Cash Flow Problems: How Working Capital Risk Forces Founders to Bet the Runway

At Klear, the fintech startup that I founded and run as CEO, we talk a lot about Capital Intelligence and spend a lot of time with founders and boards organizing complex data into living capital plans, but we didn’t always do this. 

We spent a lot of our early days playing the role of financial EMT. One of our clients’ CEOs or board members would have an emergency capital situation that arose out of something very similar to the scenario outlined in installment two. These companies had an incredible product, an all-star customer base, we’re at one point well funded by rockstar VCs and still found themselves with too much month at the end of the money.

Money is just one form of capital and a good team of builders learns how to convert money into inputs (procurement & AP), and inputs into a finished product that they sell to their rockstar customers for a handsome profit (hopefully). 

That was the plan that was presented to the VCs and was funded and that drove early execution. Sometimes though, a team will get so good at this that they will get the order of a lifetime or a series of orders or build a massive backlog because they have:

1. Hit a vein of pent up demand
2. Had the market come to them
3. Both

Cash Flow Problems Don’t Come From Lack of Demand

When Success Accelerates Faster Than Cash

Many of our most successful clients in autonomous systems, aerospace and defense, energy and transportation are experiencing “both.” This is a version of victory and should be celebrated. 

We used to use a phrase at Klear for this moment called Yayf*$k. Both at the same time. Our recently retired Japanese American VP of Finance came up with the more elegant Shippai Kanpai which we can say anywhere out loud, without offending and although it's not a precise translation, to us anyway, means the same thing. 

Regardless of what you call this anxiety inducing moment, IYKYK. What then happens to fulfill these backlogs is a combination of two things:

1. You raise more based on commercial traction (but not on revenue yet which is painful for founders and early investors - subsequent blog coming) or
2. You find yourself in a position where you have to dun, dun dun… bet the runway

Cash Flow Problems Force the Hardest Decision Builders Make

This decision is often the most terrifying and brutal decision builders have to make and we see them having to make it over and over again. It is agonizing, sleep depriving and because many of them are data driven engineering types, not what they signed up for. However, it is a symptom of their success.

What It Means to Bet the Runway

What do I mean when I say bet the runway? In startup land, runway is the main thing VCs fund. The runway is the outcome of the “UoP” or use-of-proceeds from the investment round and basically is as simple as:

What are we going to invest this money in between now and the time we:

• Raise again - based on achieving success milestones
• Achieve profitability - imagine!

That is going to increase shareholder value and improve the prospects of the business? The runway metaphor comes with visions of taking flight but for early stage companies, rounds are like the sequence of grinding gears on the Delorian getting you to the coveted 88 MPH.

Why Runway Planning Breaks Under Real-World Growth

Defining, agreeing on and funding UoP is a key role of VCs, founders and boards and is the reason equity is sold and rounds are closed. 

UoP consists of payroll, sales and marketing, often R&D and for builders, should include working capital required. This one isn’t always as precise as it should be, is based on degrees of success and in the BIG success scenario outlined above, may even be unknowable.

Working Capital Risk Is the Hidden Cause of Cash Flow Problems

If you are a repeat founder or finance professional with experience in manufacturing and industrial supply chains this is all 101 level stuff. If you are a new investor to the hardtech, aerospace and defense space, or deeptech space or a repeat founder making the leap from software to hardware or to software defined hardware (still hardware) it is mission critical to get this part right.

What Working Capital Risk Actually Means

Here’s a great definition of working capital required WCR from our partner Allianz and a link to their article.

The Working Capital Requirement (WCR) is a financial metric showing the amount of financial resources needed to cover the costs of the production cycle, upcoming operational expenses and the repayments of debts. In other words, it shows you the amount of money needed to finance the gap between payments to suppliers and payments from customers.

Each time a builder fills an order there is WCR related to that order. If a builder fills a group of orders there is WCR to fill that group. 

A part of that WCR is payroll and if the growth spurt isn’t too big, the payroll outlined in your UoP is probably pretty close, but payroll is likely a fraction of the true WCR. 

In software startups where the majority of VC funding goes, payroll is the primary expense (often heavily weighted toward R&D) often followed by smaller spend on sales and marketing. For software payroll, a fixed amount of money comes out of the bank a predictable 24-26 times a year and makes up most of the runway. The “burn” is predictable and is forecasted against the proceeds of the round. This burn makes up most of the runway. When the founder, board and investors meet they compare the actual results to this forecast and discuss runway in this context. 

How Cash Gets Trapped as Orders Scale

For builders though, payroll often makes up a minority of the WCR to fill an order or a backlog. The majority goes into COGS (cost of goods sold), the stuff you buy to fill the order - the inputs. The financial pie slices are a totally different size (big), composition (COGS) and frequency (now) for builders and the appetite consuming them is your ravenous enterprise customer.

When these companies are doing better than expected, the orders are going up quickly, the backlog is building. To fill the orders the WCR is also going up quickly. The slices are getting bigger and more frequent and with them the promise of scaling revenue and ultimately cash is just over the horizon. Maybe more importantly, the clients are happy, your company is demonstrating the ability to scale into demand, clients have agreed to become reference customers which has led to another large order from a different enterprise or government customer and the cycle has started anew. 

Then something moves. 

A manufacturing timeline changes, a delivery misses its ship, a payor has a processing issue, a government shuts down, maybe not even as a surprise, maybe just for the holiday season and this is when the critical decision presents itself. 

Is now the time to bet the runway?

When Liquidity Is Locked Inside the Backlog

This is the moment when you begin to calculate how long your corporate liquidity (I know you’re small but that’s what it is) will be trapped in the orders as COGS and if you have enough cash to invest some of the runway capital that was reserved to be allocated to payroll into the inputs for the next order (or for shipping the current one) and then calculate if the cash will come back fast enough that the little cash you leave behind as a buffer won’t be gone before it does. This terrifying scenario is betting the runway and we see it happen all the time. It is one of the most challenging aspects of scaling industrial startups.

Let’s add one further degree of difficulty to this juggling act. 

On your spreadsheets and in the model in your mind, the calendar stays still. If everything goes according to plan, the math works and the balls stay in the air. What we all know though is that the calendar doesn’t stay still and the math always changes. 

Planning Assumptions vs. Operational Reality

This level of planning, data management, orchestration, coordination and communication is a skill that you need to build inside your business. It may be the skill that separates the winners from the losers. 

Our clients often excel at building precision in their solutions. Precision manufacturing, precision launch, and precision guidance. They write books about it, are experts in their fields and push the boundaries of when, where and how precision can be achieved and delivered (underwater, in space, in swarms at hypersonic speed!). The best teams want and need that same level of precision inside their organizations and strive to run their companies at the same tolerance they can machine a part or land a probe.

Much like they design their technology, they know that the environment is unforgiving, will always change, and they need a built-in responsiveness to change to be a feature of their strategy and not latent a bug. That’s why they’re learning to master the skills I’ll write about in installment four: Optionality and Control.