Keeping Tabs on Your Cost

With the equity gap widening, start-ups are looking to find new ways to stretch their scarce resources.

Cash burn is a problem for any start-up - and contrary to common belief, the components that really drain your bank account can't always be anticipated. 'Let's just say we blew in the region of a million dollars on recruitment, redundancy costs, and staff ups and downs,' admits the CEO of one start-up, explaining how desperate attempts to land its first sales had forced it to hire and fire a succession of expensive employees.

With the so-called 'equity gap' continuing to cause problems for smaller technology companies that don't qualify for venture capital funding, implementing tight financial controls could be the main factor that ensures your seed capital keeps you in business. Long gone are the days of plush offices, fancy cars and state-of-the-art equipment. Now more than ever the old accountants' warning - if we halved our revenues and doubled our cost base would we survive? - is starting to ring true.

The existence of an equity gap in London's capital markets is nothing new. In April 2003 the Government announced a consultation effort dubbed 'Bridging the Finance Gap', a joint initiative between the Treasury and the Small Business Service. The document says: 'SMEs seeking equity pass through different stages in the funding life-cycle, typically starting with personal capital, often supplemented with bank debt and equity from friends, family and other private investors including 'business angels'. Only a small minority raise equity in amounts over �250,000 from these sources. Above this threshold, SMEs must generally look to the formal venture capital sector to meet their equity funding requirements.'

But this is where the problem emerges: 'Many commercial venture capitalists are reluctant to invest in small amounts (a �1 million threshold is often cited) for a variety of reasons, principally high fixed transaction costs, shortage of available exit options, and a perceived greater risk in investing in early-stage companies. Although the UK has one of the most developed private equity markets in the world, it has increasingly focused on later-stage deals.' The document notes that while the overall number of private equity investments has increased by 17 per cent since 1997, the number in the �500,000 - �1 million range has declined by 10 per cent.

From the VC's perspective, there's a simple explanation for this phenomenon. Glenn Stone, corporate finance partner at Grant Thornton, says: 'Raising capital is very hard today - and I'm saying that as someone who can get in front of VC funds. Venture capitalists have become almost as risk averse as the banks. Some are not at all interested in start-ups. They won't even talk to you unless you have a pipeline of sales. They call it risk capital, but really [what VCs are offering is] development capital - and yet they still want VC returns.'

The Government's answer to the problem is to attempt to mirror the US, where state-aided Small Business Investment Companies account for nearly 60 per cent of investments. After more than 150 responses to Bridging the Finance Gap, the resultant output calls for, among other things, the creation of Enterprise Capital Funds (ECFs), the bidding rounds for which recently closed. These will add to the existing Regional Venture Capital Funds (RVCFs), the largest of which is London's �50m Capital Fund. But with the RVCFs designed to invest sums of less than �250,000, and the success of the ECFs still to be evidenced, the best option for many entrepreneurs is to make seed funding stretch as far as possible.

It's not, as one investor recently put it, necessary to 'prepare for poverty', but start-ups need to be ready to tighten their belts until regular sales start coming in and the business gains some stability. 'Starting a business is more than a full-time job,' says Geoff Sankey, managing director of the Capital Fund. 'It's a life activity and it absorbs most of your waking hours.'

Boxout: Controlling costs: the start-up's perspective

1) Ensure major suppliers have a vested interest
One business that has been through the experience of stretching out a �250,000 DTI-backed Loan Guarantee Scheme loan is hospitality and charity technology provider Eproductive. Chris Cowls, CEO and co-founder, recommends ensuring suppliers are pulling in the same direction as the business. 'Our technology partner is now an equity stakeholder, which means all of the key players have an interest in the success of our venture.'

Cowls says keeping its main supplier onboard has been one of the key factors in its delivery of Internet-based management control systems. The ongoing commitment of suppliers can be critical to the success of any small business, so giving them a vested interest in the success of the business is a good safeguard of future wellbeing.

2) Keep a lid on people costs
People costs are often the largest single item on a start-up's P&L, but they're not always managed as well as they could be. For one thing, smaller businesses often don't have time to carry out formal performance reviews - yet these can often give both employer and employee the chance to step back and assess their work. It's not just about analysing someone's performance in their job - it's also about establishing whether the employee's skills and knowledge are being put to the best use. Many tasks and activities are carried out as a matter of routine, even if the original objectives have long since changed. It's also worth assessing what value each employee creates and asking yourself whose job would go if you had to make redundancies - that may give an interesting perspective on how well you're deploying your human capital.

In addition, consider pay scales carefully. One business angel argues that no executive in a seed capital funded start-up should be earning more than �30,000. While reward should always be in line with the value an individual adds to the business, keeping a cap on salaries is an effective way to ensure costs don't spiral.

3) Control cash flow
Everyone knows that cash flow management is essential for ongoing stability, especially for businesses with high start-up costs such as software development. But how effective is your long-term planning? Rolling forecasts that look ahead six to twelve months provide a guideline for businesses to manage peaks and troughs in cash flow. Specific problems such as slow paying clients can also be managed through a combination of techniques, from payment incentives or penalties to concerted efforts to build a more mutually beneficial relationship. Those steps are often preferable to external solutions such as factoring, which comes with considerable costs attached.

4) Minimize fixed costs
'You need to keep an eye on your fixed costs' says Cowls, 'if only to keep them in check.' It's a truism that fixed costs can't be easily altered, but it's worth doing a regular review for the best deal on office rental, equipment hire, and monthly telecoms and IT.

5) Carefully evaluate asset purchases
Always ask whether the purchase of an asset is key to the development of the business or whether the leasing/rental option may be cheaper. But by the same token, don't cut corners in the wrong places. Cowls says: 'Don't scrimp and save on the wrong things. We've paid top dollar in outsourcing our servers because it's our clients' data and critical to our success. You need to pay good money for what's important'.

Written by David Longworth