One of the questions I get the most from startup execs I meet is about how best to think about cash flow, runway and the timing of their next fundraise. My answer is always the same. Beware the cash cliff. Start planning your next fundraise now.
Here’s a scenario you might recognize. You completed your last fundraise 6 months ago. You have $15 million in the bank. You just put a receivables line of credit in place that can give you access to another $2 million.
The budget your board just approved is a strong step toward profitability. According to your projections, you’ll be EBITDA positive within the next two years. Your CEO is even more confident. There are a couple of big deals in play, and if they land, he sees big upside from this year’s budget.
You should be able to breathe easy now.
But there’s something gnawing at you. You know that EBITDA postive does not equal cash flow positive. While the P&L projections are confidence inspiring, your cash flow projection is a bit less so. Your forecast for the year says you’ll deliver $35 million in revenue, but with a $7 million EBITDA loss. Losing $7 million means burning $12 million of cash. And that will have you scraping right up against the available cash that you have.
More importantly, what if things don’t go exactly as planned? A missed revenue projection or unexpected big expense is going to wreak havoc with your cash projection.
Your CEO is telling you not to worry about it, because the upside he sees will fall right to your bank account and keep you in the clear.
What do you do? Should you start planning your next fundraise already? And if so, how do you convince everyone else that now is the time.
Understand The Dynamics Around Discussions of Cash Flow and Fundraising
The topic of cash flow in a venture backed startup is far more complex than it may seem at first. Whether it taps into a founder’s fear of failure, highlights competing priorities of various inverstors or different points of view on your board, you need to navigate these conversations carefully.
Fear of Failure
Underlying any discussion about a company’s cash flow projection is a founder’s greatest fear: failure. Discussions about your cash projections have to touch on the possibility of missed milestones, under delivering on board expectations, and the possibility that the company could actually run out of cash. For many founders, this topic is so uncomfortable that they will do anything they can to avoid it. You can’t let that happen, and how you approach this topic is as much art as science.
You must get the emotion out of this discussion quickly. The key is to ground it in facts that your key stakeholders can agree upon.
Start with your last board approved budget or reforecast, as this creates a common frame of reference. Then bracket this plan with an overperformance scenario and an underperformance scenario. Having the three scenarios creates the always useful shit sandwich. This will make it easier for people to process the possibility of underperformance, and the impact on cash flow.
Focus on a few key levers in your business that you’ll toggle to give you upside and downside. If you make this too complicated, you’ll find yourself in a death spiral of questions about various assumptions you may not be able to get out of.
Finally, extend your three scenarios beyond the end of the fiscal year. I’ve found it effective to simply extend your Q4 run rate on expenses, and then put a reasonable growth target on revenue. You can do this on just a few excel sheets, rather than building big complicated models. This approach reinforces your concerns around cash flow while highlighting the potential impact on future investment. This approach also reduces basic assumptions you could end up arguing over, rather than focusing on the main issue of cash flow.
A Fund Raise Creates Leverage For Those That Need It
Between the company, the founders and the investors, the need for a fundraise creates a point of leverage where everyone tries to get what they want.
- An early investor needs to get out of their investment, and is going to need secondary in the next round.
- A later investor wants better preferences in the next round to improve their risk profile in the company.
- Your founding CEO is unhappy with her ownership stake, feeling she was unfairly diluted in the last round.
- You have a split in the founding team, and your CEO wants to buy out his co-founder with secondary from the raise.
There are a whole host of issues that can surface as a company starts to think about having to raise new capital. You need to be thinking about those potential issues in advance so that you can prepare for them.
Board Dynamics
You need to understand how your Board thinks about your current progress, how they define short term and long term success, and the interest of investors on the Board in continuing to fund your company. This can get very complicated, particuarly if your investors on the Board outnumber company and independent directors.
Remember that venture investors expect many of their investments to underperform their original expectations, or to even outright fail. That’s how their business works. This means that they are constantly assessing where your company is going to land within their portfolio, and this is is going to have a huge impact on the level of support you’re going to get from them at the next fundraise.
You may have early investors that can’t lead later rounds. Or your largest investor may be trying to wind down their fund at the end of it’s life, and doesn’t have the capital to be supportive. You have to know your Board, and their position as it relates to your company, to understand how they will suppport you through future fundraises.
Start Planning Your Next Fundraise Now
If you understand the dynamics around the topic of cash flow and fundraising, you can understand why companies often put off the discussion for too long. But you can’t wait, or you’re putting your entire company at risk. It will take longer than you expect to raise cash.
Model Possible Outcomes From the Fundraise Process
This is crucial. How much do you need to raise? What are the uses of cash going to be? These questions are also inextricably linked to your valuation, how much you’ve raised previously, and many of the dynamics outlined in the first section above. Are you raising simply to fund growth and company operations? Or do you need to raise secondary as well, for an early investor, a disgruntled founder, or early employees that want to see some value for their optoins.
This modeling exercise is going to be used to set up conversations with your existing investors, your Board and potential new investors throughout the raise process. This will become your roadmap for the raise, so take the time to be thoughtful here.
You Can’t Skip A Step
As noted above, fundraising is a journey that takes time. This starts with getting alignment between the CEO, CFO, co-founders and any other key members of the management team that have a voice on this topic.
You then need to build consensus with key board members and investors, and prepare materials for investor meetings. Investor pitches and follow up can drag on for months. It’s an incredibly frustrating process worthy of its own discussion. Don’t forget that once you’ve locked down commitments from investors for your round, you need to get through their diligence process and then paper the investments.
I’ve led several complex fundraise processes. Almost every process I’ve led has taken almost a year from start to finish. The shorter your runway becomes, the less leverage the company has in the process. Don’t wait too long. Start planning your fundraise before you need to raise.
Always Be Closing
In fundrasing and M&A, time kills deals.The way you run your fundraise process is a key part of ensuring a successful conclusion. I’m manic about being able to turn documents and diligence requests as quickly as possible. Particularly once you get term sheets, you need to be able to relentlessly drive the process to a successful close. It ain’t over until the cash is in the bank.
Always Be Building Your Data Room
Fundraising, M&A and preparing for an eventual exit are all a part of the natural life cycle of a venture backed startup. You should always be prepared. A key part of this is to always be building your data room. First and foremost, this means focusing on the day to day practice of keeping your documentation in order. You also need to have an actual data room in place before you start your fundraising meetings.
It’s very easy for startups to let even the most basic documentation fall into disarray. Do you have all of your fully executed employee option agreements in one place? Is your cap table current? Where is the final version of your office lease? Where are your fully executed employee offer letters and the related documentation related to IP ownership? Do you know if your company is in good standing with it’s state of incorporation? Are your financial statements in order and ready to be reviewed?
You’re going to need all of that and more as part of any fund raise diligence process.
If you’re spending the weeks after you get a term sheet trying to pull this together to respond to investor diligence requests, you’re leaving room for unexpected events and uncertainty to creep in.
Ask your current investors or your law firm to give you an example of a diligence checklist if you don’t have one of your own so you can get be prepared.
Get The Right Law Firm On Board
Your company needs the right advisor to help you successfully navigate this process. The law firm that helped you negotiate your real estate lease or that handles your commercial contracts isn’t likely the right firm to help you navigate the complexities associated with a fundraise. You need a partner in this process that has seen it played out many times before.
You should NOT be using the same firm that your lead investors use. The company needs its own representation in this process. You need someone that can advise you on the issues most important to the company, the founders and the rest of your team.
The right firm will get in the trenches with you, and when the time comes for that final push to close the deal, they will work round the clock and help you negotiate the right terms. Get that firm on board at the very start of the process.
Have a Backup Plan
I’ve focused on the fundraise process as the primary way to address a looming cash flow issue in your startup. But there are a number of reasons why this won’t be the path you end up taking. Perhaps you business hasn’t made enough progress against key milestones to successfully complete a raise. Or even if you can raise, perhaps the valuation you’ll get won’t be high to avoid signficant dilution of founders and existing investors, which can quickly derail a process.
Whatever the reason, you need to always be developing backup plans. Because regardless of what roadblocks might be in the way of raising additional cash, if you don’t find your way around them, you’re going to run out money, and that’s the end. Alternatives can include:
- Increasing your existing credit facility. This is often possible with receivables based lines of credit as your receivables increase. But be careful. In a cyclical business, if receivables drop from quarter to quarter, your bank will want to bring that line back down again.
- Venture debt is expensive, and you’ll find that most venture debt lenders aren’t nearly as forgiving as your primary bank. But venture debt is a viable way to bridge your way to a proper fundraise.
- Bridge financing from existing investors can get you a bit further along on a few key milestones to help close a round.
- Restructuring the company. You need to always know how you could dramatically ramp down burn rate if you have to. It’s not going to be fun, but it’s certainly better than driving the business into the ground.
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