By John Huston
There are only two types of companies -those which have achieved positive cash flow and those which have not. (Earnings before Interest, Taxes, Depreciation and Amortization, or EBITDA is the most commonly used definition of cash flow.)
While it is easy to divide all companies into just these two groups, this simplification ignores whether management has made a conscious, strategic choice about their growth. Perhaps you have decided to continue growing top line revenues at the expense of cash flow (EBITDA.) For high growth ventures being groomed for a lucrative liquidity event, this is usually a wise choice, presuming additional growth capital can be successfully raised on agreeable terms.
The issue is whether your company could pare back expenses and live within the cash it is currently generating – if you had to do so. This should be a major milestone goal of all start-ups. Until it is reached, survival still hinges on the kindness of outside funding sources.
[Email readers, continue here…] But this too is an overly simplistic view. Usually leading up to the time positive cash flow is initially reached, the management team is not taking a market wage, payables are stretched, and any slowing of receivables collections would likely cause layoffs. The team knows their current expenses are being so closely managed, that at some point they would be unable to continue in this mode. They have achieved a level of cash generation which enables “survival” – but it is not sustainable.
Now that you are more mature as a business, management can decide how to balance building revenues versus building cash flow. There is a point at which building cash flow above revenues yields diminishing investor returns considering the amount of capital and time it consumes. Furthermore, having substantial positive cash flow may sub-optimize investor returns at the exit. This is because potential acquirers often act like mere financial buyers when they see a significant positive cash flow stream. This prompts them to merely apply a multiple (often 5 – 8X) to the EBITDA or cash flow of the business, always a smaller number than when pricing an acquisition for strategic reasons. So, rarely will this strategy or outcome enable investors to reap their target in a sale.
Ventures which have negative EBITDA, but could turn it positive if they chose to do so, are exhibiting the growth which attracts more bidders. Those which generate high returns at the exit are often not sporting positive cash flow when sold, but they could dial back to be positive if required. They are demonstrating by their actions that bidders cannot bid low, because by bidding low buyers would be assuming that a sale is necessary due to the company’s negative cash flow.
The bottom line: Looking at best example companies in a sale, their acquisition strategy was to avoid growing their cash flow before the exit. Counterintuitive perhaps, but demonstrated to be effective.