I run a
How much cash reserve?
Answers
There is no magic number with respect to the proper amount of cash to hold. It will be dependent on your business. Start with three months of expenses as a reserve and then adjust the figure based on the following –
• Must you outlay costs on behalf of your client? If yes, add to the reserve.
• Do you have a minimum capital requirement associated with any client? If yes, add to the reserve.
• Do your clients pay you on time? If yes, no change. If no, add to the reserve.
• Does your business have pronounced cycles/seasons? If yes, add to the reserve.
• Do you have a line of credit you can fall back-on in an emergency? If yes, no change. If no, add to the reserve.
• Are you a mature company where there is very little unknown in the business economics? If yes, no change. If no, add to the reserve.
I worked with a technology start-up that was well capitalized, until the needs of our customers changed quickly. We had sufficient capital for our model; but insufficient capital to change our model quickly.
I need clarification on the last question to opine. Not sure what you mean.
I agree with Regis partially (I agree with all his decision factors) but I would start the baseline a little bit longer (say 4-5 months). 6+ months of reserves introduces you to the productive/efficient use of funds variable. My rationale for this is to give you time to react or pivot (if there is a need for one). Three months (as a baseline) for me is too short a timeframe to react. Once you miss the first month's projections, you basically only have 2 months to react. One thing I would add is that you make this known to your Board and investors and make sure they understand as they are your primary defense (recaps/fresh funding) once you miss projections or need to pivot.
As far as your second question, the longer the contract, the better for your company. I would LOVE to have a 1 year minimum and stretched out to 2 years if/when possible. With our economic environment, I (personally) would not expect any contracts longer than 2 (but great if you can get longer). Companies do not want to over commit themselves unless your technology is so far ahead of the competition that replacing you near term is out of the question.
Some tweaks about setting cash on hand targets, especially for a start up that is project oriented.
How frequently you review / forecast your cash position is as important as the position itself. (i.e. it's 9AM do you know where your cash is?). Being right only ever 30 days or when ever you close your books maybe too late for a young company.
Finally, what happens if you are wrong? The future is uncertain and your company is growing (hopefully). Having "enough" liquidity could mean more than just cash on hand or it could mean that even 6 months of cash on hand is now no longer enough
When looking at cash consider "strategic vs "tactical" cash targets where strategic represents an amount to be used for other than "keep the lights on" expenditures. Example: one time
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That's a really good point to separate out strategic vs tactical needs.
For a small growing company, we are pouring most of our surplus profit into strategic longer term projects that probably won't yield a return until 2-3 yrs. And if what we believe to be the right business model doesn't work out, then there is no point in dragging on.
Having a much longer than necessary cash in reserve seem frivolous luxury to me, but I need to strike that with a balance of being able to meet operational needs. For some start ups, there is simply capital investment and no revenue, so they often refer to their runway. But for us, we have continuous consulting revenue while investing into a product that will make us scale-able, so I am wondering how to make decisions based on foreseeable contracts and cash at hand for the investment (riskier) portion.
May I suggest that in addition to 8-12 months of cash reserves, you also try to arrive at a short term liquidity ratio that can provide the company with a 2-3 month operating cash balance.
Here's what I tell clients: If you want your business to survive a downturn, imagine a recession/down turn in the economy, how much your sales might decline, and for how long(-30% for 24 months, for example). Run a cash flow forecast based on that scenario and determine how much cash your business might bleed during the downturn. THAT is the least amount of cash you want to have if you want to survive. The forecast can get more detailed if you build in reductions of overhead, but you might want to plan to sustain key employees through the downturn.
The cash reserve answer depends on the stage and foundation of the company. Either way I like to keep it simple in my own businesses and those of my clients:
1. If you are just starting out a professional services consultancy, I suggest looking at things in milestone fashion. First make a goal to cover 1 payroll with available cash. Next move to 2 payrolls. Once you are stabilized to that, set a new goal to cover 1 month of payroll (both your project staff and
Eventually you will want to set your next milestone of 3 months coverage of the above costs and then 6 months.
Underlying this is the notion that will client billings you will be looking for a working capital line of credit, be it with a bank, factoring or maybe friends and family, using these funds as a buffer to payment timing.
Ultimately, a good analytic will be to set a minimum working capital ratio of 1.50 (current assets / current liabilities). Once you have reached that mark, consistently, and have 3-6 months cash in the bank to cover operating expenses, the stress level should drop.
Cash above these levels can then be earmarked for debt pay down, investment in your business or distributions. The premise is that the more cash you have in the bank, the less you need to borrow and resulting interest paid to your financiers. Also, it will be much easier to sell your story to the bank once your current ratio is above 1.50, to get other term debt to facilitate continued growth.
2. If you are a pre-revenue company and are developing a product, then shooting for 1 year minimum of runway to cover your payroll, overhead and development costs should be your minimum “ask”, especially if you are targeting a VC or other investor group. Optimally you would go for 2 years. Raising equity is/will be a huge distraction and ALWAYS takes much longer than anticipated, if you can even get it.
On the contract question – the longer the period, always the better. But to again be realistic, 1 year I have found to be the standard and accept the caveat that a contract can always be broken, for a variety of reasons. Thus, treat your client and contracted project like they can cancel at any time – every day provide stellar service and value.
Hope this helps and I am always happy to evaluate more specifically pro-bono and on a confidential basis. Feel free to reach out through private message. -Paul
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Thank you, Paul. Your recommendation of stepping up the reserves is a very practical way for me to act on as my business evolves and grows.
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