This article, Financing a Company the Startup Way, was written by Scott Bergquist of Silicon Valley Bank for CFO.com and is reposted here with permission.
Outside equity capital is commonly used to fund an entrepreneur's vision. While an attractive strategy for many, the truth is that most businesses do not source venture or private-equity dollars. Rather, many savvy entrepreneurs bootstrap and aggressively manage cash positions to increase and extend precious liquidity for growth. Such "internal" financing strategies can help propel start-ups, but they also work for later-stage businesses. Here are some ways to tap existing business to fund growth.
Manage working capital like your life depends on it. Working capital management (cash, receipts, payments, and inventory) is a critical success factor for businesses because it determines overall cash position. Cash is the only thing that will retire debt, pay employees, pay vendors, and return investor capital. Over the years, I have seen countless examples of companies with enviable revenue growth and profitability, but they were essentially broke because they failed to manage cash outflows relative to inflows.
Among the low-hanging opportunities to save cash is the discounts offered by some vendors for paying early. Many vendors offer a 2% discount if an invoice is paid within 10 days (i.e., "2/10, net 30" payment terms). Assuming a recurring monthly vendor payment of $1,000, a 2% discount is worth $240 per year. But what if the company doesn't have the money to pay so quickly? Assuming forthcoming revenue and receipts, many companies will borrow against them to capture the discount, which is a classic use for a working capital revolving line of credit. Assuming average monthly borrowings equal to the vendor payment, annual borrowing costs would be approximately $100. So, the company still gets $140 of free money.
Managing to "low or no" inventory is another strategy. There are ways to balance client demand for stock-keeping unit range and availability, with smaller absolute inventory levels. In addition to freeing up liquidity, doing so addresses costly space needs, shrinkage, obsolescence, and perishability. There are two techniques worth considering. The first is drop ship, a supply-chain management solution in which the seller does not keep goods in stock, but rather transfers order fulfillment to the manufacturer or wholesaler. This technique not only eliminates the carry cost of inventory but also creates a "positive cash flow cycle" (i.e., the customer pays the company before it pays the manufacturer or fulfillment agent). While gross product margins will contract because of the middleman, net operating margins can be greatly enhanced.
The other technique is "just in time," which tries to match, as closely as possible, inventory levels to client purchase orders. Originally introduced by Japanese auto manufacturers in the 1980s, the strategy has evolved and expanded across different industries. Amazon is a recent example: its high-speed, high-quality printing technology allows it to "print on demand." By using this technology, Amazon doesn't have to stock all 2 million of its book titles, but it is still able to meet next-day delivery expectations.
Focusing on the interval between when a customer is invoiced and when it pays is another strategy. Shorter days sales outstanding— a measure of the average time between invoice and payment — equals cash. That's why many companies offer the discount for fast payment discussed above.
A simple, no-cost path to reducing DSO is a monthly calling plan with clients. On the 15th of the month, call to inquire about product and service satisfaction, but also confirm invoice receipt, amount, and intention to pay. Remember to document the call, including contact names and titles. On the 30th of the month, call to verify payment sent or received. This calling plan is particularly important for first-time, recurring customers, as they will be quickly trained after a couple of cycles. Assuming the same sales level, each $1 reduction in accounts receivable goes straight to cash.
Get some revenue, quick. Product development can be expensive, but so is manufacturing, marketing, selling, distributing, and supporting a product. Each requires capital investment, often before revenues and cash flows are available or sustainable. The venture model can solve this, but what happens in the absence of significant outside investment? In those cases, a company has to try to front-load revenues and self-fund some capital requirements.
Before a company invests capital in project development, it should consider a revenue model with low entry costs. Practically speaking, this means delivering a fee-based service that will provide two things: low-cost capital to fund product development and prospective clients for that future product or platform. The classic example is an IT service company, such as a systems integrator, that develops a complementary, proprietary software program. After revenues fund development of the program, the company can choose to remain in the services business with enhanced margins (given the product features) or simply license the product to others and exit the less-scalable services side.
License or royalty revenue is a solution for companies that are unable to bootstrap through commercialization and the incremental expenses — manufacturing facilities, raw materials, inventory carry, distribution, and extended payment terms — that come with it. An option at this juncture is to simply license the product or technology to others and receive a stream of high-margin royalty payments, which can be reinvested in a design team to develop version 2.0. Result: a quick path to revenue, with a comparatively modest capital investment.
Maintenance contracts are another potential revenue source. Such annual and multi-year service agreements tied to product sales represent an obligation (deferred revenue), but also provide a company with flexible, inexpensive funding for future research and development or growth capital to scale the business. Assuming the product is relatively stable and adds real value, operating costs to support the service-level agreement will be modest and contract renewal rates will be high, providing a predictable level of recurring liquidity.
Rent, don't buy. A final recommendation: resist purchasing resources that can be rented or outsourced. The recent development and adoption of "variable" expense options has dramatically altered capital strategies in the start-up world and could have a material impact on any company. For example, cloud-based software and infrastructure solutions allow companies to rent only what they need, allowing capital plans to be more efficient. By increasing predictability of the operating model, you can redirect idle dollars into enterprise-building initiatives.
Included in this realm are personnel costs, which can be the largest line item on a company's income statement. Full-time equivalent employees are very expensive and reduce flexibility, particularly for start-ups. Companies should focus on key hires in their value-add positions, such as software engineers or salespeople, and rent or outsource infrastructure positions such as human resources, finance, and support. By choosing the right partner, and holding them accountable to a specific service-level agreement, quality improvements can also be recognized.
Physical space is a significant expense as well. Start-ups are creative about locations, finding co-working facilities: a cost-effective way into a professional, collaborative environment without the overhead costs associated with long-term rent or leases on office space.
For finance chiefs who spend their days looking for ways to reduce costs, tighten their belts, and bootstrap their businesses, following the lead of start-ups can result in not only increased liquidity but also more financing alternatives to help fuel a company's growth.
Scott Bergquist is the central U.S. division manager for Silicon Valley Bank, overseeing business development and client relationship activities with 2,000 companies and managing more than $1 billion in committed capital. He specializes in financing solutions for high-growth technology and life-science companies.