In innovation-oriented companies finance is frequently overlooked. Finance is frequently a separate domain outside the direct responsibility of the engineers and marketers who drive innovation in a company. The result is that important dependencies are overlooked, which can result in serious cash flow problems or even bankruptcy of a company. In this blog a framework is presented called the ‘Cash Flow Curve’, which helps innovators to manage the financial aspects of innovation.
Introducing the Cash Flow Curve
The Cash Flow Curve shows the cumulative cash flows over time. On the horizontal axis the time is given and on the vertical axis the cumulative cash flow is given. The cumulative cash flow is the sum of all the positive cash flows -money in- and negative cash flows -money out- related to a project. To explain the Cash Flow Curve, let us now have a look at how the Cash Flow Curve behaves over time for a single project, see the image below.
In general, we can distinguish 3 different investment phases of the Cash Flow Curve:
The first phase is called the initial investment phase. In this phase investors give money to start a new project. In this phase just money is spent and no revenues are coming in. So the cumulative cash flow is negative and gets more negative over time. When an innovation hits the market and is sold to customers, revenues are coming in. This means that the slope of the cumulative cash flow curve becomes less negative over time.
The second phase is the profitability phase. When a product becomes profitable, the incoming revenues are higher than the product costs and organizational costs. This results in a positive cash flow, which is visible in an upward cumulative cash flow curve.
The depth of the curve indicates the amount of capital a company needs to finance the project. The lowest point of the curve is the maximum capital a company needs to finance for the project. After this point, the company can gradually start to pay some of the investors or lenders back, but frequently still needs cash for upscaling of the business.
The third and last phase is the period of return. This phase starts when the cumulative cash flow is zero, which means that the earned cash equals the invested cash in the project. This point is also called the cash break-even point. In this phase there is enough money earned to pay back the investors, and subsequent cash can be used to invest in further growth of the business. Note: the cash break-even point is not the same as the economic profit, which is frequently used by investors, because it takes the cost of capital into account.
Sometimes it lasts very long before the third phase is reached, because it can last very long before a product becomes profitable. Some products become even never profitable, because the product-market fit is not right. In some cases this is not always visible from the outside and investors keep pouring money in. These companies are called zombie companies. In this case the investors shares are diluting and investors will never receive their money back. It can also happen that a profitable company becomes unprofitable over time. This could be because of changing market conditions. In some cases assets become less worth and need to be written off. We call these also stranded assets. For investors this means that their share becomes less worth.
Startup companies versus mature companies
The Cash Flow Curve is valid for both start-up companies as well as mature enterprises: the same financial laws apply. The key difference is that start-up companies frequently use external financing, while most mature enterprises use internal financing for new projects, like cash from mature product lines which is re-invested in future opportunities. That is why frequently financial resources look ‘unlimited’, and finance gets less attention. Also finance in large enterprises is frequently handled by a different department, and is as such less visible. But this does not mean that cash management is less important in mature companies.
Financing the project
Funding for the project can be done by internal or external sources. Internal sources can be the founders or the company itself, in case of mature companies which reinvest profits in new projects. External sources can be for instance angel investors, venture capital funds or banks.
Getting external finance is not always easy. In fact it can take a long period of time to convince investors or banks that your product of service is good to invest in. There are different types of investors, depending on the investment phase a company is in. The following table gives an overview of the different phases of a project and typical finance sources per phase.
A company needs to organize investment rounds to find the external investment it needs. In every finance round, there can be multiple investors. My personal experience with start-ups is that the time and effort it takes to get new investors on board is frequently underestimated. It can sometimes take several months to get new investors on board. This is especially the case for professional investors, like venture capital funds or strategic investors. Sometimes it happens that projects need to be put on hold, because there is no money available to continue the work.
Burn rate and runway
To manage cash flow throughout the Cash Flow Curve it is important to know 2 critical parameters: the burn rate and runway. This is especially important for start-up companies. The burn rate is the amount of cash you use in a given time frame. Let’s say the burn rate of start-up X is USD 200K per month. The runway is the amount of time before a company is running out of cash. Let’s assume that a company got USD 500K from investors and spent already 1 month of work. Assuming a burn rate of USD 200K per month, there is USD 300K left, which is a runway of 1.5 month. That could mean that this company needs to start to look for investors soon.
Summary
Cash is like the life blood of a business. Every business needs to have sufficient cash. And for innovative businesses this is even more critical, as they need to invest in new opportunities. When there is no timely cash available, a business can run into trouble or even go bust. For innovators it is therefore important to understand the Cash Flow Curve of projects. The Cash Flow Curve shows the cumulative cash flows generated by projects over time. Innovators need to make sure there is timely financing available, which is provided by different parties, depending on the stage of a project. During the entire project it is important to know the burn rate and runway of your project, in order to know when to start looking for new financing. Starting too late means that you run out of cash and have to put projects on hold. When you manage the Cash Flow Curve as an integral part of your innovation process, it increases the chance of success considerably.
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