Companies only go bust when they run out of cash.
That might seem like the most obvious statement in the world, but it can also serve as a mantra for founders to focus their minds on how to avoid it happening to them.
All founders will have built a financial model spreadsheet including a cash flow forecast as part of their business plan and pitch to investors. Most tend towards the optimistic, however. Things usually run later than planned and revenues can be slow to build. Very few companies will reach break-even after only one or two rounds of funding.
So, in almost every case, a company will need to raise more money after our seed funding round.
It might seem odd to be thinking about fundraising when you’ve only just banked your first VC cheque, but if your business is to take flight you’re going to need as long a runway as possible, so it’s best to start laying the foundations early.
When we invest in a company we typically aim to provide at least 18 months’ worth of money. Once we’ve invested, one of the most important things we then do is work with the entrepreneurs to determine ‘what they have to prove by when’.
What I mean by that is setting solid objectives to have achieved some meaningful milestones – enough to attract further investment at a higher valuation. And it’s no good waiting until the 17th month of an 18-month cash runway because it usually takes three to six months to actually raise that next round of finance.
So, we start at the end of the cash runway and work backwards. First, we work out when the money will run out. Then we rewind by about six months and set some targets for reaching those proof-point milestones by that time. We’re trying to work out what the business needs to look like at that stage in order to stand a great chance of raising more money at a higher valuation.
Proving your worth
Episode 1 invests at the seed stage, in companies that typically have a prototype and some early customer interest, perhaps trialing the product. If there are revenues to speak of they are usually small – often zero but generally only up to £10,000 or £20,000 per month. When revenues hit £100,000 a month, a company is usually in a good place to raise a good Series A round of finance, so that makes an excellent proof point to aim for.
An alternative benchmark might be to prove that the technology is applicable across a wider range of use cases. Our portfolio company CloudNC is a good example. By the time they raised their next round of funding they still weren’t selling their product but they had demonstrated that their software worked for a huge variety of parts that might be cut on a CNC machine and they articulated a big vision to completely disrupt manufacturing which impressed multiple potential investors.
We’re going through this process at the moment with another of our portfolio companies, Context Scout. They have some fantastic AI technology based on Dynamic Information Retrieval research and which anticipates the information you want while you’re browsing, effectively thinking ahead for you. But it’s like an iceberg – very little of that technology is visible above the surface right now. So, we’re working on helping them determine what they can prove to investors about their technology, building that into a pitch deck and planning at board level what the key messages should be.
Carwow, on the other hand, saw sales take off quite quickly, so fast-growing revenues provided a straightforward signal of investment potential so each of their investment rounds have proceeded as planned.
Forecasting revenues over even 12-18 months can be difficult especially for businesses at the seed stage. To allow for this, what we generally do as an investor is to assume the worst case and zero out all the predicted revenues, then work out the runway from there and make sure it’s at least 18 months.
Extending that runway
Working out when the money will run out is not an exact science. And the good news is that there are things that can be done to move that point and extend the runway.
Costs are much easier to predict – and control – than revenue and so can offer some flexibility in planning. Apart from things like office space and computers, the biggest outlay is on salaries. Hiring people more slowly and attracting talent with options rather than straight salary can make the cash last a bit longer.
R&D tax credits also offer scope for flexibility. The UK government can provide a cash rebate on R&D expenditure soon after each year end. Sometimes, by changing the year end for a company’s accounts the tax relief can be claimed early, extending runway by another one to three months. Then there are innovation grants that can feed into cash flow, giving the business longer to reach those proof milestones.
Although we can help our portfolios find accountants and financial directors, at the seed stage they are best to be part-time rather than full-time, so it is important for one of the founders to own the cash flow forecast as they are the closest to the details of what they are doing. We apply our expertise in coaching the founders in amending their forecasts so the money will last longer.
Where a lot of companies go wrong is that the founders, and often their boards, are too optimistic about what is going to happen in the future. The skill of a collaborative seed level investor like Episode 1 is to help them think ahead, consider what could go wrong, and allow for some variance in the cash flow forecast to take account of the worst-case scenario.
We are very much on the same side of the table as entrepreneurs. Once we’ve invested in a company we don’t want founders selling to us any more. From that point on it’s about doing what’s best for the company, and so board meetings should be open and honest about everything. That way we can give the best advice, helping founders through the crucially important early decisions and proving the business is worth further investment.
And making sure the money doesn’t run out which is, after all, the only reason companies fail.