Capital needs often overlooked

February 1, 2008 By    

Last month we addressed the financial fundamentals of a retail propane startup. The objective is to grow sales and gross margin to the scale that the business achieves profitability and then begins earning a sufficient return on equity capital deployed. What is typically overlooked in the business planning of a start-from-scratch operation is the significant ongoing growth capital required to build a retail business.

Carl Hughes
Carl Hughes

In order to plan for capital needs, let’s first briefly examine the economic stages of a new retail propane operation.

1. Startup phase. Initial seed capital is used for facilities, bulk storage, delivery and service fleet, fully functional office, miscellaneous tools and equipment.

2. Customers acquired. Tanks/cylinders are set. Propane is being sold. The business begins to generate revenues and incurs ongoing operating expenses. The business is losing money, as total gross margin does not cover total operating expenses. Additional capital is used for buying new customer steel.

3. Break-even is achieved. The business continues to set tanks and gain new customers. Sales and gross margins continue to grow rapidly. At some point, gross margin equals total operating expenses and a break-even point is achieved. Capital needs continue for customer tanks but also for other infrastructure needs such as more bulk storage and a larger fleet.

Capital Requirements of Startup Operation
Capital Requirements of Startup Operation

4. Growth continues and profitability increases. Investors begin to see a return on capital committed, although in early stages it is below the risk-free rate they could have attained elsewhere. All growth continues to require capital.

5. Target return achieved. The scale of the company reaches a point that the profits provide a sufficient return to invested capital that the equity investors have achieved their goal.

Let’s review capital needs of a sample startup plan. Some assumptions:

  • $500,000 initial capital outlay (plant, equipment, trucks, office, etc.)
  • Assume bank debt will equal equity capital (50/50 capital structure)
  • Annual growth rate of 250 customers per year
  • Assume break-even profit at 1,000 customers
  • Assume acceptable return on invested capital at 2,000 customers
  • Each 250 new customers requires $187,500 in new capital

Summary observations

This business plan began with $500,000 of initial capital, $250,000 representing founder’s equity and $250,000 from traditional commercial lending. Our model assumes a continuous 50/50 split of debt and equity.

In this example we’ve determined that obtaining 1,000 customers is the size necessary to reach profitability. Achieved in the fourth year of operations, this requires $1,250,000 of total capital and $625,000 of equity capital or 2.5 times the initial $250,000 invested.

In the eighth year of operation profits begin to earn a sufficient return on invested equity capital. This achievement requires obtaining 2,000 customers and a total investment of $1,000,000 of equity capital or four times the initial equity invested.

It’s important to understand that the capital needs in the model are representative of the needs of a fast-growing retail operation.

Closing questions

As you contemplate your new startup venture, have you truly grasped the intense ongoing capital needs that will be required to be successful? Have you consulted with your lender to understand the extent to which they will lend you funds? Has your founder’s equity group understood that additional equity capital will be required year after year to be successful?

The solution lies in a well-thought-out planning process that provides for a detailed schedule of capital needs over the course of your business plan’s timeline.

Carl Hughes is senior vice president of business development for Inergy LP. He can be reached at Chughes@InergyServices.com or 816-842-8181.

About the Author:

Comments are currently closed.