budget and planning
Sunk costs ~ how to evaluate futher investment
It’s natural to want to recover costs already sunk into developing a project or idea, but if you’re having to make the decision to continue and invest further funds ~ should you free your decision making from the burden of money and time already spent?
Read Fred Wilson’s thoughts as a VC.
Investment Readiness … using MyCake to help you prepare
If you’re preparing your business plan for discussions with investors, banks or other backers you can be sure that you’ll need to be able to show some quite detailed financial projections. Ultimately this means getting to grips with Excel for those delightful 12 month detailed cash flow forecasts and 3 year financial plans. But the good news is that you can use the data you hold in MyCake to do some scenario planning and ‘what if’ thinking before you start on the heavy stuff.
Here’s what you need to do to get started:
~ 1 to 3 prior years of data … entered either through the book-keeping interface if you’ve been using this to manage the minutiae of your finances or entered through the benchmark annual summaries if you want to add prior years quickly and simply (and don’t need the details of every invoice or receipt)
~ Once these data sets to have been ‘approved‘ you can look at the results section
~ click on the results section and pick say 2008 or 2009 as the annual data set to look at. Click on the graphical results button.
~ of the three types of results information the two key pieces for this activity are the ‘what if’ and the ‘spread sheet’
What if?
What if…
Investors will expect to see a set of scenarios that looks at both better and worse than expected growth. In reality they’ll head straight for the worst case examples and probably calculate yet worse scenarios!
Here are some scenarios you could look at:
- growth of income by 10%, 20%, 50% and 100%
- reduction of income by, 10%, 30% and 50%
- increase of cost base (for a major item such as production or wages) by 30% … do this both for the income growth and the income reduction scenarios
One of the things you are looking for is the breaking point of the business … ie how bad can it get and yet you still survive. I realise this sounds like a negative view on things but success is a good problem to have (and probably means you can throw money at resolving it) where as haemorrhaging cash and failing to achieve income is significantly more painful for you and is a risk that investors would like to avoid (and will also want you to have done risk planning so that you know what to do should these circumstances arise).
When you do ‘What if?’ scenarios it is also useful to write down any assumptions you make. So if your largest client is worth 30% of your annual income one of the scenarios you’d want to look at is what the impact on the business would be if you lost them – would you reduce your staff costs? Would directors take a pay cut? Would you cut an R&D budget? You should also consider how long it would take to replace the client and whether or not you could expect to replace them with one large client or several smaller ones? These assumptions will also have an effect on the speed of financial recovery of the business.
Once you’re getting to this stage you need to be running the cash flow scenarios in excel so make a note of the outcomes on the ‘what if’ page and start translating this into an excel sheet.
MyCake spread sheet
Spread Sheet:
One place to start when putting together the detailed excel stuff is the spread sheet results page in MyCake. Here you can see not just your Profit & Loss sheet for a year (or quarter) on a line by line basis but you can also see how it stacks up against the best and worst in the sector.
You can use this benchmark data to help you build those detailed scenarios of best and worst cases as well as use the information to discuss with investors (especially if you have a financial structure that puts you in the ‘Best’ category for income or key costs). Evidence that demonstrates that you are ‘Best in class’ is always a good carrot to offer an investor!
Should I bet the house?
First of all let’s make a distinction between gambling the equity in your house unwittingly vs. agreeing with a bank that your house is security on a loan.
In the case of the former I’ve seen examples of entrepreneurs using either their credit cards to fund the business or telling themselves that they are making an investment in the business when they write cheques against their mortgage to cover costs of a loss making enterprise. Many do the first example and recover; the latter is more dangerous as you are increasing your debt but have a reducing capacity to pay it back.
But what about knowingly using your house? I’d like to look at how you evaluate the decision as to whether to use your house as security against a bank loan…
Under what circumstances would you be asked to use your house as security?
Well if you want a loan rather than an overdraft from a bank it is not uncommon for them to want security against the monies lent. The most common form of security is a ‘personal guarantee’ which essentially means that any assets you have could be seized by the bank to pay back the debt should you default on the loan.
If you are seeking venture capital investment then investors like to see you have some ’skin in the game’ ie investing some monies into the development of the business at the same time as they are providing the main funds (your previous investments don’t count at this stage as these are essentially sunk costs that have already been accounted for in the growth to date and the valuation of the company). However these sums are likely to be less than 5% of the total funds raised and VC’s know they are asking for a ‘gesture’ rather than a significant investment. It is much less common for VC’s to ask for a personal guarantee.
Is your business worth the risk?
Well at the end of the day we can’t answer this for you but here are a few things to consider….
- if you have a clear budget as to how much income you need to payback the loan and you’ve already accounted for the ‘what if’ scenarios of increased cost but reduced income and you can still see how it will be paid then these are indications that the business is likely to be able to pay back the loan.
- if you are in need of working capital to develop the business to a point whereby the income will start to be able to payback the loan but at the moment you can’t see what the revenue stream or scale of income would be that would have this capacity then you are considering taking on a debt without a route to payback and this is more risky.
- if you have other sources of income and or savings and investments that you could use to payback the loan if the business was not able to then whilst you are still incurring the risk of losing the monies you put into the business but you do at least have a backup plan.
You might also look at the stage of development of the company/product. One key question when considering any investment into the business is whether or not it is sufficient funds to get you to market (and thus achieve income to pay off the investment). Typically entrepreneurs invest at the very earliest stages when the ability to achieve revenues from products and services sold are at their lowest ie when the risks are greatest; furthermore it is all too easy to under-estimate the cost and time involved in getting to market so inevitably there are stressful patches when you need to progress faster than funds will allow.
It is at these points that you need to take a bit of care … as you are likely to feel that ‘if only we had x,y,z’ then everything would be ok … you risk making non-rational decisions based instead on your emotional involvement. To help avoid this scenario again the answer is a budget looking 12 to 36 months ahead where you can see where the pinch points will come and therefore can make plans ahead of time as to how to resolve this … asking for credit from suppliers or for early payments from clients are both ways to avoid seeking loans or equity investment when you are at your most vulnerable!
If you have a partner or other source of income into the household then again whilst you are risking the money you may be able to avoid not losing the roof over your head!
Can you afford to be free?
There’s a lot of talk about ‘freemium’ business models, particularly when it comes to internet businesses so we thought we’d do a piece looking at a few of the considerations that matter if you’re trying to work out whether freemium would work for you or not.
When do businesses offer their main product for free?
- when they can offer the cut down or lite version for free but charge for increased functionality e.g. many of the software as a service (SAAS) offers such as huddle.net … so really the free version is to entice you to use it regularly at which point you’ll need the paid for version to meet your increased needs
- when use of the free product gathers data that the company can sell on
- when the free product leads to sufficient site traffic to enable them to make substantial revenues from online advertising.
Can you afford to be free?
- Let’s be clear on this – you need to achieve a sustainable income stream for your business at some point (otherwise it’s not a business, nor is it social enterprise, it’s altruism)
- Many of the companies who started out giving their product away either had financial backing or a very low cost of production at the start
- Plus if you’re smart you’ll have either a fully worked up plan as to what you’ll charge for or at least a plan to work out what you can charge for once you get going! You’d be daft to do freemium on a ‘suck it and see’ basis
- Do care about attracting a user base early (ie do be in the market early, particularly if is an online offer) as this will keep you pushing the company to develop. But do consider users as customers not just a marketing route ie don’t only look at user figures and site usage, have income in there as a key performance indicator (KPI) … this means that even if you’re not charging for it consider what you would charge and calculate the ongoing cost of the opportunity ie if they were paying this user base would now be worth £X/month (make some assumptions about what proportion of the user base would pay and be conservative in this figure) … looking at the income you’re not getting is one way to see the cost of your chosen path and set levels at which you trigger launching other (paid) versions.
Do you need to be free?
- The one time in particular where being free has been shown to be utterly crucial is in order to do a ‘land grab’ in the marketplace when the market is expanding and changing rapidly and when, once the market has set up, the barriers to entry will rise dramatically e.g. Amazon or Lovefilm where the cost of establishing the distribution centres was very high but resulted in close to a monopoly position in the market a couple of years down the line
- If you are moving faster than the market is developing (and this looks set to continue) then a land grab probably isn’t necessary. If the market will remain a fragmented one again a land grab has little to offer
- If your market is on the cusp of rapid expansion and you could get left behind then a land grab may be a sensible thing to consider (assuming you can raise the finance to support it which will in turn depend on the profits to be made in an expanded market).
If you’re free to start with will you convert people to paying later?
- Businesses that offer a free version tend to be pretty clear on what they will charge for even it if takes a few years to develop the user base to a point where they value it highly enough
- You need to be able to demonstrate to yourself (and to others) that what you offer is valuable enough to pay for ie there is a need and it’s more than just a nice to have.
And as a last point to consider … why put off revenues until tomorrow if you can have them today (and thus use them to fund your growth)? That is to say just because the big guys do freemium doesn’t mean that it’s a market entry requirement universally nor does it mean that you’re more grown up than the other SME’s around you!
In summary – see if the market will demand it of you and if it doesn’t think hard about whether foregoing revenues helps or hinders your growth plans.
how do I ring fence monies for research and development?
Having decided to invest research and development to build your creative business, how to you ensure monies set aside for R&D are used correctly?
Well the main thing is that you need to make sure that you actually spend the time and money you allocate. It is all too easy to prioritise paying clients ahead of your own development. In the short term this is not too surprising but it is the long term sustainability that we’re really interested in. Here are some tricks you can employ to develop a better balance between short and long term business gain:
- Treat R&D projects as if they were client contracts ~ so set deadlines, allocate staff (good working time not evenings and weekends) and report on them in team meetings and/or to your mentor or business coach
- Ring fence the funds in a budget and report on actual spend on R&D vs the allocated budget
- Set a target for the number of new ideas you want to generate in the first round … perhaps incentivise staff, freelancers and associates to contribute to this
- Aim for not more than three ideas to develop and pick a mix of low risk, quick and cheap to develop alongside bigger vision, more costly and long term stuff
- Perhaps involve a client as a test case and therefore make yourself accountable to them for deadlines. Make promises that you have to keep
- Make a director responsible for R&D just as someone is responsible for finance or marketing or HR
- Write it into people’s job descriptions and rewards packages
- Plan to phase out some of your older products or services and set dates by which you want this to happen. This means you’ll have to replace them with new things and will speed up the process
- Make income projections that include the new products and services. At least some of this new income will go to pay staff and overheads but perhaps it will also result in a pay rise for the directors
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Extract from the fourth MyCake Benchmark Bulletin which looks in depth at research and development ~ why it’s important for creative businesses, how to fund it and how to make best use of your R&D spend.
Download the full report here.
The Cost of Time
In order to set the price of creative goods and services, you’ll need to know the costs involved. Obviously you cannot afford to sell things for less than they cost! It’s useful to know the break-even point, if only to set an absolute minimum price. As the price goes up from there, so does the profit.
But what are the costs of producing creative goods and services? The direct costs, for example materials, are usually quite obvious and relatively easy to calculate. Fixed costs or ‘overheads’ have to be covered too. These overheads have to be covered by generating income from sales. Each product sold or fee invoiced needs to ‘make a contribution to overheads’.
However it is often the case that one of the biggest costs involved in a creative enterprise is the cost of labour – in other words, the cost of your own time.
So we need to know this cost too, so that we can build it in to the price of products and services. Without this information we cannot know if we are breaking even, selling at a huge profit – or making a loss on every sale.
It would be crazy to sell products without knowing the cost of the raw materials used to make them. Not knowing the cost of labour – which is often greater than the materials involved – is an even bigger mistake.
I suggest that creative entrepreneurs keep a track of their time so that they can allocate this cost to particular products, projects and the general running of their businesses.
Ideally we would like to have precise details, but this is virtually impossible. But that doesn’t mean we shouldn’t do anything!! Even approximate information is really useful. Just having a pretty good idea of how much time is spent on different aspects of the business can be extremely enlightening. It will help you to understand the economics of your enterprise, which is crucial.
So this is what I suggest:
1. Decide your hourly rate. How much are you worth?
2. At the end of each day, jot down approximately how many hours you spent on particular products, projects.
3. Other stuff involved in running the business needs to be counted too: marketing, administration and tidying the studio.
4. Record time as precisely as possible, ideally in 15 minute chunks, though this doesn’t mean you have to stop every quarter of an hour! At the end of the day you should be able to look back and say you spent two hours on A, half an hour on B, and three hours on C, for example.
5. Then allocate a cost to that time invested in each product or project, based on your hourly rate. This will mount up and you can include the full cost when you are calculating prices.
6. The cost of time spent on admin etc needs to be counted as well. This is then added to the cost of your business overheads, alongside things like rent, phone, insurance etc.
Doing this will help you to understand how your business works financially. It can be very enlightening. It will probably mean you reconsider your prices. It might even mean you change your business more fundamentally.
In short, you cannot afford to ignore the cost of your time.
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Further information about financial matters for creative entrepreneurs can be found in the T-Shirts and Suits blog.
Learn more about financial matters on the T-Shirts and Suits Creative Enterprise Network – a free international network of creative entrepreneurs sharing business ideas and information.
Finance is one of the business issues covered in the book ‘T-Shirts and Suits: A Guide to the Business of Creativity’, which is also available online as a free eBook.
Copyright © David Parrish 2010
www.davidparrish.com
Advice for the Recently Redundant
This is the first in a series of posts for those who have recently left the corporate world and are considering their alternatives. We will make a number of assumptions about such folks including:
- you have 10-20 years experience
- demonstrable success in your chosen field and a clear skill set be it in sales, marketing, logistics etc
- your skill set is complemented by management experience – perhaps a national or international sales manager or country/regional manager
- this means that you’re used to budget responsibility
- you’ve negotiated a redundancy package that has bought you 1-2 years breathing space
- nevertheless you have a personal overhead base (Mrs Moneypenny’s descriptions of her children as ‘cost centre 1′ and ‘cost centre 2′ comes to mind though there are those for whom this may translate as a yacht instead!) and therefore will need to find an income stream or two … and anyway you’d be bored if you didn’t
We won’t look at the corporate choices you could make afterall that’s what you’d work with a head-hunter to review. Instead we’re going to look at how you might apply this skill-set in a number of other ways and how this translates into the development of a set of income streams. In particular we will look at:
- the corporate bod turned consultant approach to leveraging your existing skills and network into an income
- the senior manager turned non-exec board director with portfolio of SME boards to sit on
- being helicoptered in as part of investment package to an SME … the angel or VC’s board representative, with or without an executive role
- starting your own business either in the sector you’ve been working in (thus leveraging your network and your knowledge of the supply chain) or in a.n.other sector of your choice
- looking for a senior role in a small but fast growing company that needs to boost its management, sales, marketing and finance skills (these are the most common holes that need filling)
We might also touch on the way you can use money and skills as an angel investor in other businesses. We will no doubt also cover some of the misconceptions and traps that people commonly fall into.
First of all however you have the challenge of becoming a little more self-sufficient i.e. now that the IT department isn’t there to keep your laptop running there are practical issues you need to solve quickly and with least hassle so that you come across as professional in this wider world of business and entrepreneurship. So lets answer a few of the commonly asked questions:
- Yes, you do need a business card. No you don’t need to hire designers or printers nor do you need to worry about logos. There are many DIY business card tools online that will send you printed cards as the output. We are fans of MOO as the cards are good quality (cardboard not too thin), the templates are simple and if you want something either with a logo or a picture on the reverse you can just pick from images you upload to flickr.
- No, you don’t necessarily need a title. If your qualifications indicate an expertise that you will be making use of e.g. chartered surveyor then sure put ‘Chartered Surveyor’ under your name on a card. However if you’re not really sure what you’re going to do and might put your toe in the water with a few different approaches why bother to have a title at all. Just explain yourself when necessary. Indeed picking a spurious title may in fact be off-putting … for ‘Independent Consultant’ read ‘freelancer’ for example.
- Yes you need a laptop, mobile phone and (depending on where you live) car. On the whole people you’ll meet won’t actually care what make or model of hardware you’re sporting. They are not signifiers of status in the SME or entrepreneurship world. In fact we’ve come across cases where driving a Porsche will lose you business because the client interprets it as a sign that the driver is spending the fees they are being charged on this not on the products and services being delivered.
- Now that you don’t have the support of an IT department you will need to get better at looking after your kit. You might want some help on this one. The big names such as PC World will gleefully sell you service contracts by the likes of Geek Squad but, as with most other forms of insurance they make their money on the monthly contract that you promptly forget and don’t use. In the last few years a whole lot of small firms have sprung up who operate on a very local basis and provide technical support to SME’s. For example, Axos Assist work within a 25 mile radius of Thames Ditton. You may not need a service contract but just knowing who to call to fix the crash/delete/panic is very useful.
- You may need a CV but it will look different to one you’d use to win a corporate job. A CV is after all just a calling card and a summary of skills. There are things which can work just as well e.g. a report you’ve written on a sector or challenge, a piece of research you’ve done (which by the way will probably necessitate you calling a bunch of people you’d like to meet anyway to pick their brains and later report back to them the findings). The key point to think about amongst all this practical advice is WHAT DO YOU WANT TO BE KNOWN FOR? or put another way what work would you like to get paid to do and why would someone buy you rather than anyone else they meet in the street? Do you want to get paid to do, to think, to challenge people, to innovate, to invent???? Have a think on that. It is the answer to these things that needs to sing out from your CV, report or other calling card (by the way you might want to be known for several things, that’s fine, you just need several different calling cards … you are no longer defined or limited by your job title!).
- You will undoubtedly need to meet more people so work out where they hang out (both online and offline). If your network has essentially been your sector colleagues and clients and your internal colleagues then there are bound to be gaps. A paid membership of Linkedin might work as it will allow you to introduce yourself to people. For some sectors Facebook is used as a business tool. There are almost certainly networking groups in your area .. try a few out (do you really want to commit to a year of once a week 7am breakfast meetings without knowing who attends?).
- The sooner you can get to a point of feeling comfortable explaining where you’re at now and the areas you’re exploring the sooner you’ll find ways to explain to others how the skills you’ve acquired corporately translate into value in other settings. You’ll also find that many outside the corporate world have a certain amount of reverence for ‘big business’ which may come as a surprise to your inside track on the political machinations, time wasting and general mismanagement that you’ve seen along your way
- You might want to make use of something such as Tactile to keep track of the business leads you meet … you don’t necessarily have to treat this just to track ‘customer’ leads but you do need a way to view the strands of discussions you’re pursuing.
- Find 2-3 people you can talk to about the routes you’re considering. These might be people who’ve been self-employed for a while, entrepreneurs, family friends etc. They probably won’t be corporate colleagues. This simply because unless they’ve worked out side corporates they won’t have much understanding of the challenges you’re now facing. You want a few people around you who have working knowledge of your new world. People you can use as a sounding board for new ideas or simply to act as a pick me up when you’re having a tough patch.
This is a bright new world you’re entering, freed from the shackles of hierarchy and the gag of the PR team. All you have to do is work out what role you now want to play, who would value this enough to pay you to do it and where you find such people. We’ll come on to that and the business models you’ll need to consider in the next post.
Financial support for your business
Naturally, most people are interested in any financial support for their business.
As a creative business adviser, I have helped hundreds of creative entrepreneurs over the years. Often, their enterprises are receiving financial support – from themselves !
This is because they are not taking into account the cost of things like use of a family computer, personal mobile phone, a back-bedroom office, or car. By ignoring the cost of these essential resources, they become ‘hidden subsidies’ to the business.
Ironically, as a result, these businesses lose money.
One effect is that they pay more tax because they seem to be making more money than they really are as a consequence of not including all their business costs.
More seriously, they often lose money because they charge customers too little. By ignoring these hidden costs, they kid themselves that the price they charge customers creates a profit. But when I help them to calculate and understand the full costs of their business, we often find that the price charged is too low to cover all the true costs of the enterprise.
This problem comes to a head when they need to buy new equipment and there isn’t enough money in the bank account – because they haven’t put money aside to acknowledge the depreciation of computers, cameras or other equipment.
As the business grows, its unprofitability becomes clearer. The true costs come out of the woodwork as the creative entrepreneur has to write cheques for office space, software, transport etc – things that were previously provided free by family, friends or themselves.
So the main reason I urge people to calculate all these hidden costs is so that they fully understand the economics of their business.
I find that those creative entrepreneurs who do this are the ones that charge their customers the right prices/fees – and consequently generate enough income to make their creative enterprise profitable and sustainable.
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There’s more about making your creative enterprise even more successful in my book ‘T-Shirts and Suits: A Guide to the Business of Creativity’ (also available as a free eBook) and further ideas and information on the T-Shirts and Suits blog.
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Copyright © David Parrish 2010.
www.davidparrish.com
Budget 2010
Directgov UK, crown copyright
The Chancellor delivered his Budget statement yesterday. There is mixed news for small businesses and self employed. Here are the highlights:
- no change to VAT, income tax and NI
- no increase in capital gains tax
- tax allowance for entrepreneurs
- business rates cut
- investment in low-carbon industries
- support for small businesses to boost skills and innovation
- Small Business Growth Fund
Business Link has a guide to How will the Budget affect your business
and here is a list of sources for business analysis, how it affects you, and copies of the full Budget speech and Budget report:
What business risks should you care about? free planning tool
How can you work out what the threats to your business are, how to recognise it if they happen and make plans to minimise the impact of these risks? Here are some tips from MyCake on conducting a risk assessment, and look out for the free download at the end of the post.
Most large businesses plan for such eventualities and put processes in place to lessen the impact should they occur. Sometimes this means training of staff, succession planning for senior roles and sometimes it means building a financial reserve to pay the costs of rectifying a situation should it arise. The principle applies to small businesses as well though the processes are probably a little simpler. Here’s how we suggest you go about it….
What are the risks your business faces?
- What or who does your future depend upon for success?
- Which of these do you have control over? … consider both factors which are internal to the business and those which are external (you probably have less control over the external ones)
- Are these factors stable or in flux? (i.e. is it actually a risk or is it stable)
- For those in flux what are the chances of a change for the better or worse? (i.e. risk level)
- What are the impacts of worse? (i.e. potential impact)
What can you do about these risks?
- How would you know if it were heading that way (i.e. what are the markers?)
- How could it be averted?
- What is the contingency plan?
- What would the costs be if you had to rectify these challenges? (consider what it would cost if you nipped it in the bud vs. if you caught it later on)
Here is a Risk Assessment Table for you to make use of so that you can look at all your risks, prioritise the ones you need to prepare a solution or contingency plans for and share the plans with your team. You could also use this approach to brainstorm the risks with your team as you might perceive the risks and solutions very differently.
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