Thursday, June 24, 2010

Businesses Don't Fail, People Do

Businesses Don't Fail, People Do

Since college, I’ve known that the most frequent cause of early business failure is insufficient capital. No doubt, some entrepreneurs go into business on blind faith. But most raise enough capital based on some sort of projection of anticipated sales and expenses to carry them through the first year or two. If and when they fail, they blame themselves for having miscalculated how much money they actually needed.

It’s easy to blame the capital side of the balance sheet. I too attributed my company’s negative net worth after its first year to a shortage of funds. But the truth was that the company’s sales, on which our capital needs were based, were shy of the estimates I had made at the outset. With the injection of more capital and further belt tightening, we bought some time. And as luck and hard work would have it, sales increased enough to bring us into the black. We had learned a lesson: as long as we kept expenses in line with cash flow, we remained profitable. I submit that often the cause of early business failure is not the lack of capital but the lack of control over expenses.

Recently a friend called to ask whether I knew of a suitable CEO for his young company. Founder of the enterprise and a creative thinker, he confessed that after seven months, managing his company was beyond him. In that time the company, having spent every cent of capital raised from investors, the bank, and the state, now had a substantial negative net worth.

When he personally delivered his financials, he extolled the success of his product, listed the many Fortune 1000 companies that had placed orders, and convincingly sold me on the product’s long-range potential. Unlike my company’s first year of dismal sales, his had no such problem. He also supplied a report describing the company’s progress and what had gone wrong. No mention was made of why it went wrong. A perusal of the financials quickly told the story.

It was clear that the company had been managed without controls of any sort. Expenses were not even indicated as a percent of sales on the company’s P&L statement. How else can a CEO learn the true direction of such items in order to take action?

The company kept no daily production or cost reports. Thus it had no means of determining its daily or weekly profit or loss for the ongoing month. Worse yet, without an expense budget, the CEO had no way of spotting excesses in relation to the original projections. As a result, information on where and why cash flow was declining was discovered too late for easy remedial action. Instead, it would have to be dealt with as a crisis.

And the balance sheet revealed that a dangerous current debt situation had developed. Of course, it could be ameliorated by an infusion of capital, borrowing (unlikely under the circumstances), delaying payments, or converting an excessive inventory (63 percent of sales) through sales into cash. But if sufficient funds couldn’t be raised or generated, it would be only a matter of time before the company, despite an excellent product and good customers, would go under.

Assuming that the above steps were successful, the company would then have to stanch the flow of cash from operations—in other words, downsize. This it must do by attacking its major expenses, such as labor (63 percent of sales), administrative costs (52 percent), and selling (33 percent). Sacrifices would have to be made, especially by the higher-salaried people including the CEO, whose pay would have to be drastically cut and perks eliminated. Workers would have to be laid off, perhaps never to return. For a startup operation, high salaries weren’t justified, and many workers shouldn’t have been hired in the first place. It appeared that management acted blindly. Instead of them running the company, the company was running them.

I recall my friend once saying that if you attend to the big things, the little things will take care of themselves. Early on, I learned that the reverse is true. Although the tools are simple and few, staying in the black involves fanatical attention to detail. I fear that my friend will have difficulty attracting a competent CEO—his only hope of ensuring the future—unless he can raise more capital. The pity is, he had all the capital he ever needed when he began.
Thx for
Start Your Own Business Business, Second Edition: The Ultimate Resource (Business : the Ultimate Resource) The Best Business Books Ever: The 100 Most Influential Business Books You'll Never Have Time to ReadThe Best Business Books Ever: The 100 Most Influential Business Books You'll Never Have Time to Read

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