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Risk/Reward Archives - Finance-Ability®

5 Jedi Mindtraps to Avoid When You Think About Financing

By | Blog, Where's the money? | No Comments
When it comes to getting a loan or taking on a partner, many small business owners feel a lot like young Luke Skywalker after he crashed his fighter – dazed and confused. Their preconceived ideas about the people and the process, most of which are just wrong, keep them from seeing how everything could work together for their benefit. So before you start talking to banks and investors about investing in your company, be sure that you don’t fall prey to these common mindtraps.

Trap # 1: Bankers & investors are smarter than me

Although bankers and investors have a different kind of knowledge than you, they aren’t any smarter (or better) than you! Because asking for help is always difficult, particularly when it involves your business, I think that we tell ourselves this story to explain our feelings of inferiority.

What to do:  Instead of focusing on what you don’t know, take the time to write down the good and bad of your business. The good is a list of your assets (what you do well) and the bad is a list of the risks (where you might need improvement, or where you aren’t sure what you will do). Detailing your strengths and your weaknesses will help clarify what you have to offer and where you need help.

Then, as you meet with them, think of your banker / investor as any other vendor. They are experts in their business, but they are there to help your business succeed. No one knows your business as well as you do, and any loan or investment will be made on the basis of what you have built. Once you are clear about what you have to offer (and where you need help), it is much easier to explain that value to someone else.

Trap # 2: Bankers & investors want to take advantage of me

As mentioned above, bankers and investors are in the business of investing. They aren’t sharks – even if they play them on TV.

The business of investing means that they need to earn a certain amount on every dollar that they invest, and they need to ensure that they make investments that will actually be paid back. Bankers and investors have a responsibility to their clients (who give them the money that they invest), namely to earn them the highest return for the risk that those clients are willing to accept.

While bankers and investors are experts in the risk/reward game, they aren’t scrooges out to steal or swindle you – they’re just doing their jobs and using their experience to do the best jobs they can for their clients.

What to do: Learn everything you can about how bankers and investors make their decisions (this is a good place to start). Use the list you made of strengths and weaknesses to understand what your business offers in terms of risks (weaknesses) and rewards (strengths), and don’t be afraid to make changes to reduce the risks and improve the rewards.

Trap #3: I need to have solved all the problems in my business before I talk to a bank or an investor

Nobody’s perfect, and if you have already solved all the problems in your business, you won’t need a loan or investment anyway. What banks and investors are looking for is not a perfect business, but a business that has a good potential and an owner who understands the risks of his business and how to manage them.

While you can’t go into a discussion with an investor without a good plan, it’s perfectly acceptable to leave some of the details to be ironed out later. How to know the right level of detail? If it will change one of your strengths by more than 10%, or increase a risk by that amount, it needs to be hammered out.

What to do:  Evaluate your list of weaknesses using “disaster” scenario. For each weakness, ask yourself “if I can’t find a solution to this particular issue, what is the worst thing that can happen?” If the answer will kill or significantly diminish your business, or if worrying about it keeps you up at night, you need to find a solution before talking to an investor. Otherwise, it’s a detail.

Trap #4: I need to pretend to be someone I’m not in order to get banks & investors interested

There’s a perception that perfect projections, pitches and owners are what win bankers and investors over. Not at all – what wins investors over is solid projections and pitches made by passionate and credible owners. Bankers and investors see hundreds if not thousands of deals over their careers, and they aren’t sold by a pitch alone.

When making an investment in your company, they are ultimately investing in your vision and your ability to accomplish that vision. You need to help them see that vision clearly, and show them what it will take to get there, in terms of money, time and commitment. If you can show a compelling vision and a reasonable probability of reaching it, you’ll be heads above all those other “perfect” pitches.

What to do:  Develop a relationship with your potential investor before asking for funds. If possible, present them with an overview of your strengths and weaknesses, and ask for their advice about improving your operations and/or reducing risks.

When you’re ready to ask for funds, understand the value in your business, and get comfortable with explaining that value – in your words, your way. A banker or investor doesn’t want some slick presentation, they want to see how well you understand your business and how you can make it work. They need to see you as credible yet passionate, enthusiastic but realistic about the challenges you’ll face. Perfect only works in the movies.

Trap #5: I’ll do a lot of work for “nothing” if I create financial projections and then don’t find an investor

Like the famous “business plan”, many owners view the creation of financial projections (budgets) as an exercise that’s only useful when asking for financing. Nothing could be further from the truth!

Just as your vision will guide your business over the long-term, your financial projections will ensure that you are taking regular steps to achieve that vision. In order to have $1,000,000 in sales in 5 years, you need to sell your first product! It’s unreasonable to expect that sales go from $0 to $1,000,000, so you need a plan to help you track your progress. That means translating the long term goal into several shorter-term targets. Perhaps the first year’s target is only $120,000 – so you know that you need to sell $10,000 per month. That’s an easy figure to check, and to keep in your head throughout the year to measure your progress.

Likewise with expenses, if you know that you have only planned to spend $240,000 in the first year of operations, any expense over $20,000 per month should sound alarm bells in your head.

Having short-term targets can help you keep your business on track, and as the business grows, can also serve as targets for employees (sales managers, etc.). By instituting a budget early on, you not only set yourself up for success, but you build credibility with future investors, since they will be able to easily measure your projections against your performance.

What to do: Build a financial projection (budget) that helps you manage your business – it doesn’t have to be fancy, but you must understand all the assumptions. You should include an income (or profit and loss) statement and a cash flow (or sources and uses of cash) statement. The income statement will help you understand when your business becomes profitable (sales are greater than expenses), which is usually a point at which you need less external financing. The cash flow statement will help you understand when you need financing, and what it will be used for (either operations, before you become profitable, or for equipment/durable good purchases after profitability).

And once you’ve built the budget, be sure that you are comparing your performance to that budget regularly: at least monthly for sales and operating expenses, and at least quarterly for any equipment purchases. If you see any major variances (10% or more), DIG IN and understand where they are coming from – problems don’t magically fix themselves, so you need to identify them and try solutions until you find the right one for the situation at hand.

Each of these mindtraps are founded on a faulty perception / point of view. Because a perception exists within your mind, you can avoid these traps by educating yourself, and taking specific action to combat that perception. You have the ability to make these changes by taking concrete steps to understand the value of what you’ve created and to build that value over time. And it will not only improve your chances of getting financing, it will also improve your outlook!

Is Finance Really a Four-Letter Word?

By | Blog, The "F" Word | No Comments

Finance has its share of villains, both in fiction and in real life, who’ve created a distaste for finance that isn’t serving entrepreneurs well.

Because unless you’re independently wealthy (in which case, you’re probably not starting a business to make money), you’ll have to work with some finance types to get your business off the ground and keep it growing.

But (Gordon Gekko aside) finance types aren’t the culprits – in fact, once you understand financial principles, you can make them work for you without feeling slimy or selling your soul. But (and this is crucial in all aspects of your business), you need to take control of your own destiny.

First, you need to understand one of the fundamental principals of finance: the riskier something is, the more you’ll have to pay to get someone to invest in it.

This is referred to as the risk/reward tradeoff*, and it looks something like this:

Risk/Reward tradoff

 

In this illustration, the dark points indicate the general range for risk/reward, and show that depending upon WHO is borrowing (and how the person lending feels about them), the reward required for someone to make that investment increases. As an example, if I want to obtain a business credit line, I know that the bank will expect a potential loss of 35%, and will want a reward (in this case, an interest rate) of about 20%.

The ovals around the dark points show how perception can influence these risk/reward tradeoffs. Within each investment type, individuals and their perception of the risk will influence the rewards they will require to invest. So, continuing my example, if I’m able to develop a great relationship with my banker, and I have a well-thought out response to most of her questions, I should be able to reduce her perception of the risk of MY business, and reduce the reward (interest rate) that she’ll require.

With me so far?

Second, you need to understand that this is not rocket science – you already use this principle every day.

When someone wants to borrow money from you, for example. If you don’t know the person at all, you perceive the risk to be high; so high in fact, that you probably wouldn’t even make the loan. However, if it’s someone you know reasonably well, you’ll review several factors (such as how much they are asking for, whether they can pay you back, how much you think they need the loan, and whether you trust them and communicate openly with them) before you make a decision.

Sound like common sense? Then you’ve already got good insight into a bank/investor’s thought process when you approach them for an investment.

Since your relationship with the bank/investor may be on the newer or more superficial side, you’ll have a lot of work ahead to convince them to provide you with funding. It means that you need to clearly understand where the risks are in your business, and then work on decreasing their impact on your business.

It also means that you need to develop a relationship with your banker/potential investor, so that they get to know you and have a better idea of how trustworthy you are. Being able to answer the following questions will go a long way to building trust:

  • What is your business is capable of becoming and what it will take to get you there, in terms of time, money and personnel?
  • What will you be using the requested funds to do? If your answer is “pay my (or other founders’) salary”, you’re dead in the water. Would you loan someone money to pay themselves a salary?
  • What are the scenarios under which the funds can’t be returned? How likely are they, and how soon can more information about those probabilities be obtained?

When you talk about those risks and how you’ll address them, you’ll build credibility. Once you’ve established a genuine relationship and trust, banks and investors will be much more likely to want to work with you.

If you don’t have enough money to finance your company – which, let’s face it, is where most of us find ourselves – you’ll be looking to banks and/or investors to provide capital (cash, dough, greenbacks, you get the idea). To make the most of what the finance types can do for you, you’ll need to put yourself in their shoes and try to identify any other risks that they may perceive (perception is NOT reality, but in this game, it’s the perception that counts until you build a stronger relationship).

Your assignment: identify three risks in your business that you could improve on, and tell me about them in the comments. Let’s see which ones we have in common!