
Cyclical Forces
The landscape for startup financing has shifted dramatically in the last 3 years. From the peak of 2021, when zero percent interest rates inspired massive speculation. To the valley we are in now, where raising capital seems harder than ever.
If you raised funds in the past 5 years you know exactly what I am talking about.
This post is for the founders of startups who are facing the possibility of not accessing additional capital.
In Latin America there are approximately 1,500 companies that have raised pre-seed and seed rounds in the 2019-2023 period, and have not yet raised a Series A round. If you are in this group, you are not alone.
What are the options
The venture capital funding model is logical. It is based on achieving milestones of progress that unlock access to more money. The system has some explicit rules like: the first step is to find a market for your product or a product for your market. Burning through cash reserves is also acceptable, no need for profits.
There are also some unspoken assumptions in this model. For instance, that it is all or nothing, you either achieve a great exit or you don’t achieve much at all. Another implicit rule: everything has to unfold in just a few years.
What happens when growth is healthy but insufficient to raise new funds in a difficult environment?
As founders you have a few options:
Keep going. This is the status quo alternative. It’s easy in that it doesn’t require difficult decisions. However, if your startup is cash flow negative you might just be delaying the tough choices.
Go normal. This option implies getting to at least cash flow break even and growing from that point forward. Upside: higher chances of surviving and building a sustainable business. Downsides: lots of difficult decisions.
Close shop. Self explanatory. In some cases, the healthiest course of action for everyone involved is to stop and start again elsewhere.
None of these alternatives are easy. But then again, you didn’t choose this path because it was the easiest one in front of you at the time.
Conversion to a normal business
Converting your startup into a regular profit-making business could become the experience of a lifetime. I’m serious. Creating a financially healthy business can give you the freedom you need to bring it to its full potential.
Remember this: the VC funding model rests on assumptions that you accepted because you had to, not because you chose to after careful review of every possible alternative.
Now you have the opportunity to choose your own rules. It won’t be easier, in fact it will probably be even tougher. But it will be yours.
How would this work
As a founder you have the power to create a new source of capital: profits. If you are effective at this, you will then have the opportunity to re-invest these profits into the business.
The value of your company will grow at the speed of your returns on capital. If you re-invest profits at very high returns, the effect of compounded interest will take you to places that are hard to imagine.
Some numbers will be helpful to visualize this.
Let’s say the starting point is a software company doing $2 million in annual revenues, growing at 40% a year and burning through $500k annually. If the company has $500k in the bank it has about a year of runway. This company would have a hard time raising new funds in the current environment because its growth is not fast enough relative to its size.
The conversion to a normal business would entail going from a $500k operating loss to some level of operating profitability. For purposes of the example let’s assume some tough choices are made and as result the business achieves a $300k operating profit.
This implies reducing annual costs from $2.5 million to $1.7 million. Hard but not impossible.
One way to go about this is to identify all of the costs -including R&D, marketing and G&A- that are necessary to maintain the current revenue base. This includes enough product innovation to protect market share.
The toughest parts of this review will be about people. There is no real solution to this. But it’s important to remember that if your company shuts down everyone in the team will loose their job.
Creating a growth engine
The company in the example now has a business doing $2 million in sales and $300k in profits, with little to no growth. Those profits are the new funding source for growth.
If the company can reinvest its profits in initiatives that generate:
1.5x dollars of revenue for every dollar invested ($450,000 in new revenues for year 1), and
A 30% operating margin on those new revenues, then
It will achieve a Return on Invested Capital of 45%, calculated by dividing the incremental profits of $135,000 (30% of $450,000) by the $300,000 in retained profits that were reinvested in the business.
That 45% is the magic number. That is the speed at which the value of the company grows every year. If its sustained for 10 years and we apply a multiple of 10x operating profits at the end of the period, the company in our example would be worth $123 million.
That might not be unicorn status but it’s still life changing money for founders, even after allowing for dilution. And considering that the great technology businesses of our time created 95% of their value after their first 10 years, there really are no limits.
What’s the point?
The point is that you have the opportunity, starting now, to create an extraordinary company that serves clients, rewards investors and provides employees with a great place to work.
Sometimes not getting what you want leads to what you really need. In this case it might be the freedom to do what you set out to do when you started this journey.
Yes, a lack of capital is a constraint, but it’s also a chance to do your life’s work in a way that is true to you.
I’ll leave you with some wise words from the coach. Good luck, I’m rooting for you.