Do you really need that money?

Business model before finance

By Allon Raiz

The chorus line in nearly every conversation with a startup entrepreneur is: “I need finance!” or “If only I had finance.” or “Woe is me, the finance-less entrepreneur.”

My question is always why do these startups feel they need finance? Is it because they need money for a prototype? Or is it because they’ve run out of working capital prior to breaking even? Or is it that their business model is fundamentally flawed and will never make money, no matter how much money they raise?

Some businesses legitimately require startup finance to create prototypes, proofs of concept or the like. I am generalising here, but in most instances this type of finance is normally derived from friends, fools and family. In other instances, it is raised from personal savings, current overdrafts or credit facilities, etc. There is a limited appetite for financing proofs of concept and prototypes.

Those who run out of working capital just before breaking even are incredibly vulnerable. They have invested so much time, money and effort already and, unless they have a compelling positive trend graph in place, they are going to find it tough to raise funding. Investors find it difficult to fund post-startups that have not broadly achieved initial predicted growth rates. It’s a matter of them querying: “You said you would grow in the past. You didn’t. Why should I believe you this time?”

It is important for startups to raise much more finance upfront than they predict they should. I recently invested in a startup business that required half a million rand. I agreed to invest up to R1 million, knowing that they had probably miscalculated their requirement. It landed up being R3,6 million by the time I had finished. There is a great saying when raising finance, “Make sure you only go to the water well once.”

Then there is also the model that will never work, no matter how much money you throw at the problem. This particular model is so fundamentally broken that it would never make money. I was once asked to invest in a restaurant and when we looked at the numbers, it was clear that the business was not making a profit. The owner said he needed cash to market the restaurant because it was only sitting at 50% occupancy.

We ran the numbers and even at 100% occupancy (every table was full and turned twice per sitting) the numbers still did not stack up. His costs for rent and staff, and the balance of the overhead, could never be covered by a 70% gross profit which he was not even close to achieving. (Most restaurants work on an approximate 30% food cost.)

His restaurant was too small (and the rent was too expensive) to generate the requisite profits to cover the overhead and no amount of cash was going to save that business. His model was flawed.

I see flawed models in so many businesses because entrepreneurs have not spent enough time carefully designing them. Sometimes it’s just a matter of how the product is sold. A great example of this is housing. How many houses do you think would be sold if there wasn’t a financing model called a bond or a mortgage? The ability to finance the product (in this case a house) increased the number of people who could afford to buy a house. The same goes for cars. So the sales model (financing versus outright cash purchase) is an equally important business model design element.

Spend time working on your model and talking to experts about how you can finesse the model. Have the humility to admit that perhaps there might be a better model to create a bigger market or bigger margin for your business.

Only once you truly understand your model and have taken it through rugged testing by cynics should you approach funders for finance.