One sign of a bubble: traditional valuation principles are abandoned because "this time it's different". See Nifty Fifty, 2000 dotcom, 1920's crash, 2015 Chinese A shares, ... . It usually requires a new generation of people to enter the market because most people learn only on their own mistakes, not on other people mistakes.
This article talks about what negative cash flow means for the company. But what does it mean for the investor? A company that cannot go cash flow positive is worth zero - the value of the company is max(all future cash flows discounted by the interest rate curve, 0). The max(, 0) comes from the concept of the limited liability company.
I catch your drift, but this isn’t technically true. A company with negative discounted cash flows might have a positive expected value because it can undertake a risky project that has a negative expected value. Usually this project will bankrupt the company, but occasionally it will provide a windfall. During bankruptcy, the company might not pay off all of its debts, but it can’t be worth less than 0 due to limited liability. During the unlikely event of success, the company is worth something.
If you want to know more, look up “moral hazard” and “real options”.
If I'm reading you correctly you are arguing to something slightly different than what OP said. OP says that if a company can't go cash flow positive it is worthless, you say there there is always a chance that a company might experience a sudden turn around and go cash flow positive. Both are true.
However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless. If ordinary investors are relying on "maybe things won't turn out the way we expect them to"-style logic to make their investment decisions then the market is doomed.
> However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless.
Well, Uber is an exception to this rule apparently.
The way I read the GP, they're just saying that LLCs are good to be used for gambling.
Not OP.
But that’s a hypothetical for a company who is already in business and is betting on a product. Right? Like Sony betting on the next gen console by selling it at a $100 loss but then make it up later when they take hold of the market. But that’s Sony and one of their products. I see Moral Hazard as an example of that.
Nowadays it’s almost every company betting their whole business hoping that their product will come out on top or they’ll let the public pay for the debt through IPOs.
In technical terms, the correct formula to use is E(max(CF,0)), not max(E(CF),0). In the words of the Merton model, equity in a limited liability company behaves like a call option on its assets/cash flow. In reality, these may follow a far more complex process than a geometric Brownian motion with drift as in the Merton model, but that only changes how you compute the expectation in the formula, not the formula itself.
For example, the generation that remembered the Great Depression and its aftermath did not fully pass from power till around 1990, for instance the elder President Bush.
I think this is a lot of why the 50s and 60s is remembered so fondly by many people in the United States. Of course there were lots of major problems at that time and a lot of that fondness is just nostalgia, but I think there are legitimate reasons to think that way. The amount of turmoil and first hand mistakes that generation had to live through early on in their lives was pretty staggering, and I think the high stakes consequences and first hand experience of what it means to make unnecessary risks, while also experiencing the unavoidability of risk, lead a disproportionate number of people in that generation turning out as good/effective leaders and team members. Basically I think that whole hard times create strong men, strong men create good times, good times create weak men, weak men create bad times thing is probably true, and it probably applies as much to economic bubbles as it does to politics/times in general.
Wouldn't that logic mean the recession will ultimately lead to Gen Y being good/effective leaders?
Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s.
Or in other words, on the timescale of decades, the mob of capital doesn't act in its own best interests. Because individual greed overcomes sustainability.
> Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s.
I think it was the entire productive capacity of the remaining world being bombed to destruction was the reason the USA experienced prosperity during that period. The US dollar becoming the international reserve currency probably helped also.
Yes, I think the near monopoly on manufacturing that the US had after the war was a huge part of the pursuing prosperity. I don't know that much about the history of the US Dollar as the world's reserve currency, but that was probably a large factor as well.
Just to clarify, I'm not trying to make the claim that the US was prosperous during that period solely because I think the war created more conscientious people. But I do think part of the reason you saw that prosperity distributed better and had things like pensions was because people back then had a better sense of what the cost of NOT distributing more fairly is, along with a better sense of the importance of camaraderie. That's an admittedly romantic view of the time, but I think there's truth to it. Widespread adoption of computers has lead to huge increases in prosperity after that period, and I think part of the reason that hasn't be shared is that the generations since then are more child like and have less of a sense of responsibility.
Not necessarily; I think the type of bad times experienced and how the majority of people need to act in order to weather them play a big part in how it affects their character.
Although obviously war is horrible and hugely detrimental on net, I think the one silver lining is that you are put into life threatening situations in which you NEED to trust the people around you. Political backstabbing, greed, brown nosing, refusal to take responsibility, laziness... these will get you and/or the people around you killed. I believe people that go through that tend to put more emphasis on creating healthy, sustainable, working organizations than their own self aggrandizement.
When people come on hard times during recessions, I don't think the dynamics are such that it makes strong people, necessarily, or that it offsets selfish impulses in the same way something deeply scaring and emotionally impactful like war can. But I do think people that come out from recessions figure out what lead to the bad times, and generally come out stronger in that they're less likely to repeat the same mistakes.
Doesn't said company still have assets? At some point, the company can just dissolve and liquidate its assets. Assuming the assets are worth more then the companies debt, this leaves something to distribute to shareholders.
If the company hasn’t been cash flow positive over its lifetime, it is unlikely that the assets will be worth more than the debts.
Investments in machinery almost invariably depreciate significantly the moment they are bought, and salaries paid to personnel, electricity to power the lights in your office building, money spent on legal, etc, all lead to zero assets.
It can happen if most of the assets are products the company made, and the company can produce them below market value, but then, why would it have have products in store, and not sell them?
There are exceptions, but they’re easily recognized. On the one hand there’s seasonal demand: companies growing Christmas trees, or producing umbrellas, hockey skates, etc.
On the other hand, there’s companies with long production times such as whiskey distillers or factories building nuclear plants.
Well, this is why it makes a lot more sense for startups to raise equity versus debt typically. There could be some exceptions such as using the debt to buy required hard assets, but typically, it makes very little sense.
Not all negative cash flows are created equal. For most high valued companies that are cashflow negative, the deficit should represent a portion of their sales and marketing budget. In that case they are literally choosing to be cashflow negative as an investment in growth, and could choose to become cashflow positive at any point by reducing the sales and marketing budget. Obviously this depends on things like their CAC and LTV being healthy, but investors aren’t stupid, and in isolation being cashflow negative isn’t an indication about the sustainability of the company.
Your case (LTV > COGS + CAC) is accounted for in a standard DCF model. If you're planning to be cash flow negative for 30 years because of R&D costs then that's fine but you better have a model where 30 years from now you're able to beat 30 years of interest (and by quite a bit given the risk profile).
Grandparent was talking about the case where CF never goes positive. In that case the company in theory still has some shareholder equity by way of assets. But in reality, especially for something like a software company, there aren't going to be a lot of assets to strip out when you unwind the company.
The existing customer base is an asset. If you can profit from taking a negative CF company, firing all the staff and collecting subscription fees from the existing customers until they all churn, then you have value that can be extracted from the company. These ”maintenance mode” acquisitions aren’t even that uncommon.
But that said, it’s not exactly obvious which funded companies will never be profitable. If it was then you’d expect it would be quite hard for them to secure funding. This is simply a conclusion that many HN commenters love to jump to when deriding a particular company, usually without a very good understanding of the company’s financials, or even of finance in general.
I think that your argument is with the part about a company being worth $0 if it's not cashflow positive?
In theory that's the case but obviously it depends on a lot of factors, and if we're talking about software startups then they typically would have very little in terms of assets to unwind. Maybe some office furniture or a bit of IP. But most of the cash is going to stuff like employee salaries, leasing office space, and cloud computing infrastructure, so by the time you decide to shut it down there's going to be very little left in terms of shareholder value.
"I have never seen growth and profitability so nicely tied together in a simple rule like this. I’ve always felt intuitively that it’s OK to lose money if you are growing fast, and you must make money and increasing amounts of it as your growth slows. Now there’s a formula for that instinct. And I like that very much."
That's an interesting rule, but doesn't account for companies running at negative gross profit. SaaS companies can have non-negligible COGS since they have (virtual or otherwise) server costs. If (for example) your AWS bill is higher than your revenue, no amount of growth is likely to make that healthy.
Your AWS rates will go down with increased usage and at any time you could switch your engineering goals from features to performance. If you are growing fast then the savings you can make this quarter will be negligible in a year but the added features won’t.
It often makes lots of sense putting tech cost efficiency near the bottom of your priorities when you are growing fast and human time is your limiting resource.
COGS typically includes payroll for employees whose labor is directly tied to production but doesn't include 'overhead' employees and other categories like rent / legal / sales / marketing.
The best way to think about it: "If we had 0 sales, would this expense still exist?" If it wouldn't exist, it's COGS.
If (for example) your AWS bill is higher than your revenue, no amount of growth is likely to make that healthy.
This is almost exactly untrue. Take an old school SAAS company with a few EC2 servers, paying say $500/month. If they have one customer paying $30/month they'll make a loss, but if they grow that customer base above 17 customers they'll be in profit.
That depends how resource utilization (really, AWS/cloud costs) scale with customer growth. Often it scales poorly when your SaaS is really a bunch of prototype-isp "MVP" code.
The traditional defense of negative cash flow is that excessive cash means that resources are idle that could be working towards growth. This makes sense in winner-take-all markets, where getting marketshare fastest means establishing a semi-monopoly and ensuring years of profit.
I think there is some validity to that thinking, but there is an implicit assumption that one could choose to step on the brakes on growth at any time and resume positive cash flow. For many firms, that is simply not the case. The firms in that position are more desperate for growth, and in my opinion the most dangerous to all. When backed into a financial corner they make comprises that harm their customers or the ecosystem as a whole.
Therefore, I think it’s crucial to distinguish strategic cash burn vs unsustainable business model. Metrics like negative return on ad spend (ROAS) are decent indicators.
I always looked at negative cash flow as default dead, regardless of profitability. Long term survival is at risk when you run out of cash to pay invoices, profits or not. All that needs to happen is financing, either by banks or investors, to stop.
> I think it’s crucial to distinguish strategic cash burn vs unsustainable business model
The only thing I don't like about the idea of a strategic cash burn is that I'd much rather see a strategic cash dividend or share buyback. Any company can hire someone who will find a way to justify spending assets for some potential ROI, and it's pretty easy to spend a company right into bankruptcy.
> This makes sense in winner-take-all markets, where getting marketshare fastest means establishing a semi-monopoly and ensuring years of profit.
I think the rest of your point is sound, but growth is important in all markets, regardless of any opportunity to monopolize. Forgoing investment in growth is an opportunity cost for any company in any market.
A lot of companies would be fine with 5-10 million in funding and organic growth. However investors don't want to manage thousands of small profitable private companies. They want fast growth and then exit quickly in a bang. This means a lot of companies get 3-5 times more funding than they need, then generate a nice profit but not enough to pay back the excess funding and finally shut down.
I once read about a simple AI strategy for multiple games that has stuck with me. The strategy at any point was to make moves which increase the number of moves available to the AI.
When making decisions now, I often step back and think about what types of decisions will give me more opportunities to make more choices. This often involves increasing the funds available to me.
Funds without encumbrance are better than a debt of any kind though... and venture capital is just a different kind of debt.
I had a long debate with an accountant, regarding what I should primarily manage. Being bootstrapped I mostly manage cash-flow and made the mistake of saying “profit is made up”. That got him real worked up.
My point was we derive profit. The actual transactions are in the cash-flow statement which does not lie.
You can hang on to a lot of cash while making lots of promises, and bankrupt a company without spending a penny.
I know you know, but it's a real problem with a lot of small operations getting their accounts done; they think they're in the black due to a bank balance, but when the accountant sees the books, things aren't so rosy.
Under GAAP, profitability for complex businesses can be highly subjective. In some cases it may only become clear in retrospect after many years whether the business was really profitable or not.
Can someone provide counterpoints to this? I also think like OP, but people can’t sometimes comprehend such decision.
I recently went to a job interview for startup, and they were selling me really (like, way below even average) crap salary in exchange for some options (not on contract, just verbal [on the approval, not even the amount]).
I told them that I would take a bit more salary than what they were offering... You wouldn’t believe their faces. It’s like they couldn’t believe I was telling them I pretty much never had debts and I liked positive cash flow, hence my initial salary choice. They dared telling me I could ask for a loan if I needed to keep some of my businesses up.
Anyways, I’m just saying that very few times I dare go negative. I have a house, car, and I travel from time to time (usually what I spent most of the positive flow in). I had to save tons of money for some, and others were result of some businesses. For the big ones mentioned I never went negative.
I’m not saying it’s possible or everyone is lucky enough to happen to them, but these were people that have a lot of money from inheritances (I know them), and what I understood from the whole interview is that they always live without positive cash flows, personal and businesses alike.
I think people are very different than companies in this respect.
An individual would want to have savings (in the form of pension - e.g. 401k - and invested savings), while a company's mandate is NOT to store significant amounts of money to derive capital interest from it.
True, but it's similar in the sense that both can leverage credit but then become dependent on their creditors, and that having a significant chunk of cash in your assets gives you freedom to do what you think should be done (invest in new facilities, etc.)
A quick google reveals that Apple supposedly has over 200 billion in cash reserves...
Well, you'll need positive cash flow sooner or later if you want to stay in business. But the advantages the op attributes to positive cash flow are really advantages of having money in the bank. The only advantage to having a slightly positive cash flow is that it makes you feel good. If your cash flow is slightly positive but your key people are getting stock options or whatever as a nontrivial part of their compensation, you are actually losing money.
Man, this kind of B.S. wisdom from VC gets me pissed. Do you think in all the thousands of boards meetings he has sat on that he ever recommended getting cashflow positive? The whole VC model is burn baby burn until you can get big a flip of the asset.
This kind of articles come out during a down market when the VC go from 'we will make billions' to 'cut your burn rate so I can see sell the startup you worked on for the past few years for pennies on the dollar.'
Everything VCs write is warped by their capital distortion field. Beware
A typical VC fund's portfolio has a lifespan of 8-12 years. This is the amount of time the venture principals have told their investors that, after which, they'll start realizing the value of the portfolio. Funds typically have multiple portfolios active concurrently, and additional investors may come in throughout the initial stages of a fund (couple years).
There isn't any way around this: at the end of the day, VCs want a return in about a decade. That's their window. They absolutely will sacrifice the long-term success of a company in order to attain a positive return within that decade, because that's when their investors want to see a return. What most people don't realize is that VCs are, usually, just middlemen. Maybe a firm is started by someone hyper-rich, but even in cases like this, they're taking in external money from dozens of sources to build these checks they write to founders.
Of course, they're not evil. In everyone's ideal world, they can see a return in their window and the business can go on to be sustainable and amazing. But the world isn't sunshine and rainbows; if they have to choose between "maybe successful in 20 years" or "sell it and break even", they're going to force a sale (if they can). I've seen it happen first-hand about three times (though, in these cases I witnessed and many I'm sure: the businesses had become "zombie startups" and likely wouldn't have seen substantial growth even with more funding. an early exit was the best outcome for everyone involved. But, in one of them at least, the CEO was pretty angry at them.)
Different motivations AND different evaluations of the company and market between the VCs and the founders. Also different risks and rewards for the VC and the founders.
Sometimes the VC thinks that the market the startup is in is a bubble and the VC will push for growth over long term health. Sometimes the VC is right and sometimes they are wrong.
I've seen this play out where the VC pushed for growth probably to get acquired. The VC may have been mostly right since the market was a bubble that popped. One competitor was able to pivot though and ended up with 4X. Most competitors failed. Perhaps the VC wanted the money or perhaps the VC didn't believe in the founders.
Sometimes the startup has no market and then the VC may push for actions that lead to acquisition. Sometimes the founders demand additional incentives in the acquisition.
I've seen this play out since the VCs probably at best break even and want to wash their hands and the founders threaten to stop the deal since they lost out on salary and stock founding the company.
What people want and the steps they take to get that are often not in agreement.
It's hardest to achieve something when you ask people to give you something that is at odds with that goal, which is basically a long running complaint about the entire VC business.
If occasionally they get a fast growth enduring company it could be luck or a stronger personality on the other side of the table as much as by any action of theirs.
You manage what you measure and what they measure most is growth, not endurance. Half the time when I push for endurance at my place of work I feel like some sort of freedom fighter, subverting a system that wants - no, demands - something very different from me.
I could tell you that I want to find is a company that grew somewhat organically that has a big growth opportunity, but that would be a lie, because I don't want lottery tickets anymore. I just want to work on something a lot of people have a positive experience with and we make an honest living at.
What I mostly find is companies that think if they can just grow all their problems will be solved. And they have VCs that tell them the same thing. The only people who are telling them differently are people who aren't courageous enough to go into business for themselves, or who they've never heard of because they're not a Unicorn. And who listens to those people, right?
USV invests in early stage companies. They don't really have incentive for those companies to need late stage capital, which will dilute USV and/or cost them money to maintain their position.
If this post said "Burn as much as you can, you can always raise more" you'd undoubtedly have had an even more negative take on it. So is your position just that VCs who have backed wildly successful businesses can't offer any useful advice on how to build a wildly successful business?
I really hate this modern way of doing business where being successful means your company implodes after losing five billion dollars a year for ten years rather than imploding after losing a hundred million dollars a year for five years.
Aside from being, you know, crazy, aren't there laws about charging customers below cost in order to fuel expansion and grab market share?
He's using the term cashflow in the wrong way. You can have positive cashflow as long as investors are investing in your company, but that doesn't mean your business is going anywhere or that you make a profit.
What you say is true, though unlevered cash flow from operations is what is typically meant rather than cash flow from operations plus cash flow from financing.
Under limited circumstances, depending heavily on what is causing the loss, sometimes this can be effective for very few companies. Of course, many people unrealistically believe that their circumstances apply, that the cause of the loss is irrelevant, and that it will be effective for them. Most are wrong.
Losing money per transaction is dangerous. Making money per transaction but plowing the profits into expansion is less dangerous. The latter is what Amazon did. The former is what too many companies are doing, not seeing the difference.
There is theoretically a scenario in which a company might temporarily lose money on each transaction due to scale, but over the long term manage to lower costs so that each transaction is profitable. Even that, I'd say it's dangerous to count on that, but it's not completely impossible.
I think that's different from dumping, which I consider to be a more deliberate attempt to outlast a competitor.
This article talks about what negative cash flow means for the company. But what does it mean for the investor? A company that cannot go cash flow positive is worth zero - the value of the company is max(all future cash flows discounted by the interest rate curve, 0). The max(, 0) comes from the concept of the limited liability company.