Why Your Startup Should Have a Spending Strategy

Proshare

Wednesday, February 07, 2018 4:10PM / WebTV

 

When it comes to starting a new business, a whole lot of factors need to be taken into consideration – salaries, marketing budget, office size, technology services, and on and on. Knowing what to spend your money on and how to spend is critical to the success or failure of a budding enterprise, so entrepreneurs must first develop a strategy for allocating limited resources across a wide range of available options. Too often, assumptions about the potential market and its clients can cloud our judgement about expenses. Let’s examine two cases, one a former colleague and the other a close friend.

 

The first is Seun. After managing a branch of a first generation commercial bank in Lagos for almost ten years, and building ample savings, Seun was ready to do his own thing. From past experience, he believed that attracting wealthy clients required high-end office space; so he leased space in a Banana Island office building at a price that would rattle anyone’s teeth.

Seun was sure his revenues would exceed costs within a year, but the large clients he expected never materialized. In fact, he began to notice that prospects would react negatively to the extravagance of his office, décor, and furnishings. So not only were the current fees too weak to support his fixed costs, but future clients were turned off by his apparently excessive tastes.
 

To address those cost overruns, Seun subleased some space, cancelled a redundant and very expensive trading service, and let one person go. Two years later, his fortune began to turn around as stronger performance helped bring in business, and he finally showed a profit. Looking back, Seun knew that his overspending had nearly cost the firm its life.
 

Let’s look at another example: Chinyere had completed her master’s degree in political science at the University of Lagos, but decided to pursue a longstanding interest in fashion by turning a vacant storefront in her Surulere neighborhood into a hub for her fashion line. While her ushering jobs in school were Chinyere’s only source of industry fashion experience, she had plenty of enthusiasm and enough savings to start.
 

The costs soon proved much greater than expected. She hired a consultant and a contractor, who found structural obstacles that were expensive to address. She replaced the first builder, but the second insisted on making even more renovations.  And although her dream industrial sewing machine was far outside her price range, she bought it anyway.
 

By the time she opened Serenity, it was 100% over budget. Chinyere had run through all her money, and resorted to borrowing from several friends. But she convinced herself, each step of the way up, that the expenses were worthwhile and would eventually pay off. Unfortunately, she failed to break even during the first year, and lost her head tailor in a struggle over the designs and staffing.

 

Hoping to bring in a partner with both cash and expertise, she met with potential investors and business partners, mostly fashion entrepreneurs of small clothing lines. These experienced fashion entrepreneurs valued Serenity well below what Chinyere had invested. When she expressed surprise, they told her that her place was beautiful and very functional, but her price was far beyond what they would pay: code for “you overspent for the location and construction.” Eventually, Chinyere had no choice but to sell the business, taking a major loss but learning a lifelong lesson.

These cases show the consequences of overspending. But of course, it’s not always easy to know where to draw the line; underspending can also hurt your new business. A dingy office without sufficient staff can give the appearance of not having enough business or being cheap. Each cost item comes with expected returns—for example, adding staff means a higher payroll, but also clearer lines of responsibility and a lowered chance of burnout.

Both Seun and Chinyere should have more carefully and conservatively forecast the timeline for expected revenues and managed their costs accordingly. This would have helped them avoid a cash crunch. They were both naïve to think that creating a high-expense; polished operation would automatically enhance their business. In reality, it only added to the breakeven level, which can kill a new enterprise’s chance of survival.

Let’s look at one last example, this time of two associates of mine, who started with a sensible spending strategy. Isaac and Lillian decided to leave their top tier accounting firm and set out on their own. They were realistic about their expenses and budgeted carefully. They leased a third-floor space in the Ikeja neighborhood, and they hired two people — the minimum they needed — for the approximately twenty accounts they had at launch. While Lillian initially wanted to hire a senior partner at a high-end law firm and rent space in a popular office tower, Isaac vetoed these moves as too expensive for the startup period. The potential tradeoff was missing an opportunity or two that a well-connected lawyer or a more dramatic view might bring them, but they agreed that those likelihoods were remote.
 

Several clients followed them, and within a year, they could afford to add more staff. Prospective customers offered positive feedback about the office space, so they knew it wasn’t over the top or below an expected standard. Isaac and Lillian were pleased that they had right-sized their investment in the new entity.
 

So how do you know what tradeoffs to make when it comes to allocating resources to build a new business? It’s hardly straightforward. But here are some questions to ask yourself to help you overcome your own spending habits and assumptions:
 

1. What is the impact of your expenses on potential clients?
 If your goal is to attract and not repel revenues, imagine yourself as walking into your office, surveying your website, or using your app to see what impressions you take away as a customer — and how you’d feel about the quality of the service. 

2. How will your employees react to spending patterns?
 If your startup spends a lot on office design or executive first-class travel, consider the impression on your staff. If the paintings on the walls are worth more than their annual salaries, they may see themselves as low priority. Think about whether you are providing what they need in terms of technology, benefits, and a comfortable environment. 

3. Do your colleagues understand that your spending is meant to benefit everyone?
 In the early stages of the firm, remember to communicate with your co-workers about key strategy costs that are required to grow the business and how their returns will justify the expense. 

4. What is your business’ core competence? How can you focus your spending on that?
  For Seun, having a strong research analyst in the conference room would have been more important for his business than powerful bass speakers. For Chinyere, in choosing between a better industrial sewing machine and the best interior decors, she was wise to go with the former. And for Isaac and Lillian, purchasing state-of-the-art accounting software was money well-spent compared to having a better view of the Lagos waterfront. 

5. What can you afford to lose?
 Finally, when you can’t hit equilibrium at the very least, ruthlessly comb through your costs and consider what is non-essential and what you can live without until revenues climb higher. Do this while there’s still time and you stand a chance of turning things around for your business.

 

Adapted from HBR.org 

 

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