Fullly Vet Your Investors’ Financial Capacity

Oops! We Didn't Vet Our Investors
Fully Enough

Mike Armour

Perhaps you've noticed that I've not sent out an issue of the inbox magazine for nearly two weeks. That wasn't my intention. Instead, my schedule got wrapped around the axle in late March when several trips were unexpectedly thrust onto my calendar.

Then, in the midst of that, one of my clients found himself in a crisis that has taken days and days of my time.

But his crisis gives me an opportunity to underscore a point that I've made at several junctures on the Startups After 50 website. Namely, most startups don't fail because they can't turn a profit. They fail because they run out of cash.

Off to a Great Start

Let me tell you my client's story. I began working with him three years ago when he had a great concept for a new ground-breaking product. By the time we joined forces, he had proven the validity of his concept by using off-the-shelf technology to build a working prototype.

Getting the product ready for market, however, would require extensive research and development. It was an electronic product, and a pioneering one, at that. We were blazing brand new territory in creating it.

Additionally, for the product to fulfill its purpose it would have to be miniaturized considerably and able to work seamlessly with a host of other electronic systems. It was soon clear, therefore, that at least a year of product development lay ahead of us, along with hundreds of thousands of dollars in engineering and testing expenses.

Next, we put together a business plan as a first step in finding capital. The plan built on very conservative assumptions. We purposefully extended the timeline for having the product ready for market. This provided cushion for the possibility of multiple delays due to unforeseen challenges with engineering or parts.

Given this extended timeline, we set the target date for initial revenue well into the future. Moreover, we estimated the first year of market revenue quite cautiously. And on the expense side we set our anticipated engineering costs rather high.

By doing so we hoped to protect ourselves and our investors against cost overruns in research and development. This seemed prudent given the fact that we were developing an unprecedented product and could not anticipate all of the hurdles that we would face.

Finding Investors

With these time and cost estimates in hand, we went looking for investors. In fairly short order we found successful businessmen in the client's hometown who saw the potential of the product and agreed to fund the company.

Hammering out an operating agreement, however, drew a host of lawyers into the mix, and the process took weeks longer than we had expected. Before the first funds were in place, we were already eating into the cushion on our timeline.

The investors came on board recognizing that over the next 18 months there would be a series of cash calls as we moved through various phases of engineering, testing, and field evaluations. Everyone signed onto that plan.

Getting to Market

With our organization in place, we next went looking for experts who could advise us on how to integrate this product into other systems vital to our our success. Fortunately, some of the best experts in our target industries were willing to collaborate with us. Very quickly they helped us avoid what could have been costly mistakes.

Yet even the experts did not anticipate some technical challenges that arose, not just once, but repeatedly. We were able to conquer each challenge that confronted us. But in the process, we chewed up more and more of the "cushion" in our timeline. And we were forced into heavier and heavier investments in engineering and testing. The result was much larger cash calls on the investors than we had envisioned at the outset.

Still, we were able to ship the first products to market right at the end of our extended timeline. And to no one's surprise, the initial market reception was enthusiastic. Orders were coming in immediately. To maintain momentum, we now needed capital to step up manufacturing. And then we were hit with another surprise.

While customers loved the product, their feedback identified a design flaw which was dampening their enthusiasm for it. Repeat sales were jeopardized. The flaw could be corrected within just a few weeks, but at considerable cost.

A Last-Minute Snag

At this point the crisis hit. Unbeknownst to my client, his investors were being tapped out one by one by the larger-than-expected cash calls. Even though an eager market was awaiting the product, the investors suddenly balked at providing additional funding. They simply did not have the capacity to go any further, even though revenue was starting to flow.

That's the challenge that my client and I have been working on for the last two weeks. We think we have the framework of a solution in place. But only time will tell.

For now I'm sharing this story with you to make a telling point about finding investors for your startup. As you qualify would-be investors, it's important to look well beyond their ability to provide first or second round funding. Do they also have the capacity to continue their participation if startup costs and timelines begin to exceed your business pro forma?

If not, you run the risk that my client is facing: a great product, a receptive market, and inadequate cash from investors to capitalize on the opportunity. Again, cash on hand, not gross income or net profits is the primary determinant of whether a startup can succeed.

Self-Financing Faces the Same Challenge

But what if you are not looking for investors? What if you're self-financing your startup? The same caution applies. Sure you have enough money for the initial launch, and perhaps some additional funding to see you through the ramp up.

But if the ramp up is more expensive or more extensive than you anticipate, do you have the wherewithal to cash flow the business even longer than you had originally thought necessary?

I faced this very dilemma myself when I started my leadership development company. I opened the doors for business just ten weeks ahead of the 9-11 attack. Needless to say, with financial chaos sweeping through the business world over the next few months, companies were cutting expenses right and left. They had little interest in contracting with consultants like me.

My business survived only because I had another stream of steady and predictable income which was able to underwrite me for a year while the country's economic situation stabilized. Had I not had that outside income stream, I would have gone under within six months of starting my business.

Events like 9-11 don't happen routinely, of course. But similarly disruptive events do happen. A Hurricane Katrina. A Superstorm Sandy. There are dozens of ways that your business environment can be disrupted while you're still getting your business airborne.

Ask carefully, therefore, whether you have the financial ability to weather some unforetellable disruption. I'm not saying that you should never go ahead unless you can answer with an unequivocal "Yes." But you should at least proceed with your eyes wide open to the risk.

And if you're relying on investors, vet them carefully before you bring them on board. Be sure that their commitment to your company and their personal financial capacity are adequate to see you through the unexpected. If there's any question that their commitment and capacity are high, you probably want to look elsewhere for your capital.

This article first appeared in Encore Entrepreneur inbox magazine on April 10, 2014.

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