Finance 101 for Startups

adult-american-analyzing-1059111As a startup founder your goal is growing your company fast and strong. Sufficient access to finance is crucial. And choosing the right type and source of funding makes it a whole lot easier. This article goes back to basics, discussing the concepts of money and finance. So you have the basics ready to get funding for your business. it is supported by research of the OECD to find out whether Dutch citizens really grasp the basic concept of money and finance. With some really interesting insights. 

Finance 101

In the last six years I have advised many startups and sme’s on access to finance. What I noticed is that most founders started with the question “how to get money for my business?”. However, I found that many of them go a bit too fast, stepping over understanding the basic concept of money and finance. And that when they do understand, they are able to find funding a lot faster. Let me be clear, I don’t judge this as wrong. After all we all expect that an adult, and especially a business owner, can handle and thus understands money, right? Wrong. The OECD found in 2016 that in G20 countries only 52% of all adults can be considered financially literate. The Netherlands scores high with 64%. Since this knowledge is so essential as a startup founder, in this article I provide a crash course ‘Finance 101 for startups’, so you can quickly gain this knowledge or freshen up on the topic. 

The concept of money

The first thing is to understand the concept of money and all the different aspects of it. Money is a lot of things and has many functions. The most important functions of money are:

  1. Money is a means of exchange. If we wouldn’t use money, we would be back to the barter system, with all limitations that brings.
  2. Money is a measure of value. It is a standard numerical monetary unit of measurement of the market value of goods, services, and other transactions.
  3. Money is an accepted way to settle a debt. When an investor gives you money, it means that you owe to him. 
  4. Money is a store of value. It’s a way to reliably save, store, and retrieve value. For example in exchange for a share of your company.

The concept of interest

A second important concept to understand is interest. Interest is the cost of using somebody else’s money. When you borrow money, you pay interest. When you lend money, you earn interest. Interest is additional money that must be repaid — in addition to the original loan balance or deposit. To put it another way, consider the question: What does it take to borrow money? The answer: More money. To find out whether we understand the concept of interest, Dutch adults were asked to answer this question:

Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

    1. More than $102
    2. Exactly $102 
    3. Less than $102 
    4. Do not know/refuse to answer

We found this quite easy. 92% of the people gave the right answer (a). Therefore we can assume Dutch adults understand the concept of interest. 

The concept of inflation

Inflation is a sustained increase in the price level of goods and services over a period of time. When the price level rises, each euro buys fewer goods and services. To test whether we understand the concept of inflation, Dutch adults were asked the following question:

Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

    1. More than today 
    2. Exactly the same 
    3. Less than today
    4. Do not know/refuse to answer

74% of all respondents got this question right and understood that you were able to buy less than today (answer c). Which means we can assume most adults in the Netherlands understand what inflation is. However, one in four does not grasp this concept. Understanding inflation is important because it affects the purchasing power of money. For businesses this can have consequences for the value of cash in the company, the price of debt and the willingness of consumers to buy. Also inflation can affect investors to prefer fixed assets, eg. company shares, over cash.

The concepts of risk and risk diversification

Risk is the potential of gaining or losing value in the future. As a general rule, the more risk the greater the potential return, but also the greater potential loss. We asked Dutch adults to answer the following question to see whether they understand the concept of risk diversification:

Please tell me whether this statement is true or false. “Buying a single company’s stock usually provides a safer return than a stock mutual fund.”

    1. True
    2. False
    3. Do not know/refuse to answer

Only 53% of all adults understood that spreading out investments is a way to diversify risk (answer a). This shows that a large proportion of our population does not understand basic concepts of risk and risk diversification, which are crucial in finance and investment. Often an investor uses risk diversification to reduce the risk of his portfolio by choosing a mix of investments. As a founder understanding risk is important, because it’s an investors job to predict future value and reduce investment risk.

The Netherlands Chamber of Commerce is one of the main partners of Amsterdam Capital Week. With a series of blogs I, Martijn Lentz, entrepreneurial finance expert at KVK, share my lessons and pitfalls on how to get funding for your startup.

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