Role Of Cash In Startups

Role Of Cash In Startups

In valuations, the usual process is to arrive at the enterprise value of companies except for financial firms, where we consider the importance of equity because debt becomes part of operations rather than financing.

Value of Equity = Value of operating assets + Cash -debt

For profitable companies, cash represents the value from operations. However, for startups/money-losing companies that burn cash, any excess cash balances represent investors’ additional equity/debt.

Let me substantiate. Any startup that wants to scale would reinvest in sales/marketing or R&D to boost its market share. Thus their FCFF would be damaging in the initial years, and they would depend on VCs for additional cash to reinvest to survive. Therefore, this extra capital infusion augments their cash balances and constitutes a significant component of the overall firm’s value.

Pre-money value of firm = PV(FCFF) + Cash

PV(FCFF) is negative for a startup as it burns cash. Thus it would rely on existing investors to raise capital. It has to raise money from new investors if that does not happen. In that case:

Post-money value = Pre-money value + Equity – owners cash out

Suppose significant proceeds in the new financing round are used for existing investors to cash out rather than getting invested back in the business. In that case, the post-money value should get adjusted accordingly.

Thus, in my view, cash is a non-operating asset for profitable companies, whereas, for young startups, cash balances determine the firm’s overall value.