In order to build a healthy business, extensive capital raising is often required. The reasons for this are numerous: the recruitment of employees, the construction of a production, marketing, and distribution infrastructure, or the financing of large advertising budgets. Businesses are also often required to finance their customers by extending generous credit in order to break into the market. In the previous sections, we emphasized the importance of business planning and the structuring of realistic forecasts. This section will focus on a crucial issue facing every startup, namely, forecasting its cash needs. Even if a startup has a promising future, incorrect preparation for the various stages of the business could cause it to collapse due to a shortage of cash, and not necessarily due to an inability to meet its economic forecasts. On the other hand, entrepreneurs are usually not interested in raising too much cash at too early a stage, mainly due to the dilution entailed by capital raising. The objective of entrepreneurs is to maximize their share at the time of exit. It is therefore essential that the raising of capital be planned so as not to result in a significant dilution on the one hand (by raising too much capital), nor in a shortage of cash that would jeopardize the existence of the business on the other. For this purpose, it is important to focus on the various distinctions between cash flows and accounting revenues and expenses.
Cash Break-even Point
As mentioned above, when examining a company's profitability, it is important to check its cost structure and particularly its break-even point. The basis for the calculation is the company's fixed costs, divided by the contribution margin from the sale of a single product unit (i.e., the revenue per unit minus the variable costs per unit). However, it is important to distinguish between the profitability break-even point and the cash break-even point. There are several different definitions of cash break-even points, the most common of which is the FCF (Free Cash Flow). The FCF point is based on the operating cash flow, in addition to the cash flow components resulting from the investment activities required in order to allow the business to reach its goals with respect to its volume of business. Any cash beyond the FCF point may be distributed by the company among its shareholders and debt holders, in accordance with its chosen capital structure. Companies usually reach this break-even point when their growth rate slows down.
The Scale of Investment Required to Reach Profitability
In order to be able to use a break-even point analysis for financial forecasting, it is necessary to examine, beyond the actual level of operations at which the business becomes profitable, the scale of financing needed to reach such a point. In practice, this is the amount of cash required over the quarters and years leading to such a point. In addition, as may be seen in the decision tree example in a later section that includes possible scenarios, it is important to estimate the various scenarios and the business results of each one, and to attach probabilities to such scenarios. In this context, simulation tools may be used, as they enable assumptions to be made with respect to parameter distributions and to the various relationships between the parameters.
The most significant parameters relating to the uncertainty clouding startups in their infancy relate to the duration and cost of the product development stage. Delays in development could affect the expected revenues from the product, over and above its development costs, since the advantage of being "first to market" could evaporate, thus tightening the company's competitive situation. The timing of breaking into the market is related to the issue of uncertainty in the pricing of products, which itself is intimately connected to the forecasted competition in the market when the product is launched.
The costs of the products, and therefore the profitability of manufacturing them, are another contributor to uncertainty that needs to be addressed in the examinations made, since they will materially affect the company's cash needs until it becomes profitable. The company must further consider its market entry strategy, which has a dramatic effect on the amount of money that must be raised. For instance, in order to support an advertising campaign for the company's products, the company will need to raise a large amount of outside short-term cash, even if in the intermediate-term such amounts may be secured by large revenues.