WHAT HAPPENS WHEN VENTURE CAPITAL STOPS INVESTING IN YOUR START-UP?
Recently I read a local article that said a sixteen year old had raised $700,000 for his start-up. In my day when I was sixteen I would not have been able to raise $700. Of course he must be an amazing young man with a great idea and I’m sure that he has very qualified and experienced people working with him. I mention this only to illustrate the state of the venture capital industry, where cheap money has created a proliferation of investment capital looking for investment opportunities. Everyone is looking for the next big investment to make them rich or richer.
I have seen companies raise 80 to a 100 million dollars in venture capital only to have the investors turn off the taps and stop putting money into the company and they cease to exist. The founder’s greatest strength of these start-ups is not their vison and strategy, it is their ability to convince investors to put their money and clients’ money into their firm. I have provided consulting services and mentoring to a number of firms and know some of them personally and I’m seeing the financial stress some of the owners are going through. I remember how it feels.
I know one start-up in the tech industry, where the founder and CEO took a full time job and laid off all their staff except for one and will work on the project nights and weekends. It might take a little longer but she will get there.
There are some very dark and troubling storm clouds gathering over the economy right now. Such as increasing interest rates, inflation, big drops in the stock and crypto markets. While the housing market is only starting to be affected, higher interest rates will play havoc with housing prices and mortgage rates. When assets have depreciated people feel less wealthy and may be more careful with where they invest their money. Hedge funds and Venture Capital funds may take a more conservative approach to investing or not have as much money to invest. Many of these funds are using borrowed money. Also the valuations may be lowered due to higher interest rates and investors being more risk adverse. So your next round of venture capital may be at much lower valuations.
What makes it more challenging for start-ups is that they have no revenue or not enough cash flow to sustain the company. They rely on investors replenishing their cash with additional equity investments.
There are dozens of Unicorn companies listed on stock exchanges with market values of over one billion dollars with little or no revenues. Their survival depends on investors continuing to put money into the company. I wonder what Ben Graham would say about this? He was the author of the Intelligent Investor and the employer and mentor of Warren Buffett.
A rule of thumb for start-ups is that for every ten companies three or four will fail completely, another three or four will lose some money or only return the original investment and one or two will produce substantial returns. I know that the reason a lot of companies fail, is they run out of money first and not passion, vision or hard work. Venture Capital is about taking big risks for big gains.
Many of the start-ups provide employment to a large number of employees, especially young employees and contribute substantially to the local economy.
To ensure your company continues to survive and prosper, you need to start planning now for bumps in the economy and make sure you have adequate working capital.
Here are some ideas to help you plan for this:
PREPARE A CASH FLOW FORECAST: A cash flow forecast is to take your existing cash balance add in any additional cash flows from revenues, investment capital or government grants, subtract all your fixed and variable costs and then determine any excess funds or shortfalls. Many companies will do a monthly forecast but for start-ups and newer firms I like to see a weekly forecast, to identify any mismatches in cash requirements. Any business owner who has to meet bi-weekly payroll, knows what it’s like if all your receivables or cash flow come in at the end of the month, and they come up short. A weekly cash flow forecast will help identify shortages so you can meet your cash requirements.
DETERMINE YOUR BURN RATE: Your burn rate is how much cash you have on hand and subtract your monthly spending. So if you have $ 900,000 cash and you are spending $90,000 a month then your burn rate is 10 months. ($900,000 / $90,000 = 10 months). Again thinking in terms of weeks is helpful so your weekly burn rate would be 40 weeks. (10 X 4 =40). If you have existing sales even if you are losing money on the sales then you would add that to your weekly cash.
So now you know your weekly cash requirements and how many weeks of cash flow you have. What to do next?
This doesn’t mean that all companies looking for venture capital will not be able to raise additional funds. Many will be able to regardless of the economy because of the strength of their idea or product. I’m just saying that it makes sense to prepare for uncertainties and have a plan B. If someone is on unemployment benefits and they run out in three months, you don’t start looking for a job after the benefits run out. You start three months or more before they run out.
Here are some risk mitigation strategies you can follow to reduce the risk of running out of cash;
1. Reduce Your Expenses: Expenses are categorized as fixed and variable, fixed are things like rent and computer equipment, while variable are salaries, marketing and expenses that can be reduced. I just read on Yahoo Finance that several large tech companies are laying off ten percent of their work force. Reducing your expenses early will conserve cash and give you more time to develop your product and get it to market.
2. Increase Your Revenues or Start Generating Revenues: This is easier said than done, because many start-ups are not at the revenue generating stage. Be creative perhaps there is a way to generate revenue with existing employees to hire them out to other companies. I know of a company doing this with one of their IT people. To start generating revenues means you have to speed up your development process, this may take additional funds.
3. Raise Additional Capital Now: Instead of waiting for your next round go to one of your backers and offer them additional equity. As someone once said to me, “I would rather own 51% of a ten million dollar company than 100% of a million dollar company.” Even if you have to reduce the price of the equity offering it buys valuable time.
4. Apply for a Loan: This is my personal experience when I applied for a business loan years ago to set up my first company. The loans officer told me to sit down and asked me how she could be of assistance. I told her that I was there to apply for a loan to set up a business. She looked at me and started to get up and as she did her skirt rode up some. She started laughing almost hysterically and walked over to the window. I thought she was laughing because of her skirt riding up, which wasn’t really a big deal. She turns from the window and says “Darrell no bank is going to loan you money to start a business.” I ended up using the money I was saving to buy a sailboat.
Later on as we started generating revenues and had 28% sales growth, the bank was much more accommodating. The moral of the story is that banks aren’t that interested in lending money to start a business unless you have lots of collateral. There are some government programs offered through credit unions and other financial institutions that can provide loans for working capital or asset purchases.
But there are many individuals including friends, family, business people and mentors that went through the same thing. Who may be willing to give you a loan at zero or a low interest rate? Don’t be afraid to ask them all they can do is say no. I know some of them and they love to be involved in bringing new companies to market.
5. Factoring: If you have existing revenues then you may be able to factor them. Factoring is when a factoring company lends you money against the amount of your invoices and takes a fee for doing it. It usually is a percentage of the invoice 2-3%, depending on how long it takes to get paid from the company. The fees may work out to being close to offering early payment discounts E.g. 2% net 30 days. You need to determine the overall cost and if it works for you. I know of a company owner who was waiting months to receive payment for invoices and was cashing them at a Payday Loan type company. Ouch that hurts.
The purpose of this blog is not to tell you how to run your business and I’m probably not telling you anything you don’t already know. It’s to get you thinking about the future and taking a risk management approach to identify and manage potential net income risks that you may face, the most severe being running out of cash. To encourage you to manage your cash flow so you don’t run out of money before achieving your dream. Every start-up is different and unique so you have to start thinking about this now and have a plan B. All start-ups matter!
When I was in my early twenties and going to university a friend of mine’s father who was a very successful business man gave me some advice on Christmas Eve, he said;
“To be a successful business person you have to have the ability to make decisions. You’re not always going to be right but you have to be able to make those tough decision.”
To this day I think it was the best business advice anyone has ever given me.