A Founder that doesn’t understand startup finance is a liability to the company.
The very survival of a startup comes down whether we have enough cash to survive. If the Founder can’t answer that question, it’d be like hopping on a jet with a pilot that doesn’t understand how to read the altimeter, compass, or fuel gauge. They might be a great pilot, but without knowing the fundamentals, that trip is going to end poorly.
Fortunately, Founders don’t need an MBA in finance to be competent, we just need to understand a few basic principles very well. While I’m the Founder + CEO of Startups.com, I’m also our CFO. That’s because I learned long ago that with a solid understanding of just a few key principles, we can make (and avoid!) really critical decisions instantly.
Gross Profit vs. Net Profit
Richard Branson famously admitted a few years back that he went decades without fully understanding gross profit versus net profit, so let’s agree even the best of us fall short on this.
If we sell a cup of lemonade for $1 and it costs 25 cents to produce that product (cup/mix/water), our gross profit is 75 cents. But if we then paid our kid sister (we’re 8 years old in this model) $2 per cup to work the stand, we’re actually losing $1.25 in Net Profit. We also royally suck at compensation models.
Gross profit is our leading indicator that we might be able to make money (the product is profitable), but net profit tells us whether we actually are making money (the company is profitable). There’s a massive difference.
In case this term is unfamiliar, a “burn rate” is another way of saying “how much money are we losing each month?” Since startups are always investing way ahead of their income, we are almost always losing money, which means we are “burning” through a certain amount of cash every month.
Remember — we can only have a burn rate if we are losing money each month. If we’re profitable, we’re golden. Our burn rate, however, is the slider that we move to exchange how fast we want to grow with how long we want to live.
If we have $1 million in the bank but are burning at $100k per month, we’ve got 10 months left to live. It’s that simple. A smart Founder will start with a target of how much runway (months to live) they would like to achieve and then manage their burn rate backward based on their cash position.
We should always know our cash position down to the dollar on any given day. Why? Because in the formative years, nearly every decision we are going to make directly impacts our cash position, which directly impacts how much longer we can survive. Not knowing our cash position on any given day is like going scuba diving without knowing how much air is left in our tank.
What we should be focused on at all times is our “worst-case cash position” which means if we paid out all the debts we owe right now, how much would be left over? We then take that number and divide it by our monthly burn rate and it tells us exactly what worst-case scenario is.
A Founder’s job is to make sure we don’t run out of money. But we can’t effectively do our jobs unless we understand, down to the dollar, exactly where our money stands.