HOW TO DETERMINE THE TOTAL FUNDING NEEDS OF A START-UP PROJECT

In this post it will be explained how to estimate the total funding requirements in t=0 of a start-up project. The methodology should take into account the following items or liquidity buffers:

  1. Cash allocated for the investment plan, known as “CAPEX” (Capital Expenditures). The assets of a company can be categorized as current assets and non-current assets. The cash flow that the company invest in non-current assets is the CAPEX, and by definition, the non-current assets are those ones that will be held more than a year in the company, they are considered the fixed infrastructure of the company, and without them, it would not be possible to manufacture and sell the product or service of the company. The non-current assets can be classified as: (I) tangible (land, vehicles, furniture, buildings, computers, machinery, etc); (II) Intangible (trademarks, goodwill, patents, software developed by a company); (III) Long-term financial assets, financial products owned by the company, with the idea to remain these assets in the company for the long run, such as shares of another company. Imagine that company “A” has an investment plan, CAPEX, of €50 millions to build a hotel resort in Aruba.
  2. Cash allocated to run operations from 3-18 months, even if the business does not generate sales or cash-flow for a period of tie. This liquidity buffer is arranged to support the operational fixed costs, known as “SG&A” (Selling, General and Administration expenses”) for “X” months. The total number of months is decided by the entrepreneurs, but it could range from 3-18 months. Some examples of SG&A are: salaries, social security, rentals, marketing budget, software licenses, taxes, external service providers (outsourced services), transportation expenses, insurance premiums, facilities and utilities. As it can be seen, this type of expenses is fixed as it does not depend on production or units sold. Let’s imagine that the monthly SG&A is €10,000 and the entrepreneurs want to have a liquidity buffer to cover SG&A for 9 months, the cash allocated for 9 months of operations would be €90,000. With this buffer we guarantee that if the company does not sell any product/service for 9 months, the operational expenses can be paid.
  3. Cash allocated for start-up expenses. When a company is created, there are several expenses that only happen at the creation of the company (in t=0), such as certain local taxes, registration of the society, notary, legal advisory, etc…Any expense that is related to the creation of the company and that is not recurrent over time, will be considered as start-up expense and must be budgeted too. They are considered as SG&A in t=0 and a non-recurring expense as it is not repeated over time. Let’s imagine that the start-up expenses in this case are €60,000.
  4. Cash allocated to build a certain level of stock. This apply to companies that manufacture a product and require a level of stock. Imagine that our start-up is a hamburger chain that has established a 5 day of supply as stock level. That means the company should hold a stock of hamburger ingredients to meet the daily demand by 5 days. Imagine that the sales forecast in units of hamburgers is 365,000 hamburgers per year, the daily demand would be 1,000 hamburgers per day, so we would need ingredients to “produce” 5 days*1,000 hamburgers (=5,000 hamburgers). If the cost of the ingredients per hamburger is 5 euros, the cash requirements in order to build 5 days of stock in t=0, would be 5,000 units*€5=€25,000.
  5. Cash allocated for value added taxes paid in t=0 (VAT). All the cash disbursements in t=0 that pay VAT, must be calculated too, as the VAT must be paid. In this case, if we assume a 10% VAT level, and assume that CAPEX, start-up expenses, stock level pay VAT, the liquidity buffer for VAT would be: 10%*(€50 millions CAPEX+€60,000 start-up expenses+€25,000 stock level). Please note that we do not have to allocate cash-flow for 9 months SG&A as these expenses do not happen in t=0, but over a 9-month period. Therefore the cash buffer for VAT would be= €5,008,500.
  6. Cash allocated for unexpected expenses or events. This is called contingency buffer, in order to cover unexpected events that the entrepreneurs cannot foresee in t=0, but might happen in the future. The management team has decided to allocate a contingency buffer of 3 months of SG&A. Please note that the contingency buffer is fully decided by the entrepreneurs. In this case it would be a contingency buffer of 3*€10,000=€30,000.

If we take into account items 1+2+3+4+5+6, the total funding needs required by this start-up project would be €55,213,500€, break down as follows:

  • CAPEX: €50,000,000.
  • SG&A to cover 9 months of operations: €90,000.
  • Cash to cover start-up expenses (in t=0): €60,000.
  • Stock level, days of supply (D/S=5): € 25,000.
  • VAT paid in (t=0): €5,008,500.
  • Contingency buffer: €30,000.

Once that we have determined the total funding needs of a project, the next question to answer is to determine the funding mix and its cost (WACC). The two major funding sources of companies and projects are “E”, equity funding” (shareholders) or “D”, banking debt. This ratio usually is 70% (E) and 30% (D), but it depends on the project characteristics, country framework and start-up ecosystem. In Spain, according to Webcapital (2016), this ratio was 86% (E) and 14% (debt) for the start-up ecosystem in Spain in 2015