There’s no denying that cash is king, and in the world of venture capital, start-ups tend to die when cash runs out. In a recently published American Banker article I outlined a framework that described what it will take for newer lenders and originators to survive a shock to the system. But what will happen if they run out of cash? Are they destined to close shop or are there other possible outcomes?
Answering this question isn’t easy. I wish I had a crystal ball (it would make my job easier), but what I can share is a framework that can be used to help think through the fate of these companies. The framework is based on a concept that I call “Climbing the Relevance Curve”, and it has two simple questions at its core.
- Will anyone notice? At the foundation of the concept of “relevance” is the notion that a business is either relevant or irrelevant through the lens of a counterparty. And the simplest way of determining whether or not a business is relevant is to answer the question: “Who, if anyone, would be significantly hurt if the business in question were to go away tomorrow?”
- How much money is being burned? The second piece of the framework is a simple set of calculations around how much money a company is burning in the current environment and how much total capital it will need to turn profitable if conditions worsen. There’s a fine line between buying an asset and buying a liability and many entrepreneurs and investors are too optimistic about where that line is.
The result is a framework that exposes a list of potentially interested buyers and a rough idea of when a business becomes relevant to each of them. In difficult funding markets, if a business has no deep-pocketed counterparty that deems them as “relevant” then the business has no choice but to rely on investors or free cash flow to carry the company while it continues to climb the relevance curve and wait out bad economic and/or market conditions.
Distance from relevance is very important because the great venture-backed fintech companies that emerged post-crisis have consistently delivered growth rates of 100-200% a year. This implies that relevance is a function of time for the best companies. Investors can always choose to infuse capital into a company if it isn’t relevant just yet but is climbing the relevance curve quickly.
But the converse is also true. From both an investor’s and an acquirer’s standpoint, if a company isn’t climbing the relevance curve quickly enough then the capital outlay might turn into a liability rather than an asset. A low growth company that’s burning cash will be seen as an albatross while the same might not be true for a company growing nicely that needs a well-understood amount of capital to succeed.
And many of you might be asking: “What about proprietary tech? What about an embedded user base? What about IP?” While there always will be exceptions to the rule, my general view about the value of all these supposed assets is simple. Value them at zero. Assets owned by a money losing business with a complex cap table normalize to a valuation of zero. And while acquihire situations are becoming more and more frequent and the tech might live on as part of a deal, the general price tag for these deals is pennies on the dollar relative to today’s current paper valuations.
While some may think I’m being overly harsh and too “black or white” in my thinking, I can point to real situations and real conversations that I know are happening right now. For instance:
- I asked the CEO of a prominent, well-funded lending platform whether his company was planning on being acquisitive if good opportunities presented themselves. His answer was a clear “no”. Rationale: Cash and equity are precious in this environment so acquisitions don’t make sense. Even at a zero valuation, he said he’d be reluctant to take on the challenges of integrating a new team/tech into the mix right now.
- I asked a high level Executive at a top-20 Bank if his consumer lending organization was interested in acquiring any fintech originators if valuation expectations decreased. His answer was “yes” but with caveats that basically meant “no”. He’d be willing to consider buying a company if the acquisition were immediately accretive, all competitive Banks could be kicked off the platform with no collateral damage, their Regulators signed-off on the deal, and the tech could easily be unleashed on their core franchise without significant integration.
- I’ve made a concerted effort to build strong relationships with many of the next-gen lending companies and originators. As a result, I can point to multiple companies with solid traction and teams that have either recently been in-market trying to raise equity capital or are talking about raising in the near future. A year or two ago many of these lenders and originators would have been funded quickly but based on what I’m hearing from the companies directly, the response in today’s environment has been one of skepticism. A few of them having even confided in me that their current investor base is insisting on an outsider led term sheet because their partnerships want new, deep-pocketed sources of capital around the table. And I also know that a few of these companies are being told that absent a successful raise they’re going to have to make a very small infusion of capital from their existing investor base last a long time and figure out how to sell the company or ride out the wave. Not all founders will see eye-to-eye with their investors on what this business plan looks like so a few companies could run out of cash in the near future.
I’ve watched this climb many times across many different business models and the story is the same. Becoming “relevant” is not just important, it might actually be the most important metric to track. And in the case of a lending business or originator, the relevance curve needs to be climbed during good times because it’s difficult to continue the climb when market conditions take a turn for the worse.
Author: Frank Rotman