There is a character in Ernest Hemingway’s novel The Sun Also Rises who asks, ‘how did you go bankrupt?’ The answer really resonated with me: “Gradually and then suddenly.”
Having invested in more than 200 startups in the last 20 years, I can talk about why companies fail.
Businesses fail because they run out of cash.
In an era of capital abundance, there seems to be an increasing assumption that further capital can easily be raised.
Startups simply don't pay enough attention to their cash balance. In an era of capital abundance, there seems to be an increasing assumption that further capital can easily be raised — which is leading to complacency and poor cash forecasting. What's more, many founders simply don't understand the financials of their companies as well as they should do and the importance of their balance sheets. Many underestimate the importance of having real financial management expertise available.
That needs to change.
Focus on revenue growth or profitability
The founder/chief executive of an early-stage startup should be aware of the company’s cash balance every day. It takes minutes and provides a simple but effective way of getting to understand the cadence, ebb and flow and major movements of receipts and payments. Any meaningful variance from revenue or cost plans will have implications for cash balances and will impact on future tactics, strategy and funding plans.
The cumulative effect of allowing missed plans to go unattended often accelerates decline as energy and focus is deflected to fundraising, pivoting or cost cutting. Fundraising becomes more and more difficult the longer this process lasts. Hence the demise occurs gradually, then suddenly when it becomes clear that further funding is not available.
Too many ambitious early-stage businesses drift between focusing on growth or cash profitability — but swinging between one and the other is disruptive, and normally drags lots of costs with the turbulence.
Of course we all want both — at some point. The question is: at what point and to what degree?
Every business needs to have a very clear idea of the milestones it needs to hit in both unit economic terms and in rate of growth for their next round of funding.
We believe that every business needs to have a very clear idea of the milestones it needs to hit in both unit economic terms and in rate of growth for their next round of funding or significant corporate event (initial public offering, exit, merger).
If cash is no object (and this is seldom the case — although there are many overfunded companies in today’s climate), then growth at all costs may be the right focus. Dominant market position may be an important long-term goal and this will call for rapid and sustained growth.
In most cases, however, cash is finite and raising further funding at a decent step up in (or even flat) valuation cannot be taken for granted. Getting the balance right is really important; probably the most important strategic decision the board needs to make. Careful judgement is needed to make the right call.
Raising further capital
I fully understand the desire for minimising dilution and raising as much capital as possible. The argument that you can raise at too high a valuation is a difficult one to make — especially coming from a venture capitalist, it is bound to sound self-serving. However, the post-money of your last round sets a bar for the next one and dictates the metrics and milestones that the company will need to aim for. Too high and the pressure on the team and the board can become intense and can deflect focus, damage morale and provoke conflicts of interest.
Really good companies can be terminally damaged by excessive and unrealistic exuberance in driving for maximum valuation.
A large dose of realism is needed when raising funds. Really good companies can be terminally damaged by excessive and unrealistic exuberance in driving for maximum valuation. Take advice from your seed investor who should be fully aligned with you.
Hard thing about hard tech
Founders’ financial knowledge is often pretty thin — and not enough startups hire a commercial chief financial offcier or head of finance. The difference between profit and loss (P&L) and cash flow can be tricky to get one’s head around, especially where inventories, accounts receivable and payable, prepayments and accruals are important features of the business.
I’m amazed at how seldom the balance sheet of the business is a topic of discussion. Investment in fixed assets, depreciation and other non-cash profit and loss items and variations of working capital are nuances that need thorough understanding, especially in those companies with a hardware element. Seasonality and payments in advance (e.g. travel, furniture, enterprise software) can all make cash balances a very unreliable measure of financial health.
Lots of sources of finance
Companies with a product or service that customers love should never run out of cash. It is a question of getting timing right — growth vs. unit economics — and getting the right source and cost of finance.
In order of cost of capital from cheapest to most expensive the following are all available at some time in the life of the business:
- Revenue from customers (i.e. sales)
- Credit from suppliers
- Bank (or other) debt, invoice discounting, asset finance
- Venture debt
- Convertible debt
Venture capital is not necessarily the best form of capital for all companies; in fact, it is likely to be appropriate to the minority of companies. The business model of most venture capital funds requires them to seek outsize returns — there is plenty written about the power law and a good understanding of its effects is helpful in deciding whether venture capital from a traditional venture capital fund is the right way to go.
Whichever way you decide to go, cash remains the most important dial on the dashboard and the levers of control need to be firmly grasped.