Economies of scale are not economies of operations

cash

I was quite surprised the other day when I was in a mentor meeting and we were discussing how the founder could grow their company. This was a very early stage startup with no funding. Yet we always focus on scaling as almost every founder we mentor wants to grow and grow big. Very few are interested in creating a lifestyle or boutique business.

Economies of scale

The other mentor exclaimed how the founder would be saving money on servers, as they grew the company, due to “economies of scale.” Buy achieving economies of scale often mean expending more cash, which isn’t saving money, it’s spending it.

Well what does that economies of scale mean? According to Investopedia:

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger factory will produce power hand tools at a lower unit price, and a larger medical system will reduce cost per medical procedure.

There’s a lot more to learn about economies of scale, so I recommend you to Investopedia. But the key point was the confusion – temporary I must assume – on the part of the mentor between operating and cash flow vs. economies of scale. In order to achieve economies of scale a venture needs to invest in scaling! That takes cash! And as we all know, cash is king in startups.

In days of yesteryear for a software company to achieve economies of scale required the investment of hundreds of thousands of dollars if not more in hardware as well as a system administrator to run it all. Today, thanks to Web services pioneered by Amazon AWS but now also available from Google, IBM, and Microsoft as well, scaling doesn’t require nearly so much cash or even a sysadmin.

Financial statements

Just the same, every startup needs to maintain the holy trinity of financial statements: income statement, cash flow, and balance sheet. For early stage companies the cash flow statement, expenses out versus revenue (income) in needs to be maintained at least monthly. Every Board meeting should begin with a review of the financial statements. And keep in mind that the larger the customer the longer they will usually take to pay you, as much as 90 to 120 days, one negative about enterprise customers. That’s why the cash flow statement has to be the most important statement, the lodestar of the CEO, because unlike the income statement, it takes into account the variable of time. As a startup you can try to stretch out your vendors like the big boys, but since 90% or more of your operating expenses will be staff salaries that won’t help much with cash flow.

Venture leasing

If your startup requires hardware other than servers, for example, lab equipment, you might be able to conserve your cash by what is known as venture leasing. Basically venture leasing enables your firm to rent, rather than buy, capital equipment. That reduces cash flow and also enables you to upgrade your mission critical equipment without necessarily needed to dispose of the old equipment. However, this financing term has venture in it’s name because this type of asset-less lending is only available to venture funded companies. No bank or other typical lender would provide equipment without collateral. Venture leasing does not require collateral, but does require that you’ve raised at least a Series A from an A level venture firm. That greatly reduces the risk for the venture leasing firm.

We did a small venture leasing deal with one of my VC-backed startups, which conveniently had the wife of one of our major investors as CEO of a venture leasing firm. But be advised that often venture leasing firms want warrants to give them some upside for taking on the risk of basically renting you your needed capital equipment. Once again we will turn to that very helpful web service Investopedia, just in case you don’t know what a warrant is, or the difference between warrants and stock options.

stock option is a contract between two people that gives the holder the right, but not the obligation, to buy or sell outstanding stocks at a specific price and at a specific date.

A stock warrant is just like a stock option because it gives you the right to purchase a company’s stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways:

  1. A stock warrant is issued by the company itself

  2. New shares are issued by the company for the transaction.

Any one who knows me knows that finance is far from my strong suit, and if it isn’t yours you may do like I did and bring on a part time consulting CFO to help you with your financial statements, setting up your accounting system, such as Quicken, and handling your accounts payable and receivable. Otherwise you can do all these financial statements yourself until you do reach scale.

Who prepares the financial statements is not important. Who keeps their eye on them is what is important – normally the CEO, CFO, and the Board of Directors.

As a startup it is usually very hard to project revenues, but expenses should be fairly easy to project. So keep a tight rein on your expenses, learn how to stretch your dollars, and watch your cash flow. Running out of cash is second most common reason why startups fail!

 

Author: Mentorphile

Mentor, coach, and advisor to entrepreneurs, small businesses, and non-profit organizations. General manager with significant experience in both for-profit and non-profit organizations. Focus on media and information. On founding team of four venture-backed companies. Currently Chairman of Popsleuth, Inc., maker of the Endorfyn app for keeping fans updated on new stuff from their favorite artists.

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