Understanding Consequences Of Funding Winter On Cash-Burning Start-Ups

Understanding Consequences Of Funding Winter On Cash-Burning Start-Ups

In June 2022, Sequoia warned their portfolio companies that the time for burning cash and chasing huge valuations had ended. With rising interest rates to restrict soaring inflation, the cost of capital has become expensive, and it is difficult for startups burning cash to raise capital. As a result, many founders of the startup reached out to me to understand how this funding winter will affect their cash-burning startups and how it will impact their valuation.

Burning cash by itself is neither good nor bad. However, venture capital firms encourage startups to burn cash because they consider it a sign of growth, whereas value investors treat cash burn as the death of a business. In this post, i provide my insights on where burning cash becomes positive for a firm and when burning cash signals a firm’s distress.

Why Firms Burn Cash

Firms burn cash when they have little earnings but lose money for an extended period. For instance, startups will start with low revenues and focus on scaling growth. So growth takes precedence over profitability, and the firm will reinvest in R&D/Marketing/New plants to grow. The combination of low operating income and high reinvestment results in negative cash flows for the firm. Start-ups hope that as they scale and grow their market share, there is an inflexion point where the firm will focus on profitability and start ramping down investments. Once that happens, the firm pivots from negative cash flows to positive cash flows.

However, the assumption that negative cash will always turn into positive cash flows does not always happen. For instance, assume a startup with a negative contribution margin but continues to reinvest to gain market share. Here the growth does not add value because when the firm grows, its cost structure bloats up and, consequently, will continue to burn more cash with no sign of becoming profitable.

So the firm must decide when it can burn cash or take quick steps to prevent burning any additional cash. In my view, the answer lies in its business model. If the startup operates in a market where its products/services do not have differentiation and cannot charge a higher price, it must not reinvest to gain market share. These firms operate in a matured market or provide a commodity service/product and are engaged in price wars. When startups resort to price wars to gain market share, they will continue to burn cash. Here, there is no hope for the firm because negative cash flows become more extensive, and if the cash flows turn positive, it is insufficient to cover the burden of earlier negative cash flows.

Incorporating Share Dilution Effects

When the firms burn cash, what is the probability of them shutting down? These firms have survival risks. If the firms do not have cash reserves but continue to burn cash, it has to raise capital. Such firms cannot raise capital through debt because they will have poor credit ratings, and thus the cost of capital becomes high. Further, lenders will incorporate covenants that will restrict startups from growing.

Thus, the firm has to issue new equity, and the founders will have to give up some of their firm’s ownership. When the firms continue to burn cash, it has to keep issuing new equity resulting in very low ownership. Thus, when it becomes successful, it is highly likely that founders will own significantly less stake because it must have issued equities to investors.

When the economy faces a recession risk, the probability of firms that burn cash to raise new capital is low because few VCs are willing to provide cash due to the higher cost of raising capital. In this scenario, the firm has to either scale back its growth plan, which will impact its valuation or take steps to improve its cost structure. Thus, we see startups resorting to layoffs to cut costs. However, despite taking cost-cutting measures, if the firms have negative operating cash flows, there is a high chance that they will shut down by liquidating themselves. In such situations, the firm’s liquidation value is a fraction of its going concern value.

Benefits Of Discounted Cash Flow Valuation

I can incorporate the above scenarios (Dilution effect, Growth effect and Distress effect) in DCF valuation in the following ways:

Assuming that the firms will have negative cash flows for a few years before they turn positive, the present value of the firm will witness a higher decline when it takes longer to generate positive cash flows because of the time value of money. For instance, if a firm’s cash flows become positive at year seven instead of year 2, the discount rate to discount cash flows from year 7 is higher than year 1. This combination of negative cash flows and discounted positive cash flows will reduce the firm’s value, and we assume this reduction as discounting equity stake for future dilution. Here, we assume that the firm will have access to external capital.

When the firm does not have access to external capital, it will have high survival risk. Here, the DCF allows us to incorporate the probability of survival and thus discount firm value accordingly. For instance, when access to capital is difficult due to a challenging macro environment, the firm must either scale down its growth and if it cannot do that, it has no alternative but to shut down. If the firm scales down its growth by limiting reinvestment, i can adjust my DCF valuation accordingly.

If i assume that the firm cannot survive without raising new capital, then there are higher chances of shutting down. I can incorporate this assumption in my DCF valuation. For instance, if the probability of liquidation is 10% and the liquidation proceeds as zero, then the value of the firm is:

Firm value = 90% of Going Concern + 10% of Liquidation value

However, it isn’t easy to incorporate the above adjustments in pricing.

A venture capital prices a startup by forecasting revenues/earnings for a future period and then applying an exit multiple, which assumes the price a potential buyer will pay or what the VC receive in an IPO. They discount earnings back using a target rate of return to arrive at today’s price. VCs do not adjust for any explicit cash burn rate in their financial model by adjusting their cash flows. Instead, they increase the target rate of returns to account for failure and growth risks. Thus, we see VC’s target rate of returns is as high as 50%, while for a matured company, the discount rate is usually 8% to 12%.

Final Thoughts

VC firms investing in startups that burn cash must decide whether this cash burn is positive or malignant for their investment. Thus, in my view, VC must do the following:

1. VCs must understand why the firm is burning cash. Is the firm burning cash as a down payment for future growth, or is it because they have negative earnings? A money-losing company reinvesting less is a disaster because there is no potential for growth or profitability in future. On the other hand, if the firm has a poor business model/operates in a matured market/engaging in a price war, this cash burn is malignant.
2. A firm with more significant cash balances will have fewer issues during a recession where access to capital is less than firms with low cash balances.
3. A firm’s management that can keep costs under control has pathways to profitability and is flexible in its reinvestment strategy. As a result, it will tide over more challenging situations better than firms that view burning cash as a sign of growth.

Burning cash by itself is neither positive nor negative. It is positive if the underlying business model is positive and there is a strong probability that the firm becomes profitable over a period. Firms like Amazon and Facebook burnt cash in their earlier stages, but their business model helped them to pivot from negative cash flows to positive cash flows.