You may be launching your enterprise on a shoestring, which is doable, but underestimating the resources you will need to keep going while waiting for revenue to stream in can quickly shut you down. Failure to prepare for unexpected expenses may find you burying your business in debt. Financial Adviser Anthony J. Domino, Jr., a managing partner at the New York area-based firm Strategies for Wealth, encourages startups to properly capitalize their ventures before opening their doors for business. In this discussion, he lays out some basic ground rules for determining how much you need to stay liquid.
How much capital does a startup really need? What should the entrepreneur consider when determining this amount before launching a business?
A startup needs every bit of capital they think they need, and then more. All businesses use different metrics and require varying amounts of capital, but rarely do the uninitiated gauge properly. Most entrepreneurs can accurately predict initial startup costs. Generally, those should be increased by 70 to 100 percent for the ‘inevitability’ that ramp up time is longer than expected and the ‘contingency’ that launch is not as smooth as hoped.
Can you recommend a formula small business owners could use to determine how much should be kept in cash reserves to ensure adequate cash is available to meet needs? What types of accounts are best for holding these reserves?
A good gauge is at least six months of operating expense in reserve at all times. In the very early stages, it is a good idea to keep another three months liquid. Much depends on how long the sales cycle is and how long before revenue is realized. Note, this is not the same as sales being made.
Typically, very liquid or easily pledged accounts should hold reserves or capital that is expected to be deployed soon. Retirement plans can be a source of quick equity via participant loans. A good line of credit for backup purposes never hurts either. Reserves should be kept in demand or money market accounts; no reason to subject them to market risk.
When facing unplanned expenses, such as emergency repairs, what factors should a business owner consider when deciding between obtaining short-term financing or dipping into reserves?
Develop a comfortable working knowledge of the financial concept of ‘opportunity cost.’ Borrowing at five percent when you have a 20 percent profit margin makes sense unless it takes four years to realize your profit. The money you spend or invest is like the splash of a stone into a pond. The effects are immediately evident. Nonetheless, the environment is more impacted by the ripple, the long term effects felt by the initial splash.
This article was written by Gillian Burdett for Small Business Pulse