Starting a business involves a great deal of risk. You’ve probably run across this statistic from the small business administration before: 30% of new businesses fail in the first 12 months of operations. 50% fail in the first 5 years, and 66% fail in the first 10. The odds are not terribly good that a new venture will grow into a viable company.
For many businesses that do end up failing, the problem usually isn’t that there’s no market for new product or service and the founder’s idea doesn’t work. The problem is that the founder runs out of money. I’ve heard the story at least a dozen times: entrepreneur quits a stable job to start a new business. Their objective is to make the new venture profitable enough to fund their living expenses before their savings run out. It takes a little longer to get up and running than initially thought, and their savings accounts falls to dangerously low levels. They can’t hold out any longer, and are forced to cease operations, take a step back, and find a job that offers a steady income.
The amount of cash you have in the bank is commonly known as your “runway”. The longer your runway, the more likely a business will succeed. So how long should your runway be, exactly, when starting a business? If you’re about to take the leap into entrepreneurship, these are the exact steps I’d take to figure that out.
Initial Business Planning
With any new venture, the first place to start is with some market research. Whatever industry you’re in, go out and talk to some prospective clients & customers. Buy a few people in your target demographic lunch/coffee/beers/etc. and ask for their objective feedback about what you’re planning to do. Describe the product or service, explain why it’s different, and get their thoughts. This should be done before you develop your business plan – not afterward. (Although, if you have intellectual property concerns, make sure you protect your idea legally before spreading the word too much). It doesn’t make sense to spend energy on finance/operations/staffing/etc. until you have confirmation your product actually adds value to peoples’ lives. This interview feedback will be extremely valuable, and some of the people you speak with will probably even become some of your first customers.
Once you’re feeling pretty comfortable with the product (and the response from your target demographic is positive), it’s time to work through the rest of the business plan. Dream up the company’s mission & vision, and think about how you’ll go about producing the product, delivering it, and marketing & selling it. As important as writing a business plan is, don’t forget that it’ll evolve significantly over time. Unless you have investors asking for it, don’t spend too much energy documenting every nuance of every process. Chances are they’ll change a dozen times in the first couple years anyway.
Pro Forma Financial Statements
Now your business plan is starting to take shape. You have a product or service that your target market has confirmed would be valuable. You’ve mapped out what it’ll take to produce the service, and know how you’ll market it, sell it, and what your initial staffing, office, and other overhead needs might be. The next thing I’d do is to project what it’s all going to cost, and when you might begin making some sales.
For this exercise, I like to make a huge laundry list of everything I think I’ll need to purchase to get the venture off the ground. I then categorize everything into accounts as they’ll appear on your income statement: cost of goods sold, insurance, employee compensation, computer & technology, rent, legal, and marketing are all typical categories. The exact account names tend to vary by industry.
Then, project what these expenses will look like over each of the next couple years. Some of them might be a function of your sales (like cost of goods sold), others will be based on how many people you employ (which is probably more dependent on profitability and revenue growth). Try to be conservative here. It’s easy to make pro-forma financial statements look good by over-forecasting growth or under-forecasting expenses. I prefer to err on the side of caution & be pleasantly surprised if my numbers are off.
With the expense picture in place you can now focus on sales projections. Some businesses take a while to get some revenue in the door – this could be because they need time to produce and refine the product, or because the sales cycle is simply longer. Be conservative with top line sales numbers too. Again – it’s not hard to talk yourself into an unrealistic sales projection. You should be excited about your idea and upcoming venture, and chomping at the bit to get out there and convince the world that they need what you have. This enthusiasm will be helpful, but don’t get carried away.
This part of the exercise should give you a better idea of how long your savings will need to last you. Use your fancy new pro-formas to determine how long it will take to become cash flow positive, and how long after that before you’re paying yourself a decent wage. The time between the day you launch and the day that your income from the new business reaches your income from prior employment is what I call the ramp up period. Your ramp up period ends when your income from the new venture is higher than what you were making previously. If possible, run through this with someone else in your industry who’s been there before. An experienced mentor can be invaluable here, and tell you whether your projections are realistic.
How Much Cash to Keep On Hand
When my firm takes on new financial planning clients, one of the first things we do is a cash flow “audit”. To get an idea of how much money is coming in each month and how much our clients are spending, we pull their bank & credit card transactions from account statements over a 3-6 month period. To accomplish this we use a financial planning program that our clients link their accounts to electronically. This allows us to download transactions and export them into an excel sheet. (Mint.com is an excellent free alternative).
However you decide to upload them, the idea here is to look at all your household expenses over a 3-6 month period. Categorize them in a way that makes sense to you, and then review your average spending by category. If there are one-off expenses that won’t recur (new water heater, vacation, etc.), then strip them out of your average.
Summing your average monthly spend will give you an idea of what your total cash need per month looks like, given your current lifestyle. And if you have some cash in the bank you’re building up to start a business, you can divide that amount by your monthly living expenses. This is your cash runway.
Couple things to keep in mind about your cash runway. First is that you might want to keep a little cash tucked away in a “failsafe” account that you don’t touch no matter what. Most financial planners (myself included) recommend keeping somewhere between 6 and 24 months’ worth of living expenses on hand as a cash safety net. Building up to 24 months’ worth on top of your runway and start up expenses may be unrealistic. Even so, I wouldn’t suggest using 100% of your safety net towards a new venture. Even $5,000 to $15,000 in a savings account gives you flexibility if you reach the end of the rope.
Secondly, don’t confuse your runway with your business start up expenses. The runway is meant to pay for groceries, rent, and other personal living expenses – not business expenses. Obviously, the easiest way to make your runway longer is to reduce your living expenses as you’re building the business. When I started Three Oaks Capital we actually moved out of the San Francisco bay area to reduce our cost of living. I’m not sure the firm would have made it if we didn’t.
To sum all this up, I’d suggest splitting your cash savings into three different buckets:
- Cash needed to fund the business
- Cash runway needed to live
- Your cash failsafe
The longer your runway, the better chances your business will have. The real litmus test will be the difference between your cash runway, and when you project you’ll be earning a decent wage from your pro forma financials. If you expect to run out of cash for living expenses around the same time your ramp up period ends, you’re basically flipping a coin that you’ll be able build the business to profitability in time.
Rule of thumb to boost your chances? Don’t launch until your runway is twice as long as your ramp up period.
*Caveat: There are all sorts of businesses and all sorts of exceptions to the rule. The example I describe here works pretty well if you’re quitting stable employment to start a business. If you’re getting started in a side hustle without quitting your job, there’s really no reason to wait to build up your savings account.
Where to Stash the Cash
This is a question I get almost weekly from clients. Once you have your runway objective sitting in a savings account, it’s time to decide to where to park it longer term. Should this cash continue to sit in savings? Should you invest it? What about CDs? There are many options these days.
At the moment, I’m a fan of a cash product called money market mutual funds. Money market funds are just like other mutual funds that invest in stocks or bonds. The difference is that they’re only allowed to invest in short term bonds and debt obligations. The reason I like them is that they’re liquid, readily available, and generally pay a higher yield than what you’d get in a savings account. Plus, a money market fund has a manager whose sole responsibility is to get you the best yield possible on your cash. Within the parameters outlined in the prospectus, that is. This means that you have an advocate for your cash. As interest rates rise, the fund manager will want to make sure your cash is getting the best rate possible, and invest it accordingly.
Bank accounts are a little different. Even if a savings account pays a similar yield to what a money market fund offers, banks are often reluctant to hike your yield when interest rates rise. Remember, the primary way banks make money is from the difference between the rate they lend money out at & the rate they pay for your deposits. Instead of having an advocate on your side as rates rise, a bank would probably prefer not to adjust since it will crimp their spread.
There are two types of money market funds: government and prime. Government funds can only invest in government securities. This means they’re slightly less risky than prime funds (although both are extremely low on the risk spectrum), and their return is a little lower. Prime funds invest in short term corporate debt as well as government paper, and offer a more compelling yield. There’s also a caveat with prime funds you should be familiar with: in times of financial stress, prime funds can restrict your redemptions for up to 45 days. Few prime funds have ever exercised this option, but it’s something you should know about when deciding where to park your cash.
CDs can also be an option, but I’m not generally a fan of locking up cash for months on end. With a new business venture it’s usually beneficial to stay as liquid as you possibly can. Even if the yield is a little better in a CD than a money market fund, it’d be a shame to pay an early withdrawal fee if you really needed the cash. And as good as you may be at producing pro forma financial statements, there’s absolutely no way to accurately forecast how successful your business will be. You may want access to your cash before maturity.
The right approach to cash management and runway length can vary by wide margins. Different industries, businesses, and products tend to have different ramp up periods. Even so, always remember that the longer your runway, the better chance you have at success. At least for me, it took a little longer than I’d first forecasted to get through the initial ramp up period.
Alongside that, don’t produce pro-forma financials and keep them to yourself. The best feedback you can get here will come from others who’ve been where you want to go before you. Get their feedback and ask them where you’re wrong. Ask them how long they’d guess it’ll take you to build up your business to a point of financial comfort. Then build up a cash runway twice that long.
I don’t know anyone who’s studied this, but I’d love to know what the failure rate of new businesses is at different lengths of runway. My guess is that it’s one of the best indicators of success. The longer you give yourself to figure things out and make a profit, the higher your shot at succeeding.