People often ask me, “How can I start a business when I don’t have enough money?” My advice? Don’t. Too many businesses start out undercapitalized, and it’s downhill all the way from there. What makes things worse is that banks don’t like lending money to small businesses. So what are your options if you still want to start out on your own or take your business to the next level?
You may decide to go out and look for private funding, but I’ll warn you, there’s a skill to going after investors. First, you need a quality presentation and a solid plan. You then need people (prospects) to whom you can present your concept. You also need to be smart about what you ask for and what you intend to do with the money. Also, if you do raise outside capital for an existing business, you have disclosure responsibilities to your shareholders, either legally or ethically.
I went four years without getting a paycheck from Paychex. That’s the reality of starting a business. And I wasn’t laughing at the irony, I assure you. The reality is that financing won’t be easy to come by, and it won’t come to you; you’ll have to go out and knock on doors to make it happen.
Before you begin, do some simple arithmetic: estimate your operating costs for the first year, add whatever you need to pay yourself (zero is a good number), and then figure out how many widgets or services you need to sell to cover that amount. This will give you a baseline of your financial requirements. Look at the quantity of products or services you need to sell and assess whether it’s reasonable. If it isn’t, reduce it to what you believe will be achievable. You may now be showing a loss. These basic numbers do not take into account when you will need access to cash to pay for capital expenditures and other overhead expenses. You should take your cash requirements into consideration before coming up with the amount you need to either launch your new venture or grow your existing business.
If you can finance your business without borrowing money or bringing in investors, all the better. If you truly believe in your business concept, whether it’s a start-up or a going concern that requires investment, you should seriously consider liquidating personal assets to self-finance. The way I look at it, if you are asking other people to risk their money, or in the case of banks, their customers’ money, then you should feel comfortable risking your own.
Take a close look at your assets: real estate, stocks, bonds, potentially even your 401(k). It’s not uncommon for entrepreneurs to sell their Harley-Davidson motorcycle, a baseball card collection, or a signed football. Interestingly, a baseball signed by the original eleven baseball Hall of Famers recently sold for almost $630,000—that could have been the answer to an entrepreneur’s immediate funding requirements.
All my partners and franchisees in the early days of Paychex were employees of institutions or companies, and none of them, to my knowledge, had run a business before. Although they started with me in Rochester, they moved across the country to open offices, funding their new businesses through the sale of their homes. A few borrowed from family and friends.
If you’re not willing to invest money in your own business, then you might want to reconsider your options. Sorry to be brutally honest, but the most help I can give you is a reality check before you go too much further. As I suggested earlier, it’s unrealistic to expect an investor or a bank to invest in your business or lend you money while you are protecting your own personal assets. Why should they take all the financial risk? You have to believe in your enterprise. If you aren’t willing to put a second mortgage on your house or sell your boat, it’s going to be difficult to convince an investor to give you start-up capital and almost impossible to get a bank to give you an unsecured loan or line of credit.
There’s a big difference between sweat equity with no capital and sweat equity with capital and the value of that equity (perceived or otherwise). Some investors put a higher value on sweat equity than others, but all like to see you have some skin in the game.
Generally, banks are reluctant to lend to small businesses, especially to start-ups. They will, however, consider lending money if you have liquid, pledged collateral (for example, a stock certificate that is easily saleable) or if you get a first or second mortgage on your home. They may also require someone to cosign a loan, and that person will need to be someone of substance.
Building a strong relationship with your bank manager is important; it played an important part in the funding of Paychex over the years. In fact, my first bank officer, Tom Clark, became Paychex’s chief financial officer.
When I first started Paychex, I was forced to take a second mortgage on my home, and I also managed to get some consumer loans, thanks to understanding loan managers. These loans were ostensibly for consolidating personal debt but were in fact used to finance my company. As an entrepreneur you have to raise money wherever you can, and sometimes you have to be creative.
Coincidentally, those same loan managers came to a Paychex annual meeting recently, and although they’re now long retired, I recognized them and introduced them to the gathering. I told everyone that these guys went out on a limb for me in the early 1970s to help me keep my Paychex dream alive.
Approaching your parents and other family members is a valid way to raise capital, but it comes with baggage. They know you too well and are more likely to question how you are running the business. And they won’t be shy about asking for their money back if they need it for something else. They are sometimes not the most educated of lenders.
I used this particular “bank” myself in the very early days of Paychex, and without it the company may not have survived. We were developing new software to run payrolls, and we got to a point where I didn’t have the money to continue paying the developers. Without an immediate influx of cash, we were going to be in serious trouble. I talked to my sister, Marie, and she offered me whatever I needed from the insurance benefit she had received when her husband passed away. I borrowed $30,000 from her; without it I doubt Paychex would exist today. Family can often come through for you when your back is against the wall. As a result of her generosity, Marie and her three children became significant shareholders in Paychex.
Selling shares to friends and acquaintances is a bona fide way of raising start-up capital. It can be effective, but it’s not without its pitfalls. People will ask when and how they can get their money out and what the return on investment will be. Tough questions. Then, if something does go wrong, you have to consider how it might affect your reputation in the community.
Venture capitalists can be an option, but they are self-centered, tough negotiators with their own agendas. They want to invest and then liquidate, so their timeline might be very different from yours. If you are trying to build something long-term, you have to ensure the venture capitalists you are working with are on the same page. Another thing to beware of is that they may take advantage of the fact you might need funding urgently and use it against you when negotiating terms.
Public offerings have become less popular in the last decade for several reasons, the primary one being that federal regulations have made it very difficult and very expensive to run a public company. Utilizing venture capital is a lot less expensive.
There are many reasons, however, why it’s beneficial to take a company public. One of the biggest is the ability to raise money for capital expenses such as new hardware, computers, and the like. It also offers liquidity for shareholders, who then have the opportunity to buy or sell shares whenever they want. They also have the freedom to sell as many or as few as they like, although there are restrictions on what are called insiders (board members and senior management), whose level of buying and selling activity is monitored by the SEC.
Going public is good for marketing. If you’re a public company your name is out there, and it provides a high degree of credibility. It makes recruitment of high-quality employees easier as they are more likely to seek you out when you have a high-profile name. You are also seen to have substance and permanence, as opposed, for example, to a privately owned family company that can be viewed as being more volatile. Prospective employees also realize they may be able to take advantage of stock options and other benefits.
There are downsides, of course. You and your CFO have to commit yourselves to dealing with Wall Street on a regular basis. Wall Street will be concerned with consistency; it doesn’t like ups and downs, and it can be difficult to run a business like that.
My suggestion is to get a lot of advice and counsel before embarking on a course that leads to a public offering.
Let me share with you a little of the excitement I felt when I took Paychex public. My criterion for going public was based on the company reaching a seven-figure or $1 million post-tax bottom line. By the middle of 1983, Paychex had not only reached that milestone but also had twenty-five thousand clients and five hundred employees. I felt at that point we were established enough and would generate sufficient interest and support for the company stock that I would be comfortable going public.
With the decision made, all I had to do was make it happen. I remember it was Friday morning, August 26, 1983, twelve years after I started the company, and the market was at the tail end of a bubble. My advisors and I had to decide on the price per share; we were looking at between $11 and $13, which would have given us a market cap (outstanding shares multiplied by market price) of about $65 million. How it worked was that we got the range and then the investment guys ran around to their institutional customers trying to stimulate interest.
Bob Beegen, my midwestern partner, and I were in Rochester, and our chief financial officer and our lawyer were in New York. Along with some seasoned board members, we were all on the phone with the investment banker and he said, “Tom, the price is $11.” I wasn’t quite sure how I felt about that, so I put them on hold to talk to Bob privately. Although I had muted my voice, I could still hear everyone else on the line. The conversation was illuminating; I heard the others say that the act of going public was more important than the specific value at which the initial share price was set. That made sense to me, and I was confident the share value would rise as interest in the stock grew. Therefore, based on the information we had at that time, we went public at the recommended $11 a share. Consequently, as expected, the figure rose steadily, and we raised $7.7 million, which we mainly invested in new computer hardware.
I liked running a public company, in part because I enjoyed working in an environment of discipline and structure. Institutional investors are mostly concerned about growth, but that growth has to have predictability. As I said earlier, they don’t like hills and valleys; they look for steady, consistent growth. Fortunately, Paychex was a company that demonstrated very predictable growth.
As CEO of Paychex, I made a lot of friends in the investment analyst community, and I enjoyed working with them. Too many CEOs seem to resent that community, primarily because analysts are very inquisitive. The less predictable your company, the more difficult they make your life. And that is reflected in a fluctuating stock price. The more consistent and predictable your company’s profits are, the easier it is for analysts to recommend working with your company and to recommend your company to their institutional shareholders.
Stock analysis is a very important part of a CEO’s day-to-day activity. Public companies must have a CEO and CFO who like working with analytic institutions because they can make or break you as far as your stock price is concerned. If the analysts don’t have a high level of trust and confidence in your company, and in you personally, they are not going to be kind to you.
Wherever you get your funding from, never lose sight of the fact that your investors eventually want to see a return of their capital along with a return on their investment. This return can be delivered via dividends or capital gains from the selling of shares.
When you have outside shareholders, the percentage of ownership is a major issue for negotiation. You may find yourself in a position where you have to sell more shares, and this will, of course, change your ownership percentage.
Shortly after I purchased the Buffalo Sabres hockey team, I remember Larry Quinn, the CEO, laughing at my ruler because it had a magnifying glass embedded into its entire length. I still have it, and I still use it. It enables me to focus line by line as I study a spreadsheet, something I find exceptionally useful. I used it to look at the Sabres’ financial statements. Larry was amazed that I went over every line in such detail. It also came in handy when I cornered President Bill Clinton in my box at a Sabres game to go through a conference budget when I was founding sponsor and underwriter of the Clinton Global Initiative.
If you don’t understand financial statements, you are running your business blindfolded. I think many entrepreneurs get into trouble simply because they don’t understand their financial statements, of which the balance sheet and the profit and loss statement are the most important.
As we discussed earlier, profit and loss statements, balance sheets, and cash flow statements are vital to keeping your finger on the pulse of your business. Too often businesspeople run their businesses on a cash basis—in other words, they focus on their bank balance: if that is healthy, then they feel all is right with the business. I never get involved with a business that operates this way. In my opinion every entrepreneur should take a basic accounting course and learn the fundamentals of good accounting practice.
People get scared by the numbers. If you feel mathematics is not your strong suit, don’t worry; understanding your business’s finances requires nothing more than simple arithmetic. After all, if you can learn the basics of a program such as Microsoft Excel, it will do all the calculations for you. Most entrepreneurs avoid the numbers behind their business—but to me, it’s where I discover all the answers.
I’m a numbers guy, and it has served me well, very well, over the years. If you know your numbers, you know your business. Any entrepreneur who does not understand financial statements is in great danger.
A balance sheet is a snapshot of your business at a set moment in time. Your balance sheet shows your assets (cash, accounts receivable, inventory, prepaid expenses, furniture, equipment, etc.) and liabilities (accounts payable, unpaid expenses, etc.). If you take your assets and subtract your liabilities, you have your company’s net worth. Your net worth contains the profits you have made and money you or your shareholders have invested. This snapshot can be taken at any time.
We went over this in chapter 2, but as a reminder, this document is sometimes called an income statement and is a recap (either for a month, a quarter, or a year) of all the revenue you brought into the company and all the expenses you incurred in maintaining the company. The difference between the two is either your profit or your loss.
A cash flow forecast predicts the company’s monthly revenue and expenses over a period of time, usually twelve months. It shows your monthly opening bank balance, revenues, expenses, and monthly closing balance. Revenue predictions are usually based on your sales forecasts. A cash flow forecast is a useful tool both for monitoring your company’s performance and for identifying your cash requirements ahead of time.
It’s important to have someone who understands financial statements in your company, someone who knows how to read them and how to prepare them. You can get into a lot of trouble with bankers and investors if your financials are not reconciled and up to date. More importantly, without accurate current financials you won’t have a realistic view of your business’s financial situation.
Many mature businesses will have outside auditors audit their financial statements annually, but if your company is smaller you should at least have an accounting firm carry out an overview of your financial statements every year.
One last thing: you should never take for granted that your financial statements are correct. People make mistakes, so your statements can be wrong. Have someone you trust, a good financial person, look after your financials.
The primary reason you are running a company is to make money. You owe it to your shareholders, your investors, your staff, your customers, the charitable organizations you support, and yourself to make money—and you can’t do that if you are not making a net profit. I know that sounds obvious, but I come across entrepreneurs all the time who can’t explain their company’s financial situation, including how much profit they’re making. They refer me to their financial statements, but when I ask questions, they look at me blankly, as if I’m speaking a foreign language.
Understanding profit margins is essential to the overall health of your company. I’m now going to share with you the whole essence of Paychex’s impressive profitability by first asking you a question. The underlying lessons in this story can apply to a wide range of companies selling both products and services.
So, the question: If you are a payroll processor, would you rather service ten 10-person company payrolls or one 100-person company payroll?
The answer may surprise you. It’s better to service ten 10-person company payrolls. That may sound counterintuitive at first, but here’s why: clients with a large number of employees and therefore paychecks per pay period pay less per check than a small company with only a handful of employees. This principle holds true in many industries: the larger the purchase, the higher the discount.
Back to Paychex . . . Servicing ten 10-person payrolls grosses 2.5 times more revenue than one 100-person payroll. You are probably thinking this will be offset by an increase in overhead costs in dealing with ten customers rather than just one. In reality, I assure you, the additional overhead is not proportional to the additional revenue.
You may also be considering that it must be tougher to make ten sales than just one. On the face of it, that would appear to be the case, but again, this requires further investigation. First, a 100-person payroll company is harder to sell to because usually it has someone on staff already handling its payroll demands. In addition, larger companies can be more demanding and more price conscious.
Second, believe it or not, it’s easier to sell ten 10-person payrolls than a single 100-person payroll. Although, admittedly, that has changed a little in recent years for Paychex. Back when I started my company, everyone was ignoring the small guys, so I had the market virtually to myself. Today, due to the Paychex approach, increasing numbers of payroll processors now target small business owners, so the competition is far stiffer.
It was this basic principle that EAS (the first company I worked for in payroll processing) didn’t understand when I tried to sell them the idea of opening up the small business market. Maybe I didn’t push it hard enough, but I always knew there was a massive opportunity hidden in that math. Could this approach offer you a new target market?
To prove the validity of this profit-margin lesson, here we are almost fifty years later, and Paychex’s pretax profit is around 38 percent, while ADP’s is about 19 percent. The reason? Our revenue per check is much higher. The lesson here is that the best route to higher profitability is not always the most obvious.
It’s this counterintuitive approach to business, and my constant questioning of the way things have always been done, that I want to share with you in this book. Don’t always believe common business lore. In this case we explored the concept that it takes more work and is less profitable to cobble together a bunch of small customers than to land one large client. It’s not always true. Question commonly held beliefs every time.
One of the problems entrepreneurs face is determining the price of their product. A lot depends on the cost of production and the price your competitors are charging. The concern is always: Are you selling your product at a high enough price to allow the margin between the sale price and your costs for that product to cover all the rest of your expenses? In some businesses the margin is not high enough and therefore they will never be profitable.
The challenge is that sometimes the market won’t bear a higher price and if you raise it too high, sales will drop. This becomes a balancing act between revenues and expenses. If you can’t justify increasing your prices, you will need to take a long, hard look at your production costs.
Whenever people ask me what the first thing is that they should do when they start a business, I don’t skip a beat. I say, “Get a prenup!” Sure, they all laugh, but then I repeat myself. “I’m serious, get a prenup.”
A concern any entrepreneur should have is that, unfortunately, relationships don’t always last, and here I am talking primarily about marital relationships of any type, including common-law. Life happens, and people change and divorce and separate. In fact, it’s becoming increasingly common.
Without a prenuptial, if you own a business and you’re in a community property state, you may be faced with a situation where you have to sell your business to make a settlement with your spouse. If you find yourself in that situation, there are a couple of major downsides over and above the obvious. First, you may not be able to get the price you want for your business because you are under pressure to sell immediately, and second—I know this seems obvious, but hear me out—if you sell your business, you don’t have it anymore. Think about it. All of a sudden you have lost your source of income.
If you start your business and you are already married, you can get a postnuptial agreement that outlines what would happen with regard to the business should one of you want to take a different direction in life.
There is nothing more serious than protecting your ideas, your investments, and your business from day one. I have seen many great entrepreneurs and businesses disappear because a relationship went south. From the outset you have to protect yourself and your business. You have to make it a major priority.