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Key Risk Factors For Startups

Startup founders need to know their financials

20Apr

The word startup has become somewhat romanticized in recent years. Once, companies strove to shake off the tag as quickly as possible. Now, they cling to it like a badge of honor - often long past the point where it really has any meaning.

A major driver of this is the rapid and well-publicized growth of tech startups, driven by vast - often baffling - amounts of venture capital investment. Another factor is the attraction of maintaining the ‘energy’ of a startup, and the spirit of innovation and flexibility that it helps to foster. However, this romanticism belies a darker reality. It is now a cliche that nine in ten startups fail, but it is still true, and founders just expecting success will, in the majority of cases, not see any.

It’s true that a startup cannot grow without some element of risk, but there are also many factors that founders simply fail to consider that can, and usually do, lead to failure. Failure is often the result of problems intrinsic to the business, and therefore fundamentally unsolvable. In a CB Insights survey, 42% of respondents said the ‘lack of a market need for their product’ was the single biggest reason for failure. Television programs like Dragons Den have also aptly demonstrated a folly many startup founders fall foul of - having an idea and persevering with it despite no public demand, under the irrational hope that they’ll convince people of the merits of their product.

The basic foundations of a startup are a good product, thorough market research and a strong consumer desire, and a deep understanding of the competition and marketplace. Past this point, in the main, it really comes down to a basic inability to properly manage the financials.

Founders usually have to cover the entire C-suite by themselves, and this means being their own CFO. Founders polled in the CB Insights survey cited a lack of sufficient capital as one of the main drivers of failure, with 29% citing it as the most likely cause. It is vital that there is sufficient cash to hand relative to burn. Without it, the company is under imminent threat of going under. When a company is operating at a loss, having a year’s worth of cash on hand relative to net burn should be a sufficient cushion if tied to realistic future funding plans. Startup founders need to be aware also of net and gross burn, the amount of cash relative to net burn, debt-levels and the maturity of that debt, and how much funding has been raised to date.

Raising funding is now easier than ever. VCs are pumping huge amounts into startups, but these need to be thoroughly researched. An investor with a good reputation can be a positive for the company, and committed institutional investors are more likely to support companies through any slumps that may occur in the early stages. There are also the wealth of crowdfunding websites, such as Kickstarter and Indiegogo, to provide investment, and well as angel investors.

One thing to get straight early on, before investment, is the allocation of equity. Many startups fail because they allocate all their equity to their co-founders at the birth of the business, and then have insufficient equity to give to key hires and investors later in the startup's lifecycle, which severely hinders growth. This is easily mitigated against by allocating only a small amount among the co-founders initially and leaving a large amount free to distribute based on value creation.

Founders should also know their limitations. It’s important to get someone in with financial experience as early as possible. If a business grows quickly, there is a danger it will outstrip the capabilities of the founding team. By hiring in a CFO or someone similar, a startup can better manage growth and monitor the kind of financial risks that founders, who are often concentrated so keenly on the idea and the demand, will miss.

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