Power in Profit

It’s Thursday, I’m Jason, and this week I’ll be your High Priest of Profit for this issue of INTRO to Finance. We’ve been spending the last few months exploring financial topics that we source from you, our loyal readers. This week we have a question that may sound strange to some, but is entirely too familiar to others:

“Do profits prevent me from raising capital?”

Silicon Valley has built an archetype of what a fundable business may look like. Venture Capital has been on a binge over the last decade. The headlines have left many feeling that capital is readily available for those who can fit the “fundable” business profile. 

Unfortunately, that model is depicted as a company that’s displaying growth while losing inordinate amounts of money. For example, Forbes recently published a list of “The Next Billion Dollar Startups” who all shared a common love for fast growth and incinerating cash (on average these future Unicorns were spending $4 to generate $1 in revenue).

In the shadow of these headlines, entrepreneurs have been left feeling it’s more important to conform to that Silicon Valley ideal over everything else. This has translated to sloppy business operations and a generation of founders with the perception that profits can have a negative impact on the ability to access capital. However, there’s nothing wrong with having a profitable business. Today we’re going to discuss why you don’t have to gamble away profits for a chance at outside funding.

Showcasing Your Management Skills

Although equity investors like to talk about metrics, and lenders like to talk about ratios, the heart of a financial partnership is the belief that the team and company will execute. Your reputation as a management team inspires confidence in financiers. The best display of strong business management is positive cash flow. Your profits are nothing to be ashamed of. They should be treated as a badge of honor.

Leveraging Cash as an Asset

Even if your business or management team doesn’t fit the desired profile of VC or another funding source, cash flow will always provide options for your business. Financiers will view your business as less risky, and will open up less costly, non-dilutive options that others without cash flow don’t have. By not consistently losing money, you open up an opportunity for leveraging your own cash. 

• Cash-on-Cash Lending
  The lender provides the company with a % of your existing cash balance.

  • Example — You have $1M in cash and have proven the ability to maintain the cash balance. The lender may provide you with $500k or 50% of your cash balance, but requires you to keep $1M in minimum cash at all times. 

The financier is effectively allowing you to use their funds with the expectation that you’ll keep more than enough cash on hand to pay back the loan if needed. This funding option isn’t helpful to companies looking to fund large projects that will run a loss for a period of time. But treating your existing cash as a sturdy asset can help you access resources for short term and profitable projects – without sacrificing your cash position. Additionally, having the cash to pay back the loan at all times significantly decreases the risk to the financier, and can provide you with some of the cheapest funding you can find.

As previously discussed in Card Wars, even credit card companies like Brex are doing something similar. Although, rather than requiring you to keep a certain amount of cash on hand, they dynamically change how much you have access to based on the % of your cash they’re willing to provide.

Advancing Your Income Stream

Having a stream of income is the gift that keeps on giving. Not only are you supplying your own cash, you can use it to get even more capital from lenders. An even lower-risk option than cash-on-cash lending, this is one of the cheaper capital options available to any business. 

• Cash Flow Lending
  A financier provides you with multiple years of cash flow upfront. 

  • Example — Lender provides you with 3x last year’s cash flow to be paid back over the next 4 years. The company is required to maintain a certain level of profitability to pay back the loan.

Not only are you preserving cash on hand to be a source of repayment, you’re generating cash that can repay the loan. While a fairly straightforward arrangement, the key to accessing this funding is proving that you truly have the cash flow to support the loan. Most lenders will require an audit of the company to make sure the numbers are what you say they are.

If you’re in a position of pursuing this kind of financing, there’s a nearly unlimited amount of lenders out there for you. If you haven’t proven profitability for more than a few years, you may have limited options, because lenders might not feel like they have enough proof that profits will continue. However, with a long track record of profits, you can safely assume you’ll have a strong interest and negotiating leverage to choose who you want to work with.

A True Superpower

Having no history of generating a profit and living off of investor capital is a risky proposition that can still drive a successful outcome. These outliers are why Venture Capital exists. However, there’s a secret that most successful outliers share: they know how their business works to generate profit. Many of the management teams and companies still have a line of sight to profitability. A company may decide to be dependent on investor capital because it wants to invest as much capital as possible to grow. But sooner or later, every company will have to become profitable.

If you’ve already proven this superpower in your business, you have optionality that many others don’t. The choice to run your company profitably doesn’t have to be a binary or permanent decision.

You may find that an opportunity opens up that requires you to run your business without profits. There have been plenty of companies that have bootstrapped with their own capital, and/or used non-dilutive funding options to grow, before taking a more accelerated path that might require less or no business profit.

Some recent, and certainly outlier, examples would be Qualtrics and Pluralsight. Both bootstrapped to a significant scale before raising VC. Business opportunities and market dynamics may change your perspective, like the team at Notion in April 2020. However, all three examples showcase that profits don’t have to be an inhibitor of funding or an inhibitor to growth.  

Generating a profit is the highest level of business mastery, because it’s not just maximizing revenue, it’s also about managing costs. Knowing how to grow the top-line and manage the bottom-line in concert to generate cash is the strongest signal you can send to any form of prospective financial partner, and it’s nothing to be ashamed of.

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