Importance of Cash over Profits

Importance of Cash over Profits: "

Profit vs. Cash Flow : Importance of Cash over Profits. Focusing on the right financial indicators for your business.

I have been invited by folks at Power of Ideas to give a talk on the above topic as part of POI start up workshop 2010 - that will take place @ IIMA Campus from 8-17 October. I looked at the agenda of the workshop & believe its is a very good idea and should end up adding a lot of value the shortlisted teams (big improvement over last year mentoring sessions).

They requested me to jot down my thoughts about the session and share with POI folks for feedback. I thought why not jot down the thoughts on my blog and also get feedback of a larger community. I plan to use a lot of real life case studies (both good and bad) from the my experience @ madhouse and with all The Morpheus portfolio companies. Here is a related post I wrote previously: Should a startup be Ramen Profitable

Basics

• A startup should focus on only two things - Making & Selling
• When you are making something you need to spend cash & when you sell anything you earn cash
• Naturally Making comes before sales and hence cash wise spending comes before expenses
• You can divide a startup's life into following stages
• S0 - Team formation - This is the stage in which the founding team gets formed.
• S1 - Problem (or Idea) identification - This is where you decide what problem will your venture solve or what idea will you work on
• S2 - MVP identification - This when you identify the smallest part of problem you will solve with V 1.0 of your product
• S3 - Making V 1.0 - This is when you make the version V 1.0 and will need to spend the initial amount of cash
• S4 - Customer Acquisition(CA) V 1.0 - This is when you start customer acquisition efforts / which will eventually lead to "Sales"
• S5 - Making V 2.0 - Based on the feedback you receive from early users / your roadmap and results of CA 1.0 you making V 2.0 of the product
• S6 - CA 2.0 - Again based on the feedback & experience of 1.0 you evolve and execute V 2.0 of Customer acquisition
• and so on.....
• These stages dont take place serially in fact any given time you have two subsequent stages going on in Parallel.

Making

• While making V 1.0:

• Identifying the minimum set of features that you need to build in order to solve the smallest part of the "big problem" you are going after
• What you build should offer "definitive value" to the customers - so that you can users to use your product
• Getting paid for V 1.0 is optional - but getting users is important
• It should be something you can evolve (or scale) into a bigger business
• Do not invest more than 40-50% of your initial capital in making V 1.0
• It should take between 2 - 6 months to make V 1.0

• Closer to 2 months for a simpler product - lets a web service
• Closer to 6 months for a more complex product lets a hardware based device

The lesser the time & features - the lesser would be the cash you would need to spend before you can start sales

Since you have 50% of your capital still with you, there will be enough room to evolve your product into some thing that will people will pay for and something that makes money

Important pointers

• In the beginning, don't spend more than 2 weeks on discussions / analysis / customer surveys / market search and other such activities
• Remember "Doing is learning" - so start the process of making your product asap - the real learning will start when you start making stuff
• For the initial version almost all of the making should be done by founders / there is no room for hiring employees for making or out sourcing the making. You will need to spend more time / more money and you will end up with lower quality product
• Never hold a release waiting for a perfect product.

• There is nothing called a product that can not be improved and this startup who get into this mindset normally end up spending most of their cash building V 1.0
• Irrespective of how much you spent making V 1.0 - it usually doesnt sell - you need to be able to take the learnings from this phase and build 2.0 / 3.0 and some time 4.0
• So you should launch a product with minimum features and good enough quality and see what happens to it in the market
• Keeping the cost of making to minimum means your sales target for becoming cash flow positive will be lower
• Releasing early allows you to start your sales effort and you can get valuable customer / market feedback and gives you the room to make improvements early in the life of your startup , while you still have cash available

Most of these points also apply to versions that come after 1.0

Selling

• Right from our childhood we are bombarded with so many advertisement across all kind of mediums and by all kind of brands . Hence we strongly believe that the only way to sell a product is by "advertising"
• Now this is far from truth as possible when it comes to startups - there are lots of other capital efficient ways of spreading awareness about your product / generating leads / closing sales and getting repeat orders
• In good startups all money is spent on "making" and there is no budget for "Marketing or advertising" and even if they were to spend some amount, given their small budgets - no one would notice them
• In in first year or two almost all marketing and sales should be done by founders / there is no room for hiring employees or outsourcing the work. You will end up spending more time / more money and bad results
• Startups need to practice "Zero budget marketing" which consists of stuff like

• Create kick ass products which will be sold by the initial users to other users
• Start a blog / build a website - both with grt design that communicates what your startup makes
• For offline ventures create brochures / pamphlets
• On the blog and other parts of the website / create content that is relevant to users and gets you links / tweets / likes / references from users who read it
• Create channels to engage with your users : FB / Twitter / Linkedin / email newsletters / Off-line newletters / offline meetups etc.
• Build a community around you / Distribute your content via these channels
• Attend events & conferences relevant to your startup and present in as many forums as possible
• In some case you may need to get an existing data base of potential users (mail ids or phone numbers)

• Do not start spamming via email or SMS or via cold calls
• Create nice campaign to reach to these guys and ask their permission to engage with them
• And when you ask a customer to engage with you - offer them clear benefits of the engagement
• Remember engagement does not mean they start buying from you - it only means you have permission to keep in touch

Goal of marketing is to generate leads - so you need to choose channels similar to listed above to create leads

Sales

• Once you have leads - you start the process of sales
• Start a one on one conversation with a potential customer to convert them into paid customers
• Since you are a new brand you will face a problem of trust from the customer
• The best way to tackle that is to offer your customer a chance to try your product before buying.
• You must figure out a way for doing that both in case of B2B and B2C
• In B2B you should not only offer a way to try but also after the trial customer should be able to make a purchase worth a small amount / smaller quanity and if they are satisfied with that - they can move to the next level
• Building trust via - community engagement / free trial . small purchases is essential for customers

Remember the golden rule of Permission Marketing

• Convert Strangers to Friends
• And Friends to Customers

Back to basics

• Make a good product while controlling the spend on making
• Practice zero budget marketing techniques
• Founders should take care of both making and selling
• Improve the product fast to help sales take off
• There you are

• Low monthly expenses
• Early Sales
• You are now cash flow positive and that feels good

Cashflows

• Running out of cash is the biggest reasons for startup to shutdown
• Hence its very important that at every point you have a good understanding of

• Cash in Bank
• Monthly cash flow
• Runaway available

monthly_cashflow = (monthly_cash_in) - (monthly_cash_out)

For example if you spend 1000 Rs in month of September and got paid 600 Rs for the sale made

monthly_cashflow = (600 - 1000) = - 400

Having a negative cashflow means the total cash that you had at beginning of September is now less by 400 Rs

If you keep going like that one day you will have "ZERO" cash available and that would end up killing your startup

On the other hand if you become cash flow positive even by a small amount - it means at end of every month you have slight more cash than what you had the beginning of the month

This means few important things

• Your startup had infinite runway (feels good)
• You have made something people want to use and pay for
• You have managed to keep your cost of making and selling below the cost at which customers are buying
• And this is pretty much formula of a successful business

While fighting the battle of survival - cash flow and runway are the most important things a startup should pay attention to

Profits

• They also matter but more in longer term after you have won the battle of survival
• There are two kind of costs

• Monthly costs (for example - office rent / salaries etc)
• One time costs (for example the office printer you paid for this month but will use for next 2 years)

While calculating monthly profits you take the one time costs and convert them to monthly cost and compare them to your earnings

One time Cost

• You purchased a printer this month for 2400 Rs
• Printer will be useful for next 24 months
• You convert the cost into monthly cost - which is 100 Rs per month
• You add the printer cost into monthly cost

Lets you monthly cost are 1000 rs without considering the one time cost

Now to become cash flow positive you need to earn above 1000 Rs

But to be profitable you need to take into account the one time cost as well and earn above 1100 Rs

Notes:

1. I have kept the talk to Monthly Cash flows and Profits

2. I have also kept the concept a little simplified so that its easy to understand. Not gone into payables / receivables / PAT / EBITA etc

3. Once people understand basics they can build upon them

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