Conventional wisdom says that it takes 3 years or more for a new business to get established. Real world experience shows that most new businesses do not survive to the 3rd year. The actual reasons most new businesses fail can be due to any of a number of things; stiffer competition than expected, a change in market demand, poor management practices… the list goes on.
Regardless of what is the specific reason, the common denominator of all business failures is summed up in one word: money. Money issues can reflect themselves in many ways. A sampling of the most common money issues include
- Aging receivables grow too large, not enough cash flow to pay the bills
- Sales do not reach even conservative forecasts, expenses cannot be paid
- Development time on a new product or service has taken too long
- The bank did not increased the line of credit at the same pace as growth
- Enough start-up money was not generated to carry through a tough time
- Staffing needs grew faster than capital
- Sales are available, but the selling cycle takes much longer than we expected
- Employee turnover has been high; training new hires has been expensive
- Investors committed to capital infusions on a scheduled basis and they have not followed through
Most people react to painful situations in a similar way: when it hurts enough they try to fix the problem. As people work hard and long to end the pain, new and unexpected problems creep in. Soon the company finds itself in the frenzy of crisis management.
Crisis management combined with money problems is the first announcement of the death of a business. Many of my assignments with emerging and growing businesses began with getting them out of this type of quicksand.
Though every business goes through a unique situation and set of circumstances that are causing the current pain, these circumstances all come from the same fundamental, underlying reasons.
Let’s locate these roots and help you eliminate them.
Alert #1: Problems are not problems- they are symptoms of underlying causes
The most basic mistake that I have seen management and business owners make is their fervor in trying to “fix” business problems they are facing. The solutions usually are dealt with on a surface issue. The factors creating the problem are rarely if ever addressed.
As an example, lets look at one of the bulleted items above, Sales do not reach even conservative forecasts, and expenses cannot be paid.
The usual approach to solving this may include
- Re-doubling sales efforts
- Firing the sales manager and/or salespeople
- Hiring new salespeople,
- The president or a senior executive joining the sales efforts
- Reducing prices
- Downsizing the company
Each of these efforts may create some activity, but the fundamental issue was never addressed; why have sales not reached conservative forecasts? Each of the strategies listed above have more of a “shoot the messenger” quality to them than actually discovering and curing the cause.
Re-doubling sales efforts implies that management did not believe that the sales department was really working hard enough (a slight dip in sales may warrant this response, but not a significant dip).
Firing the sales manager and or/salespeople implies that either the employees were incompetent, (in which case their inability should have been discovered long before a crisis of this magnitude occurs), or management did a terrible job of hiring them in the first place (which raises the question, if management did such a poor job hiring in the first place why would they make a better choice the second time?).
The president or a senior executive joining the sales efforts implies that the sales team lacks the skills or credibility to sell the product, which leads us to only one of two conclusions:
- The sales department was inadequately training in selling the product or service.
- The product requires an executive to sell it, which means the entire selling strategy was faulty to begin with.
Reducing the price of the sale implies that the product or service does not have the fundamental value that the company believed it did, or that the company is so desperate for cash they will sell at an under-valued rate, creating massive problems later in the product life cycle.
Downsizing the company is usually an act of desperation. This type of action means that the company’s top management did not know how to change the situation and have been reduced to slashing fixed costs to stave off total collapse.
What were the true underlying causes of the sales debacle?
Obviously there is no standard answer, but there is a standard way to find out.
Determining the cause of plummeting sales requires discovering all the assumptions that led to the creation of the sales projections and correcting the faulty assumptions.
Let’s list some possible underlying assumptions that could have caused this desperate a situation.
Assumptions/Validations
1) Pricing of the product/service was correct.
- Was a price/value analysis done against competitive products?
2) The market will purchase this product/service from us.
- Did the company have exposure to the buyers from other products/services it has sold?
- Did the company build its credibility to the market through a marketing strategy including advertising and public relations?
3) The market can absorb our sales projections.
- What is the total size of the market in this product or service?
- Is it growing or static?
- Are we stealing market share from competitors or capturing sales from the growth in the market?
4) We have the better mousetrap. The market will beat a path to our door.
- Has the market been primed to a need for the better mousetrap through advertising and media exposure?
- Have we accounted for the long lead-time on new product buying from customers?
- Did we account for the length of time to create a “lemming effect”?
5) The people who need our product will buy it.
- Do the people who need the product have purchasing power, the authority to spend the money on the product?
- Who else needs to be sold in the decision chain?
6) Initial purchases will create more sales within the customer’s company.
- Does the product function well enough to generate excitement and by that additional sales?
- Does the buying cycle within a customer’s company match our sales forecast calendar?
Undoubtedly there are other assumptions attached to what built the forecast that should be listed and examined. Until the underlying causes are identified and cured, weak sales will continue to create money problems. Every sample problem we listed should face the same scrutiny to their assumptions.
Alert #2: Money problems are the root source of pain in a company. These occur because “break even” is not what you think it is.
Most people believe that if they can “break-even” during the initial phases of their business they can “survive” until they get bigger. The also believe that the definition of break-even is
REVENUE = EXPENSES + TAXES
Unfortunately, nothing could be farther from the truth. The question is not if “breaking-even” will allow you company to survive. This is true. The question is “What is break-even?”
Most businesses manage their books by accrual rather than by cash, that is, accounts receivable as regarded as assets in the balance sheet. In a cash format, only the cash in hand is regarded as an asset. CPAs will usually suggest you file corporate tax returns on a cash basis, as this lowers the profits (thus lowering the taxes), but to try to gauge your business performance, accrual is a better look at what is happening on the sales verses expenses front..
The problem this poses is that accrued receivables do not pay the bills, only cash does. As a result, you cannot define “break-even” on an accrual basis. You must have capital (cash) reserves to cover the costs that bills dictate. This changes the “break-even” equation to
REVENUE = EXPENSES + DEPREC + TAXES + CASH RESERVES
A young company faces another challenge, and that is one of growth. Launch costs are greater than initial sales revenue. A young company’s capital backing will not last forever (just ask the failed technology businesses of the past 15 years) so an increase in revenue to reach profitability is critical. Increases in revenue (growth) also cost money, whether it is through staffing, advertising, promotion, or public relations. This changes our equation to
REVENUE = EXPENSES + DEPREC + TAXES + CASH RESERVES + GROWTH
It is typical for a young company to diversify its products and services as it begins to grow. There is a simple reason for this. It is cheaper and easier to sell to a satisfied customer base than to prospect for new customers. This phase of corporate life is different than Growth. In fact, it is Risk, for whether the new products or services comes as a result of research and development (R&D), or simply addition of a product to the catalog, the “newness” represents an un-proven tactic or strategy. This changes our equation once again to
REVENUE = EXPENSES + DEPREC + TAXES + RESERVES + GROWTH + RISK
Finally, as cash flow and growth take their toll on profits, young companies quickly start to look for ways to reduce expenses. The first realization is that there are fixed expenses (rent, leases, telephone lines, Internet access, wages, etc.) and variable expenses (commissions, marketing, long-distance charges, etc.). If we assume that fixed expenses are difficult to reduce (most entrepreneurs avoid overspending their own money on fixed costs), variable costs are watched closely. This changes our equation one more time to
REVENUE = FIXED EXPNS + VARIABLE EXPNS + DEPR + TAXES + RESERVE + GROWTH + RISK
All of the expenses added together must equal 100% of the revenue for break-even to occur.
Let’s add this to a previous blog, ”Why it is impossible for a company to make and retain a profit”. What have we discovered? Of the five ways profits can be used,
- Capital Reserves
- Growth
- Risk
- Profit Sharing
- Dividends
Three of them must be counted as expenses. I call these three “Targeted Profits”, for they are profits targeted as future expenses. Without managing our finances to account for these three “hidden” expenses, we cannot “Break-even” to reach future profitability!
Most new businesses celebrate becoming profitable. I recently received a phone call from a new company calling to let me know they were having a “Solvency Party!” I was not sure why I was not invited…
In Summary:
- Problems are not problems; they are symptoms of underlying causes. Discover and root out the underlying cause and “problems” will go away.
- You must understand what “Break-Even” truly is, or you will not sleep well at night.
- Structure your fiscal management around the true “Break-Even” and you will Keep Your Head Above Water.
Read on to Part Nine
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