How and why companies fail — and what founders and boards can do to keep cash in the bank.
By Robin Klein, co-founder and General Partner, LocalGlobe
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.
PULL Q: “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 and future cash needs. 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: The struggle between revenue growth and profitability
The founder/CEO 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 business drift between focusing on growth or cash profitability. Swinging between one and the other is disruptive.
There comes a point in the life of all ambitious early-stage businesses where the key strategic focus becomes either growth or unit economics.
Of course, we all want both – at some point. The question is – at what point and to what degree. Clearly swinging between one and the other is disruptive, and normally drags lots of costs with the turbulence.
We believe that every business needs to have a very clear idea of the milestones they need to hit in both unit economic terms and in rate of growth for their next round of funding or significant corporate event (IPO, 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 VC – 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 which 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.
Q: “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 CFO or head of finance soon enough. The difference between 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 P&L 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 (eg. 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/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 (ie Sales)
Credit from suppliers
Bank (or other) debt, Invoice Discounting, Asset Finance
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 VCs requires them to seek outsize returns – there is plenty written about the power law (eg: https://visible.vc/blog/understanding-the-power-law-curve-of-vc/ )and a good understanding of its effects is helpful in deciding whether venture capital from a traditional VC 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.