Using Your Own Money to Grow
Entrepreneurs generally have their sights set on rapid and prolonged growth of sales and market share in their targeted market space. But the way to go about meeting that objective is always the pressing challenge for the typical emerging enterprise.
Sometimes the market is so ready for the new venture's product or service that keeping up with customer demand actually becomes a problem for the business. This can often happen without much of a concerted marketing effort or highly detailed advertising and promotions plans. It's all about being in the right place, at the right time, and with just the right price relative to the competition.
In other situations, an entrepreneur develops and implements a very specific strategic plan and then navigates the company on a long-range course to meet targeted milestones in sales and volume over time. In this case, it's all about maneuvering across the competitive landscape, one new account or distribution channel at a time, on a calculated and incremental growth-curve.
Regardless of the type of growth scenario you're involved in, the question that is often left unanswered is how you're going to pay for that growth. Remember, increasing sales revenues and moving greater volume out the door is expensive. Here are the major expenses you'll encounter when trying to grow your company:
- Recruiting, hiring and training new employees, both regular staff and managers
- Increased customer service and support for the new buyers
- Increased advertising, promotions and marketing budgets
- Buying materials in larger lot sizes leading to larger total invoices
- Increased administrative and other technical and office support
- Increased information technology capabilities and IT support
- Increased manufacturing capabilities (for example, machinery, equipment and vehicles)
- More floor space in offices
- More floor space in manufacturing and production areas
- More floor space in warehousing and shipping/receiving
Expanding your company requires capital to pay for all this new infrastructure. The plain and simple fact is the money will have to either come from within your business, or from sources outside of it. Expansion with internally generated funds can be a very difficult process to plan for and realize. The main consideration is whether there'll be sufficient room within the normal internal cash flows to pay for the expansion outlays.
First, you have to determine whether your business model has sufficient "margin spacing" to support cash allocations toward growth. Margin spacing refers to the capacity of your business's gross profit margin and operating profit margin to accommodate contributions toward expansion-oriented allocations, outside the normal flow of daily operations.
It works like this. Let's say you have a product priced at $100 with a cost of goods sold of $60 and a $40 gross profit (40 percent gross margin). After your normal fixed overhead is accounted for, you have a 20 percent operating margin on a pre-tax basis. Assuming 35 percent will go to taxes, you end up with 13 cents net after-tax profit for every $1 of sales. Next, add back in any depreciation deductions, and that result is your net after-tax cash flow (ATCF).
You can then calculate how much of that ATCF will be distributed to your shareholders and other investors in the form of cash dividends, if there are any. The remaining ATCF balance is the net available for investment (NAI). Whatever this dollar value is, it's then divided by the total revenue to find a percentage margin. Looking back on our example and assuming the total dollar-value depreciation has been factored in and a certain cash distribution is made to the shareholders, you might have an NAI of 10.25 percent (margin on sales revenue).
You must now make reasonable projections of sales revenue on a quarterly basis over the next two to four years, depending on the length of the growth "window" being planned for, and then apply an expected NAI to that. This will create a map of the ATCF that's available for investment into expansion spending. The NAI margin must be shown as a component of the gross margin, operating margin and net margin for your company in order to chart the margin spacing or free cash flow that should be happening at each stage of the profit and loss statement. When a gross margin gets reduced due to price decreases and/or labor and material cost increases, the margin spacing for eventual NAI is also reduced. The same can be said for much higher overhead, which also reduces NAI spacing. On the other hand, if your production costs can be reduced with steady or higher prices, or overhead can be reduced disproportionately compared to increased sales, your NAI margin spacing will increase.
You'll have to compare your quarterly projected NAI from sales and all operating cost projections to determine whether the margin spacing is sufficient to generate funds for your expansion "wish list" of new purchases and investments. If, over time, the NAI can be matched to the expansion allocations, then you may not have to seek outside funds to move forward with your growth plan. But if the NAI can't keep pace with the planned uses of funds scheduled, then you'll have to consider raising external sources of capital in order to stay on track with your expansion plan.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine, and has contributed to publications including Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc., and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.
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