A Twitter follower just asked me how much dough did I have when I started trading full-time. Â Instead of a quick response that will soon be lost in the Twitterverse, I decided to share a document that I wrote 5-6 years ago addressing this very question. Â To be honest I haven’t reviewed it since, but it made sense at the time.
Capital Needed to Walk
It’s a consensus agreement among entrepreneurs that a business plan is essential for anyone starting a business. How can you reach your destination – if you don’t know where you are going? Most don’t question this wisdom, especially if start-up funding is sought. It’s quite simple – whenever I am approached about investing in a business, I ask two deal-breaking questions: How and when am I going to get my money back? Those questions are impossible to answer satisfactorily without a plan.
I remember writing my first business plan and discovering the power of Microsoft Excel. My business could be moderately or extremely successful by simply changing a couple variables in my revenue projections. It was quite interesting how I always managed to make money no matter how much I tweaked the numbers. Mystically, the sales always materialized.
One of the many lessons I learned during my first full-time entrepreneurial venture was that you can never have enough start-up capital. I was so convinced that my day job was limiting my opportunities that I quit before securing the big contract. All of my revenue projections included this contract as the baseline, without it – being moderately successful was a pipe dream.
In addition to not closing the large contract, collections were a challenge. As I waited for payments, the operation had to continue – payroll had to be met, supplies had to be purchased and don’t forget the rent man. It is crucial to have enough cash on hand to manage through these types of circumstances. You can probably guess how this story ends.  Nine months later I was back punching the clock. It didn’t have to end this way or at least not as quickly.
This story is quite common. Ask ten entrepreneurs and most will have experienced similar scenarios. I am willing to bet that even Bill Gates has a comparable story or two. It is very rare that an entrepreneur doesn’t have cash flow problems at some point. My latest venture is much different. I didn’t walk away from my J.O.B. until I had 4.5 times my annual expenses in the bank. Why four and a half times? Why not three or five? Let’s take a look at how I derived the number.
First, I divided my capital into three buckets – day to day cash, intermediate cash and long term cash. The day to day bucket is to address everyday living and business expenses. The intermediate is to address unforeseen matters 1 to 5 years out. Long term is for issues at least 5 years in future.
Next, I determined the return on investment (ROI) my business would generate. This is quite subjective. Really the only true measure is if it is based on history. Thus, I highly recommend working the business part-time before venturing out. The steady paycheck takes a tremendous amount of pressure off and allows time to determine whether the business is feasible. The ROI is simply your profits divided by your investment. So, if you invest $300,000 and return $100,000 – your ROI is 33%. If your ROI is less than 20% – it may be wise to figure out what’s necessary to make your business more profitable before venturing out.
Once you are satisfied with your ROI, your Capital Needed to Walk (CNTW) is simple to calculate. The basic formula is the inverse of your ROI plus one and a half times your expenses.
CNTW (20% ROI) = 1/.2 + 1.5= 6.5 * Expenses
CNTW (25% ROI) = 1/.25 +1.5 = 5.5 * Expenses
CNTW (33% ROI) = 1/.33 + 1.5= 4.5 * Expenses
In my case, based on history, I believe that I can generate a 33% return on my investment each year. So, before quitting my 9 to 5 – I accumulated 4.5 times my annual expenses. The logic is that if one has 3 times their annual expenses invested in the business and can generate a return of 33% it will result in enough money to cover the next year’s expenses. If this can be continued in perpetuity there will always be enough money to keep the doors open. Obviously, some years will be better than others. So, in the good years the additional money is moved into the intermediate bucket. This serves as reserves that can be drawn upon in the in bad years.
Here are some CNTW break downs:
33% ROI:
- 1 Year Expenses Up Front
- 3 Years of Expenses Invested
- 0.5 Years Expenses in Intermediate to address shortfalls
25% ROI:
- 1 Year Expenses Up Front
- 4 Years of Expenses Invested
- 0.5 Years Expenses in Intermediate to address shortfalls
20% ROI:
- 1 Year Expenses Up Front
- 5 Years of Expenses Invested
- 0.5 Years Expenses in Intermediate to address shortfalls
Let’s take a look at a couple examples.
Annual Expenses – $100,000
ROI – 33%
Capital Needed to Walk = 1/.33 + 1.5 * ($100,000) = $450,000
Annual Expenses – $100,000
ROI – 25%
Capital Needed to Walk = (1/.33 + 1.5) * ($100,000) = $550,000
Annual Expenses – $100,000
ROI – 20%
Capital Needed to Walk = (1/.2 + 1.5) * ($100,000) = $650,000
Obviously there are many variations on this thesis. Maybe one would be more comfortable with more reserves. For instance, 2 years of expenses up front and 1 year for intermediate needs.
Annual Expenses – $100,000
ROI – 33%
Capital Needed to Walk = (1/.33 + 3) * ($100,000) = $600,000
Or maybe expenses can be reduced from $100,000 to $80,000.
Annual Expenses – $80,000
ROI – 33%
Capital Needed to Walk = 1/.33 + 1.5 * ($80,000) = $360,000
Cash is king and this rings especially true for businesses. I have applied this approach to my stock trading business, but I believe that is applicable to any type of business. The bottom-line is under capitalization is the demise of many businesses.
For the inquiring minds:
How did I accumulate my CNTW?
I did it the old fashion way – I earned it. Whenever I received a bonus or a pay increase from my J.O.B. it went into the bank. It seemed kind of boring when my friends were buying all kinds of neat toys, but not so much now when they are stuck in traffic driving to work. Also, I learned to use the bank of Wall Street.  Simply depositing money into the local bank is not good enough.
If you have read my blog in the past – you know that I am a big Apple supporter.  I own many Apple products, own shares in the company and respect the way that the company is run.  I also realize that many people hate Apple for numerous reasons.  Whether you love ’em or hate ’em the following Steve Jobs speech, to his new VPs, provides a valuable lesson for everyone.  I find it especially applicable in my world of  investors and entrepreneurs.
