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Free Cash Flow: Burn Rate, OOC, and TTC

The core concept in determining the external financing requirements of your venture is free cash flow. Three vital corollaries are the burn rate, time to OOC, and TTC. Let's define each of these concepts:

• Free cash flow, simply stated, is the amount of cash generated by your operating company after you have paid the government the required taxes and after you have invested in the current capital needs of the company. Historically, it has been considered as cash that is free to be returned to shareholders. For an entrepreneurial company, free cash flow is almost always used to grow.

Exhibit 4.5 Entrepreneur's Bargaining Power Based on Time to OOC

Highest

Relative bargaining power (RBP) of the

entrepreneur versus sources of capital

Nil

Now 3 6 9 12+

Time in months to OOC

Burn rate is the amount of your cash reserve that your company uses (burns!) each day.

OOC, or "Out of Cash," should be the first thing an entrepreneur thinks about in the morning and the last at night. It is defined in terms of the days until the company is out of cash.

TTC, or the time required to close the financing - and have the check clear!

The message is obvious: if you are out of cash in ninety days or less, you are at a major disadvantage. OOC even in six months is danger­ously premature. But if you have a year or more, the options, terms, price, and agreements that you will be able to negotiate will improve significantly. The implication is clear: negotiate with the capital mar­kets from a position of strength and you will get a better deal!

The cash flow generated by a company or project is defined as follows:

Earnings before interest and taxes (EBIT)

Less Tax exposure (tax rate times EBIT)

Plus Depreciation, amortization, and other noncash charges

Less Increase in operating working capital

Less Capital expenditures

Economists call this number free cash flow. The definition takes into account the benefits of investing, the income generated, and the cost of investing, the amount of investment in working capital and plant and equipment required to generate a given level of sales and net income.

This definition can be fruitfully refined further. Operating working capital is defined as:

Transactions cash balances

Plus Accounts receivable

Plus Inventory

Plus Other operating current assets (e.g., prepaid expenses)

Less Accounts payable

Less Taxes payable

Less Other operating current liabilities (e.g., accrued expenses)

Finally, this definition can be simplified:*

Earnings before interest but after taxes (EBIAT)

Less Increase in net total operating capital (FA + WC)

where the increase in net total operating capital is defined as:

Increase in operating working capital Plus Increase in net fixed assets

Critical Variables

When financing is needed, a number of factors affect the availability of the various types of financing, and their suitability and cost:

• Accomplishments and performance to date. This is a big advantage
for the existing small business. Investors will be impressed by:

- Loyal customers, suppliers, and channel partners

- A business model that yields profits and free cash flow

Investor's perceived risk

Industry and technology

Venture upside potential and anticipated exit timing

Venture anticipated growth rate

Venture age and stage of development

Investor's required rate of return or internal rate of return

Amount of capital required and prior valuations of the venture

Founders' goals regarding growth, control, liquidity, and harvesting

Relative bargaining positions

Investor's required terms and covenants

Certainly, numerous other factors - especially an investor's or lender's view of the quality of a business, the management team, and the growth opportunity - will also play a part in a decision to invest in or lend to a firm.

Generally speaking, a company's operations can be financed through debt and through some form of equity financing.* Moreover, it is gen­erally believed that an existing business needs to obtain both equity and debt financing if it is to have a sound financial foundation for growth without excessive dilution of the entrepreneur's equity.

Usually, short-term debt (i.e., debt incurred for one year or less) is used by a business for working capital and is repaid out of the proceeds of its sales. Longer-term borrowings (i.e., term loans of one to five years or long-term loans maturing in more than five years) are used for work­ing capital and/or to finance the purchase of property or equipment that serve as collateral for the loan. Equity financing is used to fill the non-bankable gaps, preserve ownership, and lower the risk of loan defaults.

Even the underlying protection provided by a venture's assets used as loan collateral may be insufficient to obtain bank loans. Asset values can erode with time; in the absence of adequate equity capital and good management, they may provide little real loan security to a bank.*

An existing business seeking expansion capital or funds for a tem­porary use has a much easier job obtaining both debt and equity. Sources like banks, professional investors, and leasing and finance com­panies often will seek out such companies and regard them as impor­tant customers for secured and unsecured short-term loans or as good investment prospects. Furthermore, an existing and expanding business will find it easier to raise equity capital from private or institutional sources and to raise it on better terms than the start-up.

A key message here is that awareness of criteria used by various sources of financing - whether for debt, equity, or some combination of the two - that are available for a particular situation is central to devise a time-effective and cost-effective search for capital.

Financial Life Cycles

One useful way to begin the process of identifying equity financing alternatives, and when and if certain alternatives are available, is to con­sider what can be called the financial life cycle of firms. Exhibit 4.6 shows the types of capital available over time for different types of firms at different stages of development (i.e., as indicated by different sales growth, and there will be variations in different parts of the country.

*The bank loan defaults by the real estate investment trusts (REITs) in 1975 and 1989-1991 are examples of the failure of assets to provide protection in the absence of sound management and adequate equity capital. The new millennium has seen a resurgence of REITs.

Exit (LBOs, MBOs) $50,000 to $500,000 $1 million and up $350,000 and up $250,000 and up $350,000to$5 million $1 million to $15 million $1 million and up $5 million and up 30% Under 30%

Equity and risk capital

Equity capital:

Personal savings/ friendly sources

Informal investors

Venture capital:

Corporations and partnerships

SBICs, MESBICs

Strategic alliances and partnerships

Risk capital:

Private placements

Mezzanine/bridge capital

ESOPs

Public equity markets

Risk

Cost of capital (annual ROR)

Thus, many sources of equity are not available until a company pro­gresses beyond the earlier stages of its growth. Conversely, some of the sources available to early-stage companies, especially personal sources, friends, and other informal investors or angels, will be insufficient to meet the financing requirements generated in later stages, if the com­pany continues to grow successfully.

Another key factor affecting the availability of financing is the upside potential of a company. Consider that of the three-million-plus new businesses of all kinds expected to be launched in the United States in 2004, probably 5 percent or less will achieve the growth and sales lev­els of high-potential firms. Foundation firms will total around 8-12 per­cent of all new firms, which will grow more slowly but exceed $ 1 million in sales and may grow to $5 million to $ 15 million. Remaining are the traditional, stable lifestyle firms. What have been called high-potential firms (those that grow rapidly and are likely to exceed $20 million to $2 5 million or more in sales) are strong prospects for a public offering and have the widest array of financing alternatives, including combina­tions of debt and equity and other alternatives (which are noted later on), while foundation firms have fewer, and lifestyle firms are limited to the personal resources of their founders and whatever net worth or collateral they can accumulate.

In general, investors believe the younger the company, the more risky the investment. This is a variation of the old saying in the venture cap­ital business: The lemons ripen in two-and-a-half years, but the plums take seven or eight.

While the time line and dollar limits shown are only guidelines, they do reflect how these money sources view the riskiness, and thus the required rate of return, of companies at various stages of development.

Investor Preferences

It is important to realize that precise practices of investors or lenders may vary between individual investors or lenders in a given category and with the current market conditions, and may vary in different areas of the country.

Identifying realistic sources and developing a fund-raising strategy to tap them depend upon knowing what kinds of investments investors or lenders are seeking. While the stage, amount, and return guidelines noted in Exhibit 4.6 can help, doing the appropriate homework in advance on specific investor or lender preferences can save months of wild-goose chases and personal cash—while significantly increasing the odds of successfully raising funds on acceptable terms.

Conclusion

Cash isn't just king; it may be the whole royal family! And positive cash flow keeps the family happy. While seeking resources, especially finan­cial resources, to build your company, more less-risky cash, sooner, is better than almost any alternative. At the heart of entrepreneurial finance is converting your vision of the company growth into quanti­fied value creation, slicing the value pie and managing and covering financial risk. If you see the future clearly (or at least more clearly than the competitors), you'll be better able to determine capital requirements and craft financial and fund-raising strategies. Of course, value creation is ephemeral if not realized. In entrepreneur ship, realization of value for the stakeholders is called "harvest" of a business. We will elaborate on this in later chapters.

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