You’ve put in months of hard work and dedication toward building something that you believe in, but even with hard work and dedication, it’s not guaranteed success. One of the biggest challenges that founders face is managing cash flow and making sure that the business is “in the black”. Negative cash flow can be a huge problem for startups, especially in challenging markets when funding is not as widely available. In this post, we explore what negative cash flow is, how it impacts startups’ valuation, and a handful of strategies you can employ to improve your cash flow—let’s dive in!
What is negative cash flow?
Negative cash flow (also known as negative operating cash flow) occurs when the cash outflows from a business exceed its cash inflows during a period. It is shown on either a cash flow statement, an income statement, or both and is the opposite of positive cash flow. In essence, this means that the startup is spending more money than it’s bringing in, leading to burn and a net loss of cash on it’s balance sheet. It’s important to note that negative cash flow does not necessarily mean that a startup is failing, rather it simply means that it is not generating enough revenue to cover its expenses.
How does having negative cash flow impact startups?
Negative cash flow can be a major problem for startups, as it can lead to several other issues. One of the biggest issues that startups with negative cash flows may face, is a cash crunch that results in them not being able to satisfy their operating expenses or outstanding debt obligations. If this occurs, and the startup does not abide by the payment terms, the lender may recall its loans prematurely, forcing the startup to face even more difficult cash flow management problems.
Another major issue that startups with negative cash flows may face is a lack of investor interest. During periods of economic expansion, the mantra of “growth at any cost” reigns supreme and VCs are willing to provide more funding to startups that are burning cash. During periods of economic contraction, on the other hand, VCs are much more cautious with their capital, providing it only to those who can show positive unit economics and cash flow. Without additional funding or a change to its revenue model, startups with negative cash flows will eventually run out of cash and face insolvency.
What kinds of startups have negative cash flows?
While startups of all shapes and sizes may experience negative cash flows throughout their lifecycle, typically those who are early on in their journey are more likely to do so. Also, biotech, agri-tech, and other highly-research-dependent startups experience negative cash flows throughout their lifetime (and are expected to do so). As startups mature, and margins increase, the goal is to reach cash flow neutral or positive. It's also important to note that occasionally startups (and large corporations) will intentionally maintain negative cash flow to avoid taxes.
What causes a startup to have a negative cash flow?
As mentioned negative cashflows are caused by an imbalance of revenues and expenses. When expenses exceed revenues the cash flow is negative, and when the opposite is true, the cash flow is positive. There are an infinite number of factors that could contribute to a negative cash flow, the most common are:
- High operating expenses - these are costs associated the operating activities of a startup: rent, equipment, marketing, payroll, insurance, step costs, and funds allocated for research and development.
- High cost of goods sold - these are the costs associated with the materials and labor directly used to create the goods or services.
- Increasing competition - the more competition there is, the more attractive price drops are for a company, resulting in less revenue and lower margins.
Is having a negative cash flow as a startup a bad thing?
Not necessarily—negative cash flow can be a natural part of the business cycle, and as such not always a bad thing. It’s important to remember that startups are constantly investing their capital to grow and expand, which can lead to temporary dips in cash flow. However, it is important to keep an eye on the cash flow reported in your financial statements to make sure that it is not consistently negative. If your cash flow is consistently negative (and this is not due to an intentional decision), then there are likely problems that should be addressed within your organization.
Differences between negative cash flow vs. burn rate?
Negative cash flow and burn rate are often confused, but they are two very different things. Negative cash flow occurs when a business is spending more money than it is bringing in, while burn rate is the rate at which a business is burning through its cash reserves. One is a specific figure that is calculated at a point in time (negative cash flow) and the other is a metric that is an average that is calculated over a period of time (burn rate).
For example, if a business has a negative cash flow of $10,000, it means that it spent $10,000 more than it brought in. However, if its burn rate is $10,000, it means that its cash reserves are being depleted by $10,000 every single month.
What is the impact of negative cash flows on runway?
Runway and negative cash flow are directly correlated. The greater the negative cash flow, the greater the amount of cash you burn each month, and subsequently the shorter the runway.
What is the impact of negative cash flow on valuation?
Cash flow, and more specifically negative cash flow, can have a drastic impact on valuation. In general, the cash flow and valuation have an inverse relationship: the greater the negative cashflows, the lower the valuation of a startup. That said, the valuation of a startup is highly dependent on the industry that it participates in, and the overall macro-environment.
The action-oriented strategy for overcoming negative cash flows
While negative cash flows can be a major problem for startups, small businesses, and large enterprises, there are ways to overcome it.
- The first step is to identify the cause of the negative cash flow. Is it because you’re not generating enough revenue, is it because you’re spending too much money on growth, or is it because the unit economics don’t make sense? The goal here is to identify what is causing your business isn’t performing as well as it should.
- Once you’ve determined where you’re going wrong, the second step is to double-click into it. Let’s say you aren’t generating enough revenue, is it because you don’t have the right tech stack in place to capture the revenue, is it that you don’t have enough salespeople or the right sales people, is it that you don’t have sales follow up or nurture flows setup to capture those who drop off? The goal here is to identify the specific reasons why your business isn’t performing as well as it should.
- Now that you’ve identified what and why is going wrong, now you should identify strategies for how you might fix it and test them—e.g. let’s say your revenue isn’t growing as fast as it needs to be because your sales team doesn’t have enough time to follow up with all of the leads. Rather than hiring more salespeople, empower them with the right technology to build the right nurtures to automate the process—then measure the results and make adjustments on the fly.
By identifying the root causes of the problems with your cash flow, the context for why it's happening (or not happening), and testing multiple solutions, you can quickly, and efficiently address your negative cash flow problems, improving your cash flow forecasts.
How to optimize working capital to minimize negative cash flows?
Working capital is the amount of money that a startup needs to cover its short-term expenses. Optimizing working capital is an important part of managing cash flow and can help startups overcome their negative cash flows. One of the easiest ways for a startup to optimize its working capital is to focus on reducing its accounts receivable. Focus on collecting payments from your customers as quickly as possible, or consider an alternative like revenue based financing that enables you to convert your future revenues into upfront capital—eliminating the time gap between contract signing and the eventual bump to your top line.
Final thoughts on negative cash flows
Having negative cash flows as a startup can signal major problems to investors, and can lead to insolvency. It’s important to understand why your business has negative cash flows, identify the set of actions you can take, should you need to, and outline how you intend to fix it in a financial plan. In some cases, having a negative cash flow is completely acceptable—in those cases, make sure you have a pulse on how it's trending month-month, so you don’t face an unexpected cash crunch down the road. In cases, where you want to get to default alive, or cash flow neutral, identify what is causing the issue, and why it's occurring, brainstorm two or three solutions and test them—doubling down on those that worked. With the right strategies, no matter what the market conditions are, you can overcome negative cash flows and put your startup on the path to long-term success.
