My basic philosophy on business is that opportunities and challenges are continuously presented to us and we need to respond appropriately. When it comes to managing challenges it makes sense to prepare in advance. My experience is that many entrepreneurs have difficulty doing this at two key points: right after a round of funding and when their business goes cash flow positive. The idea of saving for a rainy day goes right out the window and the dangerous assumption that the business will never go cash flow negative again sets in. This has destroyed many a promising start up.
The first area of expenses are what I call cosmetic or lifestyle expenses. The office location and how it is fitted out, especially the fancy espresso machine. The high powered computers to read your email, prepare presentations and manage a five sheet spreadsheet. The first class travel and five star hotels. Every entrepreneur knows that these, and many other, expenses are wasteful. However nearly every entrepreneur that I have seen has fallen victim to spending on some if not all of these cosmetic expenses.
I believe that part of the reason is that entrepreneurs have not previously been sole decision makers on the whole budget. They had a finance department with a well developed expense approval process to oversee spending. The sudden freedom in becoming the sole decision maker in a start up can be disorienting.
The second reason that cosmetic expenses are needlessly incurred is that the average entrepreneur is basically a rabid optimist. They would have to be to leave their job and start a company. If you are an optimist then it is natural to focus on positive outcomes and this leads to a willingness to spend.
The final issue that I will discuss on cosmetic expenses is the copycat effect. Many highly successful companies, especially in the IT industry, have provided a multitude of life style offerings to their employees. This has especially been made famous by Google. Now when your start up becomes massively successful, feel free to consider spending excess cash on cosmetics. But investing it at the start up phase is not going to lead to Google but rather to DeLorean.
The second major area regarding expenses has to do with necessary incremental expenses. For example, a start up that needs to hire 20 programmers does not have to hire the 20 best programmers in the world. If the start up is based in an expensive city such as New York, London or Dubai they can consider hiring programmers in India, China or Egypt. The risk of infatuation with “the best” extends to all facets of a business as entrepreneurs mistakenly believe that creating a successful product or service requires that it be “the best.” The problem is that “the best” also tends to be the most expensive and far beyond any price point that a client is willing to spend. That is why the Toyota Corolla is the best selling car in the world and not a Mercedes/Ferrari/Porsche/other expensive car.
The third topic on expenses that I wish to talk about are vendors and suppliers. Far too many entrepreneurs feel that negotiating with vendors and suppliers would send the wrong signal that maybe the start up is in trouble. This type of thinking is a trap. Entrepreneurs must negotiate prices and terms that are relevant for the start up’s financial situation. Over spending at the start up level is no different than a fresh graduate buying Armani suits, Rolex watches and a Porsche so that he looks good. It doesn’t work.
A final word on culture. It is important to build a cost culture in the start up. This means being cost conscious even if the cost is insignificant relative to the financial strength of the company. A start up that spends extra on frou-frou glass bottled water will usually end up over spending on the bigger things. This article has focussed on operating expenses. For some insight on how to tightly manage capital expenses please see Managing Negative Cash Flows and Adaptive Strategy Construction.