I was a mentor at a “Lean Startup Machine” conference recently, where people got together, formed teams and do a first layer of customer validation (“Get Out Of The Building”) for their idea. One of the key concepts of “Lean” seems to be that you don’t spend too much time imagining what can be; instead, you get to the market and if you have to, fail early. Or “Pivot” into new strategies after you hear from your market.
The teams were excellent; one was formed to get doctors for quick advice, another to sell excess stock of IT products that vendors grapple with, and yet another was a local search engine. The businesses weren’t, sometimes, apparently scalable, but they had potential and many of them pivoted even before their own presentation a couple days later.
I presented about being lean – financially. Like a complete dumbass, I didn’t consider time properly and couldn’t finish what I started out to say. So I’m writing about it – the five myths of being Lean, money wise.
What Do I Know?
Everyone should ask this question. Because everyone with a frikking keyboard has an opinion on how startups should be run. Not everyone’s advice is valid, or useful, and more importantly, you have to learn from what people did, not what they think.
I am not a hugely successful startup guy. So if that disqualifies me, stop right here and go your way. I’ve never gotten “funded” by venture capitalists. Another disqualification. I’ve very little idea what happens when your company grows to more than 50 people, because I haven’t built one of that size myself.
I’ve started up thrice – a software services firm, a market information company that became an algo trading firm, and now market education and big-data analysis. I’ve been in startups since 1997 – either one I founded or one I was an early employee in, with the latter just three years in the whole span. I know about the small stuff because I was neck deep in the small stuff, like negotiating with customs officers, getting customers to pay on time, talking to banks about bridge loans and working through hiring and firing. I’ve been lean because you have to when you have no money – all my startups started out poor.
Myth #1: You can start with nothing
I did, in 1998 and 2007. I didn’t have much, so I decided “what the heck” and started up anyhow. This is stupidity. In a lot of ways things have changed dramatically.
Earlier – probably a decade back – the biggest cost of a tech startup was building the darn thing. We built an accounting package. The cost of the hardware needed just to test various scenarious (Windows 98, 2000, “ME” and what not) added up to a couple lakhs then (which is way more than what a couple of lakhs today would buy you). The rage was Hotmail and early Google and all that. You built a good thing – and it cost you a lot to build it in the first place – and then people would come. You did “viral” marketing. People in India came cheap – at Rs. 15,000 per month you could hire a developer, and it was a small cost compared to hardware and all that.
Things are different today. It doesn’t cost that much to build, or deploy. You get hardware for a very low cost (from Amazon Web Services and the like) and tons of open source software that lets you get started for a very low cost. Laptops are cheap – you can get a developer machine for less than Rs. 40,000 today – I remember paying more than Rs. 100,000 for mine in 2003, and even that was specially imported under a zero-customs-duty license.
And because it’s so easy to build stuff, you have massive competition. People can copy and turn things around relatively fast. A new feature takes a few hours to implement and deploy, no matter how many customers you have. The cost has now moved to the other stuff – marketing, positioning, alliances, branding etc. People are no longer inexpensive in India – the minimum you will pay a good developer to work at a startup could be Rs. 50,000 a month.
Marketing costs have skyrocketed. Your lovely little must-have app has about 400,000 others competing for limited real estate on a mobile screen. Your domain name is nothing. Google ads are expensive. Facebook ads are a black hole. If you build it, they will stand far away on the highway and admire your startup as part of the general landscape but they will not frikking come, because they have a hundred other places to go to. You have to make them, and it’s going to cost you.
Startups today could need serious operational or capital expenditure. Instead of expensive computers, rents have gone up. Embellishments not required earlier – like Air conditioning in Bangalore – are now essential. Travel costs are more nowadays, not because the ticket costs are greater, but because they’re low enough for customers and investors to meet in person constantly.
Regulation adds more compliance costs. You have to pay someone to take care of the formalities of filing Service Tax, VAT, Professional Tax, Income Tax, PF/ESI and other such returns – it’s not that this didn’t happen earlier, it’s that this stuff has gotten more complex now.
When you startup, much of this is not visible. I can build that app if I hack together a couple of PHP pages on top of a WordPress content engine and put in some free databases; the cost of doing this is fairly clear. The cost of getting 1,000 people to your web site to actually transact is just a wild guess in a cell in an excel sheet – it will change by more than 50% once you actually do it.
And what about your costs? I was stunned when at least 30% of the people in the room said they have families; more dependants means that you need money in the bank for yourself while this startup thing works out. A thumb rule is: 18 months of personal expenses are what you need in the bank, apart from what you’ll put in the startup. If you don’t have that – wait to collect it, or be stupid like I was in 1998 and hope for some awesome luck.
How much do you need for your startup? Well, you know the excel drill – put all of your imaginary costs in a spreadsheet. Store this for posterity because it will be a source of much laughter five years later. And then, take the final figure you think you need, and multiply by 2. This is not me being sarcastic; In reality you might find the multiple to be many times greater than 2. You need the buffer.
Myth #2: Revenue or “Traction” is supreme
Focus on revenue, you hear, and everything else will fall in place. You’ll find investors. You’ll be able to reinvest the money in your startup. You can get eyeballs – a metric that was beaten to death in 2000 and which has reemerged now – and thus get a funnel to sustain future growth. You can target marketshare, like “I’m the #1 web site for people looking for left toenail clippers”.
While this is relevant, my belief is that the one thing you should focus on is Cash Flow.
Let’s say you find a customer willing to buy your product, but he’ll only pay you after 90 days. Your costs of delivery for those 90 days are Rs. 500,000, and the customer will pay you, say, Rs. 800,000. If you don’t have the 500K, you’re finished; you can’t even last the 90 days needed to collect your revenue. You might look to get a bridge loan from a friend, saying, give me 500K, I’ll return you 550K in three months – a fabulous return to the friend, but you still make a good profit at the end. You could utilize a bank overdraft – more on this later. You might request an advance from the customer. Whatever you do, the deal here is to focus on cash flow, not just revenue or expenses.
On an accounting perspective, taking an advance for a service given over 12 months means you split the money 12 times and post an entry every month. The unused amount is a “liability” until you finish the 12 month. But from a cash flow perspective the advance is the difference between the full amount (since you can deliver) and zero (if you can’t).
You might need to buffer this in with an equity investor, of course, and this is nowadays the preferred option – but even with them, at a higher level, cash flow is important. You will always want to negotiate good credit periods with suppliers, and ensuring you pay them on time. I hate it when customers don’t pay on time, so I strive to make my suppliers really happy – they will let me delay my payments when I’m in a crunch. You will want to work with banks to give you a loan “on demand”, so that money is available in a time of need.
In trading, there’s a rule that encapsulates risk and cash flow:
If you don’t bet, you can’t win.
If you lose all your chips, you can’t bet.
Myth #3: Equity Funding is Better
We’re enamoured by equity funding nowadays, with angels, super-angels, Series A VCs, Series B PEs, stock markets and PIPE investors. This is a formidable industry. However, the situation in an early stage startup might be different.
When you sell your equity for a price, you get some money today, but that stake stays sold. It might make a huge difference to your cash flow, but the loss of control and the need for constant reporting might dwarf the gains you make in the longer term.
You could also consider taking a loan instead. From the same investors at phenomenal yield, of say 36%. Or from a bank, or a family friend. The idea here is that once you have generated your profits, you give the money back, and you get to keep all the profits going forward. While this sounds stupid for a mass business like Facebook, remember that when you grow to be a billion dollar company, every 1% that you don’t have is $10 million. And you should divest when you should, but attempt to retain stake where you don’t need to.
When you take debt you don’t easily transfer risk – that is, if you are unable to make the return you want, you still need to pay the loan back. This might lead to “recourse” – that is, if the company shuts down, the bank might take possession of your personal assets (car/house etc.).
And in the end there’s valuation. Should I raise equity today when I will get a low valuation – and therefore give away a huge amount of stake – or take some debt to build up to a certain level, and then raise at a higher valuation?
One way to bridge this might be to use convertible debt. Assume you don’t know current valuations, but you do understand that if you reach milestone X (revenue/traction metrics) then your valuation should be some number that both you and your investor agree. So you take money today as debt – at an interest rate of say 36% payable as a “balloon” payment at the end of the milestone period. Then, at the end of the period, if you have reached that milestone, the investor converts his investment (plus the interest) at the pre-agreed valuation. If you haven’t, then you work out a step down function for a higher stake appropriately (or find a way to return the money).
In India, regulations such as the Startup Tax (Read my free e-book) make convertible debt even more attractive; direct equity investments at pre-revenue valuations might not be palatable to the tax department, but when converted post-traction, the case is stronger.
Myth #4: Banks don’t fund startups
In one way this is true, that they don’t usually buy equity in them. However banks do provide loans in various capacities to startups. You can request an “overdraft” which is a loan that you don’t draw immediately; you can withdraw the money when you need it, and put it back in, and you pay interest only for the time that money is outstanding. A bank might say you need collateral against such a loan – and for that, you can place, say, your car as collateral (they’ll give you only a portion of it’s value but it’s money you can get!)
Banks actually get incentivized for lending to startups – SME (small and medium enterprises) are “priority sector” lending, which needs to be at least 40% of bank lending.
The Indian government also has special interest loans for startups. This could be routed through a bank when the government asks you to pay only 5% and they will pay the rest (an interest “subvention” scheme) or they directly lend to you through a public organization like SIDBI. Don’t think this is silly and unused – SIDBI actually has lent out 48,000 cr. to SMEs.
Public sector banks such as SBI, PNB or Canara Bank are better at SME lending than the private biggies of HDFC Bank, ICICI or Axis. While the private players will give you fully collateralized loans faster, the public sector banks will value a longer term relationship and increase credit limits over time (as you repay) without the need for more collateral. You might start small, but start – over time, the benefits will appear.
If you are an exporter you might be able to get access to export funding – which is even covered partially by the RBI (indirectly). For this there is a cost at both ends, but you will be able to “discount” a large order and get some cash if you’re dealing with a reputed organization. Bill discounting works even for local orders, but this is not quite as easy to get.
Banks do help with cash flow for startups, but it’s not equity. (Though a bank may require that you back your loan with equity – that is, if you don’t pay back, they will own a significant chunk of equity in your company. And they’ll ask you to increase your “authorized capital” appropriately.)
Myth #5: The worst thing that can happen is that you run out of money.
In my experience running out of money is a good thing. What you should be really scared of is:
Running out of growth.
A business is built to make profit, and many startups do reach that goal. However, they might still be a failure and profitable at the same time. For example, you hire at low costs, and keep your personal salary low so that the company can show a profit. Is that real? Any investor who looks at the books will tell you this is unsustainable – eventually, everyone will demand their real share and the company goes back into the red. Only the hope for much bigger things – through rapid growth – allows people the hope that even if they’re underpaid today, they’ll be rewarded with much more in the future.
Hiring and retaining is tough when you’re running out of growth; you might cut expenses to a point of sustenance, and it’s quite likely you can sustain for a long time. Like a company that has sold a lot of licenses in the past could sustain a few years with lacklustre sales only based on, say, maintenance revenue. But eventually if it doesn’t pick itself up, the company is finished.
Zombie companies abound in the marketplace. And too many times, companies are zombies BEFORE they actually die. The worst thing that can happen to the startup is that it stays in the zombie state for way too long. Running out of money is sometimes a good thing, it gives you closure.
These are my thoughts. I don’t intend to paint all startups with the same brush. I don’t expect to get massive applause. This is more of a discussion and I’d love to see it evolve. And remember, that in all of this, you have to chart your own path. Take all that you read with a pinch of salt; if you’re out there to beat the odds, you can’t really care about how other random people like me think.
You can also see my slides here.