Why do new businesses need more cash?

Every business needs money to spend. Some big businesses make more money than they can deal with. Apple, for instance, has a cash pile approaching $100bn and so is beginning to give back some of that money to shareholders. Banks, on the other hand, like to give all their cash to employees who didn’t earn it and, when that’s not enough, ask their shareholders and the taxpayer for more.

Young businesses can’t do either of those things. Young, growing, businesses definitely can’t. That’s because any money which comes in from sales is spent on the operating costs required to make those sales – stock, salaries, rent and so on. If any cash is left over it usually has to be invested to allow the company to make more sales in future – by improving the website, buying a new delivery van, or hiring new staff.

There are three things a young business does which means it is likely to spend more cash than it makes from its operations. If you can predict these needs, you can prepare for them.

Finding the right product

Before you are able to make any money, you need to develop a product that customers want. This can be done in lots of different ways. Businesses who speak to me have often spent a long time researching the market and their competitors, sometimes trying out early stage products to see what customers’ reaction is. Other businesses, such as medtech companies, have to spend years on expensive research and testing as well as receiving regulatory approvals. Businesses need to spend time and money – sometimes a little, often a lot – before they have something they can sell to customers.

Selling the product

So, you’ve got a product which the world wants. But you’ve got to build it before you sell it. This might mean buying food to prepare if you’re a restaurant; it might mean printing your book; it might mean making and delivering your patented new microwaves. The problem with this is that, in almost all cases, you need to pay for what you’re selling before you sell it. The period of time between spending the cash and receiving the profit is a business’s cash cycle. And a positive cash cycle means you need enough money to cover the gap between paying your suppliers and receiving your income. The problem is worse the faster you’re growing – because, while you’re waiting for the revenue from your first product, you have to pay to make ten more; and while you’re waiting for the money from those ten, you’re making another hundred.

Improving the business

What works for you on day one won’t work in the future. What worked to sell 100 widgets probably isn’t the most efficient way to sell 10,000. Perhaps, like Amazon, you can’t hold all your stock in your garage anymore and need to put down a deposit on a warehouse. This is capital investment and it’s similar to the cash cycle, but typically it takes longer to see the benefits. Another form of capital investment is in improving the product. Facebook spends relatively tiny amounts delivering its service – but spends 45 per cent of its revenues trying to improve its product so we don’t all get tired of it next week. Think about how mobile phones or razor blades have changed over the last few years.

So – these are three reasons why you’ll need more money than you’re making at the moment. What links them all is that they are all forms of investment. They cost money but you think you’ll make that money back, and more, in future.

If you want to get someone else to give you that money you need to persuade them that they’ll make that money back and more – and you want to be sure that you’ll come out of the deal ahead as well. What someone else’s investment in your business buys them is the subject of my next post here.

Adrian Clark is a founding director of New Model Venture Capital, an investment management company which works with Find Invest Grow to finance growth businesses. Follow him on Twitter @adrianjcclark.