Why You Should Not Under-Capitalize Your Venture
You don't necessarily need piles of capital to start your business, but you do need the appropriate amount of capital. How to work out the right level of capital?
When starting a business, proper planning and research are essential to success. Undercapitalization can be a significant problem, one that may lead you right out of business. You don’t necessarily need piles of capital to start your business, but you do need the appropriate amount of capital.
As a founder, you have identified a problem, you build a solution to solve the problem and you try to sell it. There are, however, two scenarios of how this story could continue.
In the first scenario, you have sufficient capital, have hired a good team of people who get the product right by experimentation. Because not uncommonly, it’s not the idea that is failing, but the execution. Sometimes, all it needs is a better understanding of the market needs and tweaking the product to better align with those needs.
In the other scenario, you thought you assume that the first version of the product will work, you do not have the right team, and you do not have the funds to test and amend the product. This is the worst case because nobody buys it, you run out of capital, and that is it. The business is dead.
Heard of raising too much capital? There is also raising too little
There is one financial number that every founder needs to have at his fingertips: How many months can my business last before it runs out of capital?
Ideally, no less than 18 months because if it is less than that then there will not be enough space to experiment. Undercapitalization is a major reason for small businesses never taking off. You need to make sure right from the start there is enough financial runway to get your wheels off the ground.
If you have not raised an appropriate level of capital, the consequences can be catastrophic
First of all, your work will most likely not be of the best possible quality. You will not be able to hire the appropriate number of people with the right capabilities and experience. There will always be a gap between your vision for the product and the product. At some point, this gap will become evident to your customers, your investors and potential talent. At that point, you will be trapped in a downward spiral which will be difficult to get out of.
You will invariably lower your goals and just try to survive. But it will get harder and harder. You will also lose opportunities because your potential customers will get concerned about the longevity of your company and possibly not even buy your product or solution anymore. And then the day comes where capital runs out, and you will have to shut down your business. Your vision. Your dream. Sounds terrifying?
This is why proper planning – especially from a financial perspective – is crucial to the success of your business. And that does not just mean raising large amounts of capital. There should always be enough capital so you & the team can focus on advancing the business.
How to work out the right level of capital?
What does “the right level of capital” mean? When starting a business, you need to define how much investment you will need to build, test, iterate the product. One key advice that every founder will agree on: Don’t start with the investment required but start with what are the milestones that need to be achieved, what are the capabilities needed, time required to get to the next value inflection point. Only when you are sure about this forecast the capital that will be required. Whatever number you get out of that financial planning, always include a buffer of 25 per cent. And then go, raise that capital and build your business.