One of the least intuitive cash flow drivers that startup founders face is the impact of working capital on a startup’s burn. Venture-backed, early-stage companies should use accrual accounting - I won’t get into the details here as to why, but if your goal is to raise serious VC funding or get acquired by a public technology company (or eventually have an IPO), you need accrual-based accounting.
The impact of working capital on a startup’s burn rate is one of the items that can come as a surprise to first-time founders. After all, shouldn’t the income statement show a company’s cash burn?
Unfortunately, the answer is no.
Why? The biggest item that regularly makes a “traditional,” VC-funded startup’s operating loss not equal to their cash burn is working capital.
As a startup founder, understanding and managing your working capital is crucial for your company’s financial health and growth. This guide will explain what working capital is, why it’s important, and provide practical tips for effective working capital management.
We’ll also talk about how a startup’s working capital can come into play during an exit - something I’ve advised several of our clients on when they sold their startups. At an exit, fluctuations in working capital can really impact the return to the investors and founders, so pay attention people!
What is Working Capital?
Working capital is the difference between a company’s current assets and current liabilities. In simpler terms, it’s the money available to fund your day-to-day operations if you didn’t have VC funding. For most startups, this boils down to the difference between when you get paid by clients and when you have to pay your expenses.
If you get paid fast and don’t have to pay your vendors quickly, you end up in what’s called a “positive net working capital” position. If you have to pay your vendors before you get paid (which happens to a lot of you have inventory), then you are in a negative position.
A positive working capital indicates that a company can help a VC funded startup burn less.
Working Capital Formula
The formula for calculating working capital is:
Working Capital = Current Assets - Current Liabilities
In this formula:
- Current Assets typically include cash, accounts receivable, inventory, and other assets that are expected to be converted to cash within one year.
- Current Liabilities usually include accounts payable, short-term debt, and other obligations due within one year.
Why Accrual Accounting Matters
Venture-backed, early-stage companies should use accrual accounting. If your goal is to raise serious VC funding, get acquired by a public technology company, or eventually have an IPO, accrual-based accounting is essential. VCs expect accrual based accounting. The alternative is cash based accounting, which will confuse your VC.
The Impact of Working Capital on Burn Rate
First-time founders are often surprised by how working capital affects a startup’s burn rate. The items that impact working capital will show up on the balance sheet in the current assets and current liabilities section, and also in the cash flow statement. The income statement doesn’t always reflect a company’s actual cash burn due to several factors:
- Accounts Receivable (AR): When you make a sale, you record revenue on your income statement. However, if the client hasn’t paid yet, you haven’t received the cash. Instead, you have Accounts Receivable on your balance sheet, which will stay there until you get paid (or if you have to write off the money).
- Accounts Payable (AP): If you’ve received goods or services from vendors but haven’t paid them yet, you have Accounts Payable. This appears on your income statement even if you haven’t paid, creating a difference between your operating loss and cash burn. Check out our guide to Accounts Receivable and Payable here.
- Deferred Revenue: Common in SaaS businesses, this occurs when customers pay you in advance. You receive cash upfront, but it’s recorded as a liability on your balance sheet until you deliver the service.
- Corporate Credit Cards: Using a corporate card can help conserve cash, but remember that outstanding balances can make your bank account look healthier than your income statement suggests.
- Inventory: Not all startups have inventory, but since it is purchased ahead of billing clients, this can be a major cash use and can drive companies to a very negative working capital position.
- Prepaids: Prepaid rent and other expenses are cash uses that will depress your cash before they show up on your income statement.
Working Capital Management Tips for Startups
- Streamline receivables collection: Implement a structured invoicing system, offer early payment discounts, and set clear credit terms to ensure timely collections. Invoicing software is a great idea, even starting with the basic one that comes with QuickBooks Online.
- Negotiate favorable payment terms with suppliers: Build strong relationships with suppliers to negotiate extended payment durations or discounts for early payments.
- Regularly review and adjust credit policies: Assess customer creditworthiness and set limits based on payment history to balance sales growth with cash flow management. You don’t want to be unable to collect from a big customer.
- Monitor cash flow regularly: Use cash flow statements and forecasting tools to anticipate future cash needs and make informed financial decisions.
- Implement a robust financial planning system: Develop a well-structured system for budgeting, forecasting, and scenario planning to prepare for both opportunities and challenges. And maintain a buffer between you expect to run out of cash and when you begin fundraising for your next round.
- Leverage technology for automation: Use accounting software to automate routine financial tasks, reducing errors and freeing up time for strategic planning - this really is a must for VC-backed startups; you have to use accounting software.
- Diversify revenue streams: Explore additional revenue sources or diversify your product offerings to maintain consistent cash inflow.
- Prioritize payments: During cash crunches, focus on critical expenses and consider deferring non-essential costs.
- Set clear payment terms with customers: Clearly communicate due dates, late payment penalties, and any discounts for early payments.
- Collaborate with financial experts: Consider working with financial consultants who can provide insights into optimizing your working capital management. Kruze advises clients on best practices - consider working with someone like us!
How Working Capital Impacts M&A
So, we’ve advised a number of our clients on their net working capital calculation when they get acquired. In many M&A transactions, the purchase price is adjusted based on the working capital of the company at the time of closing. This adjustment ensures that the buyer receives a business with sufficient working capital to continue operations without immediately injecting additional cash.
Key points to understand:
- Net Working Capital Target: In M&A agreements, there’s often a predetermined “Net Working Capital Target.” This is the amount of working capital the buyer expects the business to have at closing.
- Purchase Price Adjustments: The final purchase price can be adjusted up or down based on whether the actual working capital at closing is above or below this target.
- Cash Often Excluded: In many cases, cash is removed from the working capital calculation and dealt with separately. This is because excess cash is often considered an additional asset that the sellers may distribute to themselves before the sale.
- Detailed Calculations: The calculation of working capital for M&A purposes can be quite complex and is often spelled out in detail in the purchase agreement.
Ok, we are going to analyze some language that we’ve seen in several acquisition agreements - two points, both the same. One, always work with an experienced attorney when you are selling your company. Two, this is not advice, you need to hire a CPA to advise you if you are selling your company!
Example from an Acquisition Agreement
Let’s break down some key elements from a typical acquisition agreement:
- Estimated Consideration Statement: Prior to closing, the selling company provides an estimate of the total consideration, including estimated working capital. This gives both parties a preliminary idea of the final purchase price.
- Post-Closing Adjustment: After closing, the buyer typically has a period (often 90 days) to prepare their own calculation of the working capital at closing. This can lead to adjustments in the final purchase price.
- Net Working Capital Calculation: The agreement will define exactly how Net Working Capital is calculated. For example: “Net Working Capital” shall mean the Company’s total consolidated current assets (excluding any Tax assets) minus the Company’s total consolidated current liabilities (including all deferred revenue… and excluding Third Party Expenses and Closing Indebtedness), in each case as of immediately prior to the Effective Time.
-
Adjustments: The agreement will specify how adjustments are made based on working capital:
- If actual working capital is higher than the target: “Net Working Capital Positive Adjustment”
- If actual working capital is lower than the target: “Net Working Capital Negative Adjustment”
-
Total Consideration: The final purchase price (Total Consideration) is typically calculated as: Base Purchase Price
- Closing Indebtedness
- Unpaid Transaction Expenses +/- Working Capital Adjustment +/- Cash Adjustment (if applicable)
Impact on Founders and Investors
The working capital adjustment in an M&A transaction can significantly impact the final payout to founders and investors. Here’s why it matters:
- Cash Management: Efficient working capital management leading up to a sale can increase the purchase price. For example, collecting receivables quickly and negotiating longer payment terms with suppliers can improve your working capital position.
- Negotiation Point: The definition of working capital and the target working capital amount are often key negotiation points in M&A deals. A favorable definition or target can result in a higher purchase price.
- Potential Disputes: Post-closing working capital calculations can lead to disputes between buyers and sellers. Having clear records and understanding the agreed-upon calculation method is crucial.
- Cash Flow Impact: If a company has negative working capital (common in some business models), this could reduce the purchase price, even if the business is growing rapidly.
Understanding these dynamics can help startup founders better prepare for a potential exit and maximize the value they receive from a sale. It’s another reason why maintaining good financial practices and understanding your working capital position is crucial throughout your startup journey.
And even if you aren’t selling your startup, good working capital management is a great way to improve your burn rate.
