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On The Money

Figuring out how much cash you really need to start your business
April 20, 2006
URL: http://www.entrepreneur.com/article/24718

Entrepreneur magazine, September 1998

Anxious to start turning a profit, entrepreneurs often launch their companies without carefully estimating the amount of capital they'll need to actually get started. Many insist passion and enthusiasm will be enough to get them through the rough periods. "Passion and dedication are important," agrees Marge Lovero, president of the Entrepreneurial Center Inc., a business training and consulting firm in Purchase, New York, "but unfortunately, they can't pay the bills or keep you alive during the start-up months."

Lovero recommends new companies start out with enough capital to cover projected expenses for at least six months. "It's foolish to expect to generate revenue immediately," she says. "It's best to play it safe and plan for all contingencies."

The type of business you start plays a critical role in determining the amount of start-up funds you require, says Lovero. "A retail business, for example, can regenerate revenue immediately, whereas service businesses typically have to wait between 30 and 90 days before they're paid," she explains. "These facts give you some idea [as to] how much working capital you'll need during the early months."

The following four scenarios provide a window into situations you may someday face-and might help you avoid mistakes when predicting your start-up expenses.

Bob Weinstein is the author of 10 books and is a frequent contributor to national magazines.

Proceed With Caution

Nick Yonano, 31, spent his money carefully when he launched Tea Body's Inc., a Turlock, California-based gourmet iced tea company, in 1995.

The former attorney financed his company through his savings and modest borrowing from friends and family. His vision? To develop iced teas and market them to specialty food stores throughout the United States. To achieve that end, he watched his pennies, meticulously planning each step.

The tough part, he says, was determining how much money he'd need. "The idea was to eliminate nonessential expenditures," Yonano says.

When he reviewed his estimated costs, he figured $60,000 should allow him a modest start. So he sold his Porsche 911 for $18,000 and tapped into his savings. Soon, he was in business.

Yonano's most significant costs were in product development. "About half the start-up money was apportioned to buying quality teas," he says. The rest of his costs were allocated to marketing, promoting and packaging.

It didn't take Yonano long to realize that his business would cost more than he imagined. Originally, he thought he could finance his company's art, graphics and logos for around $5,000. But once he began getting estimates starting at $25,000, he increased his own estimate to between $10,000 and $15,000. Fortunately, Yonano was able to find an artist who worked from home to create the graphics for his fledgling company. The job's final cost: $12,000.

And when it came time for market research, rather than paying rates of up to $10,000 for the help of an expert, Yonano did it himself for only $1,200.

Rent? That was easy: Yonano converted his garage into a blending facility. Later, he moved to a small, rent-free office in his parents' company until he could afford the $600 monthly rent payment for his first official office.

Even with such meticulous planning, $60,000 in start-up fees barely covered it. To keep the company afloat, he borrowed $20,000 from his parents.

Today, Yonano's cautious financial strategy is paying off. Last year, sales jumped 250 percent, from $50,000 to $175,000. This year, he's confident sales will reach the $300,000 mark.

Even though things are looking better, Yonano is still a cautious pragmatist when it comes to projecting his finances. To save the business money, he didn't take a salary until last year. "My salary ranges between 2 percent and 5 percent of sales," he says. "I plan on keeping it that way until we're well on our way."

Wake-Up Call

As careful as Yonano was in estimating his start-up costs, entrepreneur Gerald Chamales, 47, was downright careless when it came to estimating how much money he'd need to launch Omni Computer Products, a Carson, California, manufacturer and recycler of computer supplies.

Chamales launched the business without a financial plan and evaluated his costs through trial-and-error. "I didn't have a clue [as to] how much money I'd need," he says.

With a meager $7,000 in savings, in 1980, Chamales leased an office in Santa Monica, California, and started Omni. He rented office furniture and phones, hired two salespeople, and contracted with a company to label his products and then drop-ship them to customers-allowing Chamales to start quickly without investing in inventory.

But other expenditures crippled Chamales during that first year in busines. "I was paying way too much rent," he says. "Tack on expenses for office equipment and supplies, and I burned through the $7,000 in just a few months."

Six months after launching Omni, Chamales found himself running his company out of his apartment in Venice, California. With just $1,200 left on his credit card, he was forced to rethink his strategies.

"When I was down to the proverbial wire, I wised up fast," says Chamales. "I realized I'd better get my financial act together or I wasn't going to make it."

Fear is a powerful motivator, as Chamales soon learned. "I lived simply and turned everything I made back into the business," he explains.

He says the whole experience has taught him many lessons. "Before you launch a company, [make sure you] have enough money to cover all your projected expenses for a year," Chamales advises.

As for determining accurate cost estimates, Chamales says a good rule of thumb is to assume everything will cost more than you expect. "My telephone bill, for example, was three times higher than I imagined, and the same went for my travel and gas expenses," he says. "Until you're generating predictable sales, you'd better be prepared with flexible money strategies."

After the first six months, Chamales took no financial risks. In fact, he paid himself only $200 a week for five years.

When Omni had moved into the black, he relocated the business to a new office and moved into a small studio apartment to lower his living expenses. "I evaluated every expense," Chamales says. "I was determined to succeed."

And he did, far exceeding his expectations. Two years after starting the business, he had 15 salespeople and hefty profits. Today, Omni employs 275 people and boasts sales of nearly $30 million.

Too Much Is Never Enough

Deborah Simpson had a good idea from the start as to how much money she'd need to launch Santa Clara, California-based MetaSound Systems Inc. in 1996. MetaSound makes cutomized software that programs and plays music and messages for callers on hold.

The former corporate consultant knew she'd need at least $1 million to finance research and development expenses. However, she had to settle for only $300,000 of angel financing-an amount that barely got her out of the starting gate. Six months later, the money was gone and she was forced to raise an additional $1.3 million through angel financing.

Simpson, 41, was prepared to give away up to 90 percent of ownership in her company to secure big returns. But soon she, too, discovered she needed far more capital than she had originally estimated. While the amount surpassed that of most start-ups-software development requires large amounts of capital-the lessons she learned could be applied to all fledgling companies.

No matter how much time you spend estimating start-up costs, Simpson urges entrepreneurs not to follow them like gospel. "Take what you think you'll need and multiply it by 10," she says. "The more you have, the faster you can build the foundation of your company."

Simpson also recommends raising money-even when you think you don't need it. This strategy has certainly worked for her: Last year, MetaSound's sales hit $500,000; she expects they'll jump to $2 million this year.

Where The Money Goes

Smart planning for the start-up years

Tom S. Gillis is a successful Houston entrepreneur who has been starting and selling businesses for more than 50 years. His book, Guts & Borrowed Money (Bard Press), is used by the University of Houston's Center for Entrepreneurship and Innovation and covers the critical stages of running a business.

Entrepreneur asked Gillis for his thoughts on money management in the start-up stage:

Entrepreneur:How do you determine how much money you need to start your company?

Tom S. Gillis: You need enough capital to cover all expenses until you reach the break-even point. You break even when the revenues from customers pay all the expenses, including your salary, with a little bit left over for repayment of debt. But all businesses don't have the same capital requirements.

Entrepreneur:How does an entrepreneur determine his salary?

Gillis: The entrepreneur ought to receive a paycheck only after employees and bills are paid.

Entrepreneur:What kind of bank is more likely to loan money to a start-up company?

Gillis: The key to opening the door to bank funding is a proven record of loan repayments. If you don't have that, the next best things are collateral and a profitable operation.

Still, all banks are not the same. Some specialize in small businesses, while others concentrate on midsized and large businesses. Talk to as many bankers as you can, and establish banking relationships as soonas you start your business. It's best to have a relationship with a bank before you actually need money.

Ask The Experts

Surround yourself with a corps of advisors.

When getting your business off the ground, don't go it alone. Consult the experts in virtually all critical areas of your business, especially financial advisors who can help gauge start-up costs, says Kathy Jones-Price, a senior financial advisor for American Express Financial Advisors Inc. in Salt Lake City. "It's worth the effort to build a tight corps of advisors who have experience with small business," she says.

These advisors should include a CPA, an attorney and a few entrepreneurs with backgrounds in all aspects of the start-up experience.

A financial advisor offers tips for both saving and making money. For example: "No matter how limited their working capital and reserves, [entrepreneurs] should maintain both a checking and an interest-generating market account," says Jones-Price.

It's a commonly used tactic of midsized and large companies. "It may not translate into enormous amounts in the early years," Jones-Price explains, "but if you keep sweeping money into a money market account, one day you'll have a substantial nest egg that can be used to build your business."