You reached the final part of this story. This series told stories about frequent errors in Startups and growing companies. In case you haven’t read the previous post about the survival kit in contracting expensive staff, you can do so now.
This last chapter deals with the danger from massive growth and success. Sounds weird? Read on!
Chapter V: You are better than expected. You grow broke.
Successful Startups are a joy. Sometimes the transition from some small, first steps to an experienced performer is going really fast. But especially those outperformers run at high risk if their business requires lots of floating capital.
I remember a small computer company about 30 years ago that started a hardware business in an early bird phase. There have not been any PC stores in the cities, the internet was several years away and software was limited to word processing and spreadsheets.
The founders went to the local bank and asked for a credit to be able to buy some parts in China to assemble the computers in their garage.
The estimated turnover of the company was 50 TUSD in the initial year. The bank agreed to a loan of 20 TUSD. Of course with co-signers to be backed up by parents and grandparents.
6 months later the company asked for an extension of the loan to 200 TUSD, as the order volume had increased to 350 TUSD already.
At that stage, the founders had realized, that paying the computer parts in advance with a shipping time of 3 months, an assembly time incl. delivery of 3 days and a customer payment target of 30 days required incredible amounts of floating capital.
With very tight financial management and a huge margin, these guys mastered an unbelievable growth curve with almost no cash in their pockets, still living at mom’s and dad’s.
After 12 months the need for floating capital had risen to a catastrophic dimension of 750 TUSD with an order volume of 1.5 Mio USD. Most of the customers where accredited big corporations, governmental institutions and industry players, so risk for a shortfall in payments was low.
Still, the bank that had given the loans did not accept the orders as assurance for further loans, they wanted collateral security.
But the young entrepreneurs did not have anybody to backup their loans. The parents and grand parents that co-signed for the first 20 TUSD reached their limits with the extension to 200 TUSD.
Comment: The described situation is not really seldom. Even though the sample happened various years ago, chances are high to run into that situation especially with the rising strictness of loan laws.
But back to the story: What happened then to that company?
The bank became afraid of the steep growth rate of that company. Their fiscal policies required a more solid backup for their loans. Which they could not get. Which caused the bank to cancel their contracts with the company.
Despite the incredible success, full order books, best outlook for even steeper growth and an incredible profitability, the company almost grew broke in 1994.
Comment: This happens very fast, if companies are low on equity and if floating capital needs grow faster than profits can compensate floating capital needs:
Imagine a company selling a computer for 1100 USD and earning 100 USD per computer. The company needs floating capital to bridge the time between buying the product at the supplier and getting the payment from the customer. Assuming it takes 2 months in between and a company buys and sells 100 computers per month, floating capital needs will be 2 months * 100 computers * 1000 USD = 200 TUSD. Earnings will be 100 computers * 100 USD = 10 TUSD.
That means that the ratio between floating capital and earnings is 20:1 which implies a huge need for equity or dept capital.
Back to our company: How could they survive the cancellation of the loan contracts?
The answer is: They met an angel. Or better: An angel investor. This guy did not only deliver the relevant liquidity, he also delivered profound knowledge about how to finance growing floating capital needs with supplier credit. He taught them how to shorten payment cycles with customers. He showed them how to contract with bigger companies and share cost and risk.
However, 5 years later the company died. But this is a completely different story and based on people relationship problems. Another killer in the dangerous fields of entrepreneurship.
Lesson 5: Living on debt works on planned growth curves. But if you exceed the expectations, the need for liquidity might grow faster than your earnings can compensate. This makes your financial partners very nervous up to a point where they won’t follow your growth path. In the worst case they even cancel existing contracts.
I recommend to not rely on just one source for floating capital. Never run your business at the edge of liquidity. And be sure that you really understand finance and track it like your GPS tracker follows your path an the map: Always inspect the environment in all directions.
I could probably write a book about “The art of dying” and add another 200 triggers for company failure. And maybe I will do so one day.
But so far, I am happy to see you reading the last chapter of this series and hope you enjoyed the story and found some useful advice that prevents you from blundering.