This is a syndicated post originally written for Xcelerate Financial, a fully outsourced CFO and accounting firm for startups and entrepreneurs:
Liquidity risk is always a concern among startup companies and business owners. A common problem facing small businesses today is a lack of financing. In fact, a recent survey conducted by the Federal Reserve found that as many as 44% of all small businesses have trouble finding adequate funding.
What’s more, for companies doing less than $1 million in annual revenue, the need for capital spikes to more than 65% of all small businesses. And sadly, only 45% of all small businesses with revenues below $1 million were able to get financing from traditional banks, lenders, and through other normal means.
What this shows us is that small businesses are in dire need of capital. But we already knew that, didn’t we?
For a young company looking to grow, this lack of capital financing has led to increases in “startup liquidity risk.” However, while it may seem nearly impossible to get a cash injection from debt or equity financing, it’s possible for companies of all sizes to plug funding gaps with customer cash. Let’s take a look at how this is possible and how it can help your company.
WHAT IS STARTUP LIQUIDITY RISK?
Liquidity risk is a broad term that’s typically used to describe the fact that financial assets such as a stock or piece of property can’t be sold quickly. What this means is that when you invest in an asset, you won’t be able to access the cash you used to purchase the asset with any sort of speed.
For a startup, however, liquidity risk describes situations where a company either has cash tied up elsewhere or not enough cash in general to meet working capital and expansion needs. It is, in a sense, close to the actual term for liquidity risk. Like with a real estate investment, startup companies face liquidity risk because they can’t meet future payment obligations due to current obligations.
What this typically means is that a startup needs capital to invest in the business but either has a drag on liquidity or not enough cash in the bank to make the investments. For example, if you have a signed purchase order but not enough cash to purchase the required inventory, you’re facing startup liquidity risk.
HOW DOES STARTUP LIQUIDITY RISK AFFECT YOUR STARTUP?
Ultimately, startup liquidity risk, if taken to its end, results in the insolvency of your business. Calculating your financial runway, for example, is the act of calculating how much liquidity risk your business faces. If you need an influx of cash to keep the lights on within the next 30 – 60 days, it’s safe to say that you have high levels of startup liquidity risk.
But startup liquidity risk doesn’t always result in an insolvent business. No, instead, it might cause you to flounder and suffer, deciding to lay off employees not because you want to, but because you can’t pay them. Or maybe it causes you to miss opportunities because you don’t have the means for an up-front payment or something similar.
Overall, your startup liquidity risk affects the ways in which you can meet your working capital needs. A high level of risk means that you’ll have near-term trouble meeting your overhead requirements. A low level of risk means that you’re either profitable or have enough cash in the bank to weather most storms on the horizon.
HOW TO USE CUSTOMER CASH TO PLUG FINANCING NEEDS
It’s pretty clear that you want to avoid startup liquidity risk at all costs. But how? Most startup companies often rely on cash injections or seed investments from investors or something similar. Some small businesses that can’t get investor funding rely on debt, but as we saw above, it’s not common.
It’s therefore necessary to look outside of the “traditional” ways to plug financing gaps and keep up with working capital needs. Below are 4 ways that you can use new or existing customer cash to plug any financing needs. The result is a more stable business with a reduction in startup liquidity risk.
1. Offer a Subscription
The subscription revenue model isn’t new hat anymore. Still, many startup companies fail to consciously think about moving to a subscription model when they need working capital. A subscription model is when a company, usually a SaaS business, charges you a recurring monthly amount for access to their product or service.
The beauty of a subscription revenue model is that your future earnings are more stable and predictable. This allows you to measure your financial runway with more clarity and ensures that your startup liquidity risk doesn’t creep up on you. What’s more, since users typically pay at the beginning of their subscription, this model will usually give you cash injections at the beginning of each month.
2. Act as an Intermediary
Another great way to generate working capital and fulfill your financing needs is through what’s known as the “matchmaker model.” This model is the act of being an intermediary and connecting wealthy buyers with sellers. Of course, to make revenue, your company takes a portion of the deal struck between buyer and seller as a “finder’s fee.”
Online platforms are a good example of this. Facebook acts as an intermediary that connects advertisers with relevant consumers. The platform itself isn’t the “product” that generates revenue for the tech giant. The same goes for agencies. Savvy digital advertisers, for example, might only sell their knowledge as a premium to companies, helping them launch and manage Facebook ad campaigns.
The result is that companies that make their money as intermediaries don’t need intensive upfront capital. Instead, their largest investment is their time and the energy it takes to connect the right buyers with the right sellers.
3. Collect Upfront Payments
This might be the best way for you to deal with any startup liquidity risk. Collecting upfront payments is a great hack to generate cash quickly, and at the same time, keep your existing business model intact.
This is because when you collect up front payments you’re making your customers commit with cash rather than a verbal agreement or something similar. If you have a large purchase order but not the funds to fill it, for example, you can ask your customer for 50% up front in return for a 10% overall discount. This has the dual benefit of helping you meet the order as well as increase customer satisfaction.
4. White-Label Existing Products
The last option for using customer cash to cover any financing needs is by white-labeling existing products. White-labeling is the act of taking a generic product, putting your label on it and reselling it in the marketplace. This is common with health care supplements and almost any generic-type product you see on Amazon.
The beauty here is that if you’re trying to disrupt an industry or meet an underserved need, you can white-label an existing product to grow your customer base and generate cash while you build your real MVP. You can even use a white-labeled product to collect market data so that your real product benefits.
The bottom line is that all startups need working capital help at one point or another. However, not many companies look to customer cash as a way to fill their financing needs. Make sure that when you’re facing startup liquidity risk and the fear of insolvency that you explore all your options, including the 4 ways to use customer cash outlined in this article.