a corner and cash flow starts to improve. That’s assuming the business is viable on paper. If projected cash flow never improves, the business is not viable, and you should find something else to do. But if the business is viable, the amount of start-up capital you need is theoretical y equal to the largest cash deficit on the statement. If you put that amount into the business, you should be able to avoid running out of cash—in theory. In practice, I always increase the number by at least 50 percent. With Bobby and Helene, for example, it looked as though they would have negative cash of about $15,000 in their worst month. I told them the business would probably require an investment of $25,000, but they had to put in only $15,000 up front.
There are two reasons for building in a reserve. First, things always cost more than you anticipate, and profits are always less. So, in fact, you probably wil need more capital than appears on the projected cash flow statement. But there’s also a psychological and emotional issue. It’s one thing to put up additional capital down the line if you know from the start you might have to. You feel very different about it if you think you’ve already made the maximum investment required.
Doing the business plan leads right into the next phase because you’re learning what has to happen for the business to survive. With Bobby and Helene, I was breaking survival down into terms they could understand and numbers they could monitor. They were seeing the difference between sel ing cleaning supplies with a gross margin of 50 percent and magnetic media with a gross margin of 10 percent. They were beginning to understand how gross margin, credit, col ection, and so on would affect their cash flow, and how cash flow would determine whether or not they’d last long enough to see if the business was viable in reality as wel as on paper. They were finding out where they had to focus their attention to have a decent shot at succeeding.
I should say that Helene was finding it out. She learned very quickly. Bobby took a little longer, but, then, he had more obstacles to overcome, especial y the sales mentality.
Ask Norm
Dear Norm:
My home-based design business sells store fixtures and related equipment to the retailers we work with. I try to operate on a 25 percent to 30 percent gross margin, but I don’t know if that’s appropriate. I always wonder how much more revenue we could get if we charged less.
Norbert
Dear Norbert:
You’re wondering about the wrong thing. You should be asking yourself how much less revenue you’d get if you charged more. Gross- and net-profit lines are far more important than sales. I’d greatly prefer to have $20,000 in gross profit on $50,000 in sales than to have the same gross profit on $100,000 in sales. Why? Because I’d have fewer headaches, fewer shipments, fewer people, and on and on. If I were you, I’d look for ways to increase your margins, not reduce them. Maybe you can get better deals on the products. Maybe you can cut your shipping costs. Yes, there are circumstances when it makes sense to cut prices, but I wouldn’t do it unless you’re certain that you’l get the additional sales—and that they’l be worth it.
—Norm
Overcoming the Sales Mentality
Almost al entrepreneurs have the sales mentality when they first go into business. They want to see sales go up every month, every day, every hour.
I myself didn’t care about anything except our weekly sales figures. My investors were the same way, and many of them were accountants. They never asked me about profits. Al they wanted to know about were sales. That’s the sales mentality. It’s the idea that you should focus al your attention on making sales, and it’s very dangerous, especial y when you’re operating out of your basement on a shoestring.
Why? Because sales do not equal cash, and cash is what you need to survive. You run out of cash, you go out of business. End of story. It al goes back to the fundamental reality that you are working with limited capital. If your gross profit is not enough to cover your expenses, you have to dip into your capital to make up the difference. You dip too much, and pretty soon you run out. Out of that reality comes the two most important rules for every new business. Number one, protect your capital. Spend it only on things you are certain wil generate positive cash flow in the short term.
Number two, maintain the highest monthly gross-profit margin you are capable of achieving. Do not go after any low-margin sales.
You probably think these rules sound simple enough, but it takes discipline to fol ow them. It’s very easy to go off on tangents, mainly because of the sales mentality. Bobby Stone was a classic case. He had been trained for fourteen and a half years to think only in terms of sales. He’d never even heard of gross profit. His only job was to sel as much as he could at the prices he was given no matter how much, or how little, gross profit he generated.
So what would he do when he found himself having a bad month? Let’s say that in his business plan he’d projected $20,000 in sales for the month. That was his break-even point. Now he’s in the last week, and he’s done just $10,000 in sales. He starts getting desperate. He cal s up sales reps until he finds one who wil buy $10,000 worth of supplies if Bobby wil come down on price. They negotiate, and Bobby gives him a good deal. Bobby’s happy. He’s made his goal. He’s moving a ton of product. He comes in and tel s Helene, “We did it. We hit our number.”
But what has he real y done? First, he didn’t break even. The price he negotiated left him with a 10 percent gross margin on the sale. Break-even was $20,000 at a 40 percent gross margin, or $8,000 in gross profit. He had sold $10,000 at 40 percent and $10,000 at 10 percent, for a total of $5,000 in gross profit. The margin was 25 percent, not 40 percent. That wasn’t enough to cover expenses. He was short $3,000, which had to come out of capital. Five more months like that, and the business would run through the entire $15,000 Helene had put in.
Second, he’d wasted his time. He should have been using it to go after high-margin customers, which general y means smal er-volume customers. That’s another rule: Spend your time developing relationships with your highest-margin customers. Let the low-margin customers come to you, and then negotiate the price up. Beyond that, Bobby had tied up $10,000 in one customer. What if the customer couldn’t pay or took too long to pay or would pay only after dozens of threatening phone cal s—on Bobby and Helene’s nickel? It was a risk, and the risk was greater because it was a single customer. Bobby had taken a gamble without knowing it, and it came straight out of the sales mentality. Commissioned salespeople never worry about getting paid.
Don’t get me wrong. I don’t think the sales mentality is al bad. It’s fine as long as it’s balanced. Just because you have it doesn’t mean you can’t grasp the other pa
rts of the business. You must grasp them, or you won’t survive. You’l make too many costly mistakes—just to avoid having a bad month. And it’s better to have a bad month, even a series of bad months, than to let your gross margins slide. I realize that’s awful y hard for a salesperson—and most entrepreneurs are salespeople—to accept, but it’s important. Why? Because of your goal, your long-term goal, the one you decided on before you did the business plan. Bobby and Helene wanted financial independence. The question was, would this business get them there? They needed to find out. The sales mentality gets in the way by substituting a short-term goal, making a sales target, for the long-term one: determining viability. So what if you have a series of bad months? Those results could be tel ing you something—that the business isn’t viable, or that you’re not capable of sel ing at a high enough gross margin to achieve your goal. If so, you should pay attention.
The usual alternative is to delude yourself with a series of high-volume, low-margin months. It’s easy. You just drop your price below your competitors’, and you can make al the sales you want. You’l think you’re doing fine. You won’t run out of cash as long as your sales keep rising and you can col ect before you pay. Trouble is, you also have more payables than you can handle. You’re bankrupt, and you don’t know it. Al of a sudden, you hit a couple of bad months, your cash disappears, and you lose everything. It happens al the time. The way to avoid that fate is to fol ow the rules and watch the numbers. If you watch closely enough, a picture begins to emerge. You can actual y see what’s going on. You can feel it. The picture gets clearer, and the feeling gets stronger, until you realize that you’re going to make it—or that it’s time to try something else.
Staying the course isn’t easy, however. It certainly wasn’t for Bobby and Helene. During the first year, they fought constantly. Helene kept tel ing Bobby he should get a real job. Their family and friends brought it up as wel . Meanwhile, they were stil getting Bobby’s severance pay, and they stil had his COBRA benefits. Helene was terrified about what would happen when those ran out.
My role was to help them keep everything in perspective—and to make sure that Bobby stayed focused on making high-margin sales. He and Helene were striving for an average gross margin of 40 percent, but he kept accepting sales at a 9 percent gross margin. So I made Helene the keeper of the margin. If a sale came in under 20 percent, Bobby had to ask her if they could afford it. Usual y she said no. Bobby struggled with that.
He’d have a chance to get a $3,000 order at 13 percent gross margin, which would put an extra $390 in the bank. Helene would tel him he couldn’t do it. He’d say, “How is this business ever going to grow if we’re turning away sales?” He just couldn’t understand how a sale could jeopardize the business. It contradicted everything he’d learned for fourteen years.
Nevertheless, he stayed with the program. Slowly the margins improved, and the customer base expanded. At the end of the first year, we sat down and figured out that the business would have been short by about $5,000 if Bobby and Helene hadn’t had his severance pay. I’d already warned them that, without the subsidy, the second year would be more difficult than the first, and they did, in fact, have a crisis when they had two bad months back-to-back. I told them they had a choice. They could put up the $ 10,000 they’d held in reserve, or they could go without salary for two months. They did the latter.
That blip notwithstanding, Bobby and Helene were clearly getting the hang of things. They’d been tracking the numbers month by month for a year and a half, watching sales and gross margins by product category, and fol owing about ten categories of expenses. I’d told them, “As a business grows, it’s normal to have creeping expenses. Just be aware of them. Sometimes you can’t help it.” But Bobby rose to the chal enge, and Helene seemed more and more confident as time went along.
Ask Norm
Dear Norm:
I’m thirty-four years old, and I’m struggling to get my business up and running. I feel as though I’m riding on the edge of disaster, trying to hold the business together and build it at the same time. I’ve made mistakes in advertising, cash management, and just about everything else. You name it, I’ve blown it. I think my strongest attribute at this point is my willingness to endure pain. I’m just hoping my cash flow catches up with my stupidity before it’s too late.
Scott
Dear Scott:
Your e-mail takes me back to the first real business I started when I was thirty-three years old. I know exactly how you feel. Believe it or not, you’re going through an experience that you’l look back on someday with a good deal of nostalgia. It’s an experience that shows what you’re real y made of. I hope your business doesn’t fail, but if it does, you’re going to learn some important lessons, and I’m sure your next business wil be a success. So hang in there.
—Norm
Critical Mass
It’s always a mistake to let yourself get too relaxed in business—to ever start thinking you’re out of the woods and safe and secure. I’m not just talking about start-ups. I mean companies of any size, at any stage of development. Because fundamental shifts occur in business, and they can be good or bad. A business to me is a living thing, and living things change. People change. Trees change. So do businesses. They may change because their customers develop different needs or because they start sel ing to another type of customer or because a new competitor enters the market. There could be dozens of reasons. But those changes occur, and you may not be aware of them at first. They are often hidden. If the changes are bad, and you’re not on top of them quickly enough, they can destroy you.
I had that in mind when I got Bobby and Helene to start tracking their numbers. I wasn’t thinking only about their immediate survival. I wanted them to see from the beginning how a business changes, so they’d recognize the shifts that were bound to happen later on. And I had another purpose as wel . After al , we knew their business wasn’t going to be a start-up forever. We wanted to figure out when the startup phase would end and the business would reach what I cal critical mass.
By that, I mean a particular threshold that every successful startup crosses sooner or later. It usual y depends on some key factor in the business hitting a certain level. The factor may be the size of the customer base. It may be the number of active accounts. There are probably ten different types of critical mass. But however many variations there are, they al translate into the same thing for every business : self-renewing break-even cash flow. I don’t mean break even on a profit-and-loss basis. I’m talking about getting to where the cash generated more or less automatical y each month is enough to sustain the business and al ow it to grow without going outside for new investment.
That is the major turning point for any new venture. Before critical mass, a business is a fledgling enterprise surviving on external capital. It stil has its umbilical cord. After critical mass, the business is a freestanding, self-sustaining entity capable of making its own way in the world. It’s your next goal after you achieve viability. The chal enge is to figure out where the goal line is.
We determined, for example, that Bobby and Helene’s critical mass had to do with their customer base—specihcal y, the number of regular customers they had. We saw that, over time, customers tended to stick with them and reorder supplies almost automatical y. Some customers might have to be nudged with a fax or a phone cal , but that was about al it took. Accordingly, once Bobby and Helene had a broad enough customer base, they’d know they were going to get enough sales to break even. The question was, how big a customer base did they need to get there? Wel , if you know that regular customers reorder at more or less regular intervals, you can translate the number of customers you have into a specific volume of sales. That is, you can predict how many sales you’re going to get from this customer base over a given period of time—say, the next year. Not that you’l get the same sales from this group month in, month out, but the good months wil tend to offset the bad ones. And because
we knew Bobby and Helene’s gross margins, expenses, bad-debt ratio, and how long it took them to col ect their receivables and pay their bil s, we could also predict the cash flow those sales would generate.
If you can establish the correlation between cash flow, sales, and some other factor, you can determine critical mass very easily. You simply work backward. With Bobby and Helene, we knew the monthly cash flow they had to have, on average, to make their business self-sustaining, and we could translate that figure into average monthly sales. Then we just calculated the size of the customer base required to produce those sales. That was their critical mass. As soon as they reached it, they wouldn’t be depending on Helene’s savings to bail them out anymore. They’d just have to maintain their customer base, assuming there was no fundamental shift in the business.
After critical mass, growing a business becomes a matter of choice. That is clearly a huge change from before—a predictable one, and a good one, but a change that has major consequences. It opens up a whole world of possibilities that you couldn’t even think about during the start-up phase. As long as you’re surviving on external capital, you real y have to focus on building the business you started to build. You have to be very careful, for instance, about experimenting with new products or services, at least until you’ve expanded your basic business as far as it can go. You can’t afford to experiment. You don’t have the time or the money. It goes back to those rules I talked about, al of which stem from the fundamental fact that you’re living on limited capital. You have to do everything you can to reach viability before your capital runs out.