The Truths Of Risks & Rewards

The Truths Of Risks & Rewards

Last time you saw this space, I was focusing on the key components of the ideation phase of entrepreneurship. First was, “what’s YOUR problem?!” Every innovation starts with a unique solution to a problem – the ‘unique selling proposition’ or “USP,” according to that Marketing class you may (or may not) remember. If your solution is truly unique and highly desirable, it alone may be sufficient to create a successful product. Truth: that’s not a common occurrence. Secondly, we discussed that an additional suit of armor is often necessary to protect and grow the product. Patents, low price and great service are examples of ‘competitive advantages.'

Last time we talked, you – the entrepreneur – were getting your new idea or prototype product ready for that rigorous “shark tank” testing. The next step is deciding whether to partner with an existing distributor, or go it alone. This decision requires careful analysis and soul searching of the risk-reward relationship inherent in both scenarios.

You are already familiar with risk analysis: lenders and investors do it with every investment. The higher the risk they perceive, the higher the return must be. Or, in the case of a lender, the higher the loan cost they will charge.

So, it's decision time – you may decide you can’t take a high level of risk and instead choose to share your profits with a distributor, as he already has the infrastructure to deliver fast results through an established sales network. Frankly, that isn't an unsafe bet; the broader the scope of distribution, the faster the results! At a minimum, a distributor may buy your product and distribute under your brand marketing efforts. At a maximum, he may license the product from you and handle the entire sales and marketing under his own brands. As you can guess, the reward needed increases as your distribution partner’s risk increases with his investment in your brand.

If you ‘go it alone,' however, you are the investor – the lender to yourself.

You lend yourself the investment in dollars and sweat, in exchange for the full opportunity. This is extraordinarily risky! Truth: Less than 5% of startups succeed. And only a fraction of those succeed beyond the entrepreneur’s original income: that’s a terrible return on investment, particularly given the risk.

And that risk is huge. You may not have to give up everything, but you better be ready and willing to. You will have to invest both time and money – there’s no way to avoid it. Truth: Time is more rare than money (it's ever-diminishing); and you will almost certainly give up all of your free time, and perhaps all of your savings too!

Here's the kicker: If you're lucky enough to be a part of that fraction of that 5% – you’ll still need money for cash flow, particularly at the point where you must buy product in anticipation of sales. Whether that’s the first sale or part of ongoing sales, this is a period of real cash crunch. Ever hear the phrase “cash is king and profit is prince?” It describes this situation really well. But more on that math later.

I was a very good employee, but not very good at working for someone else.

If you’re like me, this rings true – you may have to, or want to do this on your own. If so, you'll need two things – first, a market – and then production. Fiction: “In life, there are no shortcuts.” To get the market, call your prospective buyer. Just pick up the phone! Yes, it’s that simple, provided you use the right approach. A great way to say it is, “I have a unique new product that focus groups of your target consumer love. What is the best way for me to show it to you?” Essentially, you are asking whether to use a broker to pitch your product or make a direct appointment to do it yourself. The bigger the customer, the more likely they will want you to use a broker – and they will gladly recommend which ones, saving you some legwork! They do this because the broker helps them vet opportunities.

If they want to see it immediately and impersonally (“why don't you send me one to look at”), hesitate. Your product may sell itself, but you want to give the pitch: “I happen to be in (Chicago, Bentonville, Kansas City, etc.) next week. How about I stop in for 10 minutes with a sample and the background market research for you?”

If you called me, I would agree to 10 minutes, but would block out 30 in case I really like it. Once you have your appointment and are on your way in, review and remember this for your pitch: Features, Advantages, Benefits (FAB). Though they should really be presented BAF – because the buyer cares about his benefits first. So, tell your story from his perspective; satisfy his (or her) wants and needs.

Money – that's what I want!

Let assume the pitch was a success. So now that you have your initial purchase orders, money quickly becomes available to you in a variety of forms and costs. Truth: Do everything you can on a shoe-string budget to get to that first big order. Now is the time to cautiously assess “nice to have” versus “need to have” expenses (a patent = need to have, advertising = nice to have). Ask your vendors to give you terms, perhaps even price their product/service payable as you make more successful sales. They will probably want a premium for this, and that’s OK – cash is king, profit is prince!

Your bank will be your first and cheapest money source. They will lend against your assets to the extent that they are marketable (usually around 50% of your inventory cost and 75% of your accounts receivable). However, your cash flow budget may show you that you still need more money than the bank will lend.

Your next potential cash source at this stage should be friends, family and others who are looking for a better return than the markets currently provide. If they're willing to take a chance on you, you should expect to pay them a much higher-than-bank interest rate in return (between 10% and 20%, and perhaps even an opportunity to own part of the business, depending on the amount of requested investment). Truth: be sure to engage an attorney to help you draft or review the loan documents. There are also strict SEC laws surrounding the marketing of business shares to private individuals – check with your lawyer on that, too.

At this stage, you may find you need even more money – or cannot find an alternative funding source. This may lead you to the worlds of Venture Capital and Private Equity. VC’s invest in startups; PE’s usually invest in ongoing firms. If you're not sure where to start, your banker will have a list he can recommend to you. These funds will make much higher investments, but will take much higher returns – both 20% return on capital investment as well as an option to buy into shares at a reduced price. A good friend of mine who is part of a PE group once told me, “You don’t want my kind of money if you can find it elsewhere!”

If you have a unique new product, I hope this helps you get started.

Next time, we'll review the “4 P’s of Marketing” and how they apply to the entrepreneur. As a parting thought, here’s a quick picture of how the cash-flow cycle can be negative while profit is positive, and therefore why the rich aren’t always as rich as you may think. Remember we talked about cash, profit kings, and princes? Let's do the numbers:

Say you sell $100 dollars (easy math here) worth of your product in year one, which cost you $60. You have $40 left over to pay your expenses, which totaled $30, so your income is $10. From that, your partner old Uncle Sam gets $3.50, and you also pay the bank $2.40 interest fees, leaving you $4.10 to take home. However, on January 1 of year two, you must now buy inventory against your anticipated 25% growth rate, adding $15 to inventory cash costs – ($25 sales growth x 60% cost of goods). Yet, clearly you can’t afford that, because you only “took home” $4.10!

This is only slightly simplified for brevity – you won’t spend $15 on January 1. But, another truth: you will spend it, and you will need to finance it.

That’s exactly why cash is king over profit. The solution is to spend frugally and wisely, grow slowly, and find a good banker or a partner/distributor who takes on the capital risk.

This is also why the “rich” aren’t always rich. It’s also why (WARNING: potentially political statement here) raising taxes on the “rich” can have a negative effect on economic growth – at least among the “rich” who are entrepreneurs or small business owners. Since the vast majority of American business is small businesses, I'm still holding out to see a better solution. Good luck!

Kurt Van Keppel