By Mike Taormina, Wharton MBA alumnus and Co-founder of CommonBond
Editor’s note: This article came out of an exchange on the Venture Initiation Program listserv, where current and former members of the program go to ask the community for help in solving their entrepreneurial problems. We thought Mike’s advice to a fellow VIP alumnus was so terrific that we asked him to turn it into a blog post.
There is a wealth of advice out there for startups trying to raise money—and for good reason. Without that first round or seed funding, many great ideas would never become anything more than an idea.
We also live in a highly innovative fundraising environment today, and the attention paid to helping entrepreneurs navigate their options and access capital is critical. As a founder, it’s incredibly exciting to be starting a business at a time when doing so—while I wouldn’t say is “easy”—has never been more possible for so many people.
So, let’s assume for a moment that you’ve successfully raised capital for your business (congratulations, by the way). The question then becomes: “What is the best strategy for managing this newfound cash?”
Given the diversity of products and the multitude of providers, this could quickly become a time-consuming, complex process. When CommonBond raised its first round of funding in November 2012, we confronted the same question on how to best manage our cash, and it was incumbent upon us to find the optimal answer.
Here’s how we approached it:
First, the considerations.
1. Capital preservation is critical.
Angels and VCs invest in entrepreneurs to take risks in operating their businesses, not to take risks in making financial investments. Compounding the issue (no pun intended), any upside in today’s yield environment is so meager that it simply doesn’t compensate for any risk-taking, given the amount of cash early-stage companies have to manage. For example, let’s assume your $1mm account has an average balance throughout the year of $500,000. If we further assumed a yield of 0.10% (which would actually be quite high for a low-risk money market fund at today’s yields), we’re talking $500 for the year. That’s it.
If you instead decide to expose your cash to more risk in the hopes of a higher return, one of two outcomes are likely:
If the investment works out, yes, you’ll have more cash, but probably not a meaningful amount; or,
Your investment does not work out, and you lose principal—a cardinal sin that can quickly lose both your investor and your credibility with respect to subsequent fundraising rounds.
Given the relatively small capital base of a startup, there is simply too small an incentive and too great an investor confidence risk to take much investment risk with your cash management.
2. Liquidity. Uncertainty abounds in startup land. You may need to liquidate an investment to free up cash, so make sure that doing so doesn’t lead to an uneconomical investment. Bank CDs, for example, typically provide a higher yield than T-Bills or money market funds, but only if you lock up the cash for a period of time. The penalty for exiting a CD early (and the negative yield it can create) may be reason enough for a startup to stay clear of CDs as instruments for short-term cash management.
3. Cost management. Watch out for banks with minimum balance fees or those that charge a relatively high commission for a simple T-bill trade—a cost which can also lead to a negative yield on the transaction.
4. Counterparty risk. If you invest in a money market account, make sure you’re comfortable with the counterparty risk—the likelihood that your financial institution of choice will run into bad times that results in either a lock-up or loss of your assets with the institution.
What to do next:
- Bank account. If you open a checking or savings account, you have the $250,000 FDIC protection, so this is a great place to start from a capital preservation standpoint.
- Bank CDs. You could then invest in bank CDs. If you go this route, keep in mind consideration #2 above (“Liquidity”). You don’t want to end up locked up in a CD and having to pay a penalty to get out, negating any deposit income (again, for minimal yield upside).
- Brokerage account. If you have a brokerage account, you could invest in T-bills, money market funds, or sweep accounts. With T-bill purchases, just make sure the fees being charged don’t lead to a negative yielding investment. So long as the yield covers the fees, this is a great way to preserve capital, since FDIC insurance only covers up to $250,000 for checking accounts. With money market funds, make sure the fund’s investment mandate and holdings align with your low-risk, capital preservation strategy.
In the case of CommonBond, we decided on a combined approach: we set up a checking account and a brokerage account, both at the same bank so that wire fees or transfer time were never part of the calculus. The brokerage account invests in short-dated T-Bills and/or in a bank deposit sweep account, and the checking account is funded to ensure the company has sufficient cash for one to two months of operations—an amount that will likely not exceed the FDIC insurance threshold for the typical early stage startup.
Doing some very basic but important cash management will allow you to focus on running your business. And pushing the business forward should, and will, generate infinitely more value than any cash management strategy could ever deliver.
Bio: Michael Taormina is CFO & Co-Founder of CommonBond, a student lending platform that provides a better student loan experience through lower rates, exceptional customer service, and a commitment to community. CommonBond is also the first company to bring the One-for-One model to education and finance: for every degree fully funded on the company’s platform, CommonBond funds the education of a student in need abroad for a full year. Mike is a former VP at J.P. Morgan Asset Management and a CFA Charterholder.