After a detailed process, you have finalized your business model for your “A round” funding, and intend to turn it into a 24-month cash projection. The goal of this exercise is to determine the expected shortfall of cash in your startup during this period, which is the amount of funding you plan to request, also known as your "Ask".
For instance, a medical device startup's CEO used their business model to create a cash flow projection. Here is an example:
- Opening cash balance = $1.3M
- First commercial month = Jan/2024
- Operations costs (e.g. payroll, subcontractors) = $1.6M
- Purchase of medical devices = $1.7M
- Medical device revenues = $2.0M
Following is a snapshot from the CEO’s cash projection (presenting Q1/2024 only for the sake of simplification).
Based on these assumptions, the CEO records showed a cash balance of $0.1M by the end of the quarter. Is it an accurate depiction? Unfortunately, not.
Two critical components were absent:
1. Cash flow adjustments:
- Converting the business model's accrual accounting into a cash perspective. For instance, incorporating fixed assets expenses and excluding depreciation.
- Assigning each item to the appropriate payment month (cash inflows and outflows). For instance, in our scenario, the manufacturer of the devices follows Net+30 payment terms, and customers' payment collection is based on Net+60. In simpler terms, payments for devices bought in Jan-2024 were made in Feb-2024, while cash collection for devices sold in Jan-2024 will occur in Mar-2024 (refer to Table II).
2. Distinguishing between operational expenditures intended to support future expansion and the Working Capital effects related to timing variances. See Chart A.
Taking the above into account, observe how the subsequent table portrays an alternate situation (refer to Table II). As a result of payment terms (working capital), the company would run out of cash in Feb/2024 ($0.2M), and its cash balance would deteriorate in Mar/2024: $0.7M shortfall rather than the $0.1M positive cash in the initial computation.
Distinguishing working capital from growth capital is of utmost importance for startups as it facilitates comprehension of their financial requirements, resource prioritization, and informed fund allocation. Moreover, for investors, this differentiation furnishes valuable insight into the firm's objectives and expansion potential and aids comprehension of funding usage. By communicating this information effectively, startups can establish trust with their investors and demonstrate their dedication to long-term success.
Table III outlines the effects of working capital in a single row ($0.5M unfavorable cash flow impact for the quarter). In this scenario, the CEO will illustrate the Use of Funds (the "Ask") while delving into the $1.6M as "Use of Proceeds" (i.e. for operations and growth). The business model enables investors to comprehend that the firm intends to sell for $2.0M. The $0.5M cash shortfall from Working Capital needs to be presented separately and overcome financially through alternative avenues such as loans or factoring.
Blending working capital cash requirements with operational and growth capital aggregates dissimilar components with various weights and risk factors. Differentiating between these types of funding is imperative from an investor's standpoint to comprehend the firm's objectives and potential for expansion, and to ascertain whether the investment aligns with their expectations.
