While I was managing a Business Angel network a CEO of a company approached me seeking additional funds. They were selling a service and the CEO said to me:
“We have a profit of $500 for every sale we make. We have hundreds of clients giving us testimonials for the excellent service we provide and we can’t keep up with demand. Current clients are referring new people to us all the time. We haven’t spent anything on advertising or promotion for the last six months. I’m looking for another $100,000 so I can employ three more people to manage the increase in demand. Do you think Business Angels would be interested in investing?”
I was impressed. “Do you have skin in the game?”
“Yes, my wife and I have put $150,000 of savings into the company and we just re-mortgaged our house.”
This is sounding a little too good to be true. If the business was generating that much money why would they need more money for investment? Surely the profits from the business could simply be reinvested. I thought about the word profit… “You’re making a profit of $500 on every sale, tell me more.”
“It’s simple”, came the response, “we buy our service for $1,500 and sell it to clients for $2,000. So every time we sell to our client we make $500 profit.”
If you know the difference between Net Profit and Gross Profit you will immediately appreciate where things are going wrong. His Gross Profit is $500. Net Profit (i.e. the profit the business makes) is Gross Profit less Fixed Costs. Fixed Costs includes office space, heating, sales people, management costs, internet connectivity, etc. All these fixed costs must be paid out of the Gross Profit and still leave some over for the company to make an overall profit.
It turned out that the Fixed Costs per sale were nearly $1,000. So the company made a LOSS of nearly $500 for every sale they made. So every time they got a new customer, they would lose $500. Increase the number of customers and the losses would increase further.
So if the CEO was successful and he got more funding, he’d sell more and he’d go broke faster.
Guess what… he got $500,000 more funding from a VC and some Business Angels. He went under six months later and made the news. He blamed the credit card company for wanting more collateral for all the orders he was putting through. I think they did him a favor.