Cash is like oxygen for start-ups; founders sometimes take it for granted, but it keeps your business alive. Even if you have a great product, growing revenue, and a steady talent pipeline, your company is dead if you run out of cash.
Given the importance of cash, cash management — which includes managing runway and raising capital from investors — is understandably a CEO matter and not something to be handed off to a CFO or finance team, particularly during times of uncertainty. Cash allocation decisions, such as spending on hiring and infrastructure, also fall under the CEO’s purview, as does, if your start-up has debt, ensuring that your company doesn’t trip any covenants that stipulate holding a certain cash balance. Otherwise, a lender can take your assets as collateral.
To successfully manage cash, our guiding principle revolves around understanding timing and having a framework for raising cash, calculating cash, and determining what you spend your cash on. In this guide, we’ll skip discussing raising debt and equity, which are well covered, and instead focus on
- How to determine what actually counts as “cash” to run your business
- How to use a framework to develop a plan for your cash
- How to build an adaptable and flexible operating model (which we’ll cover in more depth in a follow-up piece)
- How to deal with a liquidity crisis. By closely managing cash and maintaining months of runway, founders can avoid many preventable (but all too common!) costly mistakes.
Timing Matters
Before we dig into the details, we want to stress that the fundamental tenet of managing your liquidity as a start-up is that timing and maturity matter. Understanding when you need what amount of cash is fundamental to operating your company. To do this, you must have an accurate understanding of when cash is coming in, when it needs to be paid out, and when it has to be locked up for other needs, both in the short and long term.
The same thought process should be extended to how you invest your cash into your operations. Your investments into product and hiring need to match when you think you can next raise capital, be it debt or equity. It’s only after you have a view into your business’s cash needs, that you can then think about whether you want to invest the cash and into what types of instruments, among other things.
Calculating Cash
So what is cash? The amount of cash you have may seem obvious — it should be the amount of money that you have in your bank account — but there’s often confusion around this topic. This is because your cash can be kept in multiple accounts, including restricted cash accounts, bills to be paid, incoming receivables, earned revenue that hasn’t yet been billed or collected, debt, and more. Cash accounting is key. As a founder, you should ideally have a daily view on liquid cash: This is your cash in the bank, not including restricted cash, investments, or anything that is tied up.
There are generally two ways to track your accounting records: cash basis and accrual basis. While accrual accounting is important for recognizing costs and revenues when earned and is the basis of GAAP accounting and reporting, it can be less useful for tracking your anticipated cash flow as a founder. Cash basis accounting recognizes actual cash payments and collections, regardless of when earned or incurred. To help think about your cash sources and uses, it can be helpful to think about it in terms of operating, financing, and investing cash flow.
As a start-up, you have cash sources and uses from operating — revenue from your customers, salary expenses, marketing spend, etc. — depending on stage. There’s also financing cash flow, which for a start-up is cash you’ve typically received from your debt or equity raises. (There’s also cash flow from investing, though this is usually less relevant for software start-ups that have fewer investments). The technical accounting definitions are less important here, but the principle behind the distinction does matter. Your start-up’s cash needs must be financed by some combination of cash generated by the business, if any, and how much cash you’ve raised. Managing this cash flow in and out is cash management.
A common mistake that start-ups make when figuring out their cash position is counting all of their earned revenue against their expenses (i.e., some form of accrual accounting). This brings us back to the point that timing matters. Cash that you have not received is not cash. Realistically, customers are going to pay you late, and some are not going to pay you at all. You need to account for this when you think about how much cash you need. Accounts receivable (i.e., the money that your customers owe you) is not actually cash because you haven’t received anything that you could use to pay your employees or make your interest payments. Until you receive the cash payment, it is not cash.
Cash is also sometimes tied up and therefore not liquid cash. This includes cash that is in an escrow account with your payment gateway, loans that you’ve extended, or equity you’ve committed as “first-loss” in your warehouse facilities. You often need to hold a minimum amount of cash so as not to trip a covenant in your credit agreement. None of this is cash you can use toward funding your business operations.
And don’t forget debt also needs to be repaid. The most conservative view is to not include debt in your cash number since you need to repay it.
Building a Cash Plan
Now that you know how to calculate your liquid cash position, you need to develop a plan to manage your runway and understand how many months your cash will keep you afloat. The key, timing-based cash principle here understands the difference between operating cash and strategic cash. Everything you need to run your business for the next 12 months is your operating cash; this includes salaries, rent, and interest payments. Strategic cash is money you won’t need for a longer period of time. You therefore have a little more flexibility with this cash.
To help you determine operating versus strategic cash and your runway, you need to forecast and set the budget for your expenses. For most start-ups, your most significant expense will be your employees, so knowing your headcount plan is essential to understanding your cash needs. Even if you’re a seed-stage company that’s not generating revenue, you need to have a clear sense of what milestones you need to hit to raise your next round, which is also a form of cash management! As you get further along, your costs become more repeatable and easier to predict, making forecasting simpler.
The key to forecasting is having a sense of your monthly spending needs and cash burn as well as your runway, and then revisiting these estimates monthly, at the least, as your start-up’s position changes.
Your forecast will give you a sense of your expenses, which can be shorthand for cash consumption, but you should also have a view of upcoming payments, some of which may be for expenses incurred in a prior period. One form is accounts payable: all payments, recurring or non-recurring, that you expect to pay. This includes a wide range of things, including but not limited to annual software licensing fees, contractual bonus payments, earn outs associated with an acquisition, office build-out expenses, and severance payments for planned reductions in force. Another thing to account for is outstanding debt payments (both interest and principal).
When determining their cash needs, start-ups also commonly forget that payments take time to clear. ACH payments, which are often used for paying payroll providers or paying vendors, take a few days to clear, and sometimes fail because of insufficient funds or other reasons. Payments that must be made between company entities often take time to clear. You can’t rely on an intercompany loan as cash! Leave yourself a buffer in timing and excess liquid cash to allow for delays. Start-ups often don’t account for this timing mismatch and end up with short-term issues, if only for a few days, which can still be fatal.
Once you have a sense of your forecasted cash needs, you can determine where to leave the cash, according to the required liquidity timing. Operating cash can be put into a deposit account that you can pull from whenever you need it. For strategic cash, since you don’t need it in the short term, you can consider investing in a yielding account like a money market fund. These accounts can be less liquid. Distinguishing between these two types is critical; if you know you’ll need cash to make short-term payments, for example, do not tie it up in something long-term.
In today’s rate environment, fortunately, you can comfortably earn 2-3% in a highly liquid low-risk sweep account or money market account. If you have enough of a cash runway to last for more than 12 to 18 months, then it may also make sense, for your near-term expenses, to explore a laddered portfolio with slightly longer-duration instruments (i.e., 6-12 months), including U.S. Treasuries, bonds, or commercial paper. As a best practice, you should draft a simple investment policy and have your Board approve it before you move forward with implementing a broader investment strategy.
(For further guidance, the a16z crypto team has put together a basic investment policy template and treasury management guide. While their write-up includes some crypto and DAO-specific guidance, the general principles they cover are the same for broader treasury management.)
Remember that when it comes to investing your cash, your first goal is the preservation of capital, and second to that is liquidity. You need to make sure you can cover all of your near-term operating expenses — even in your worst-case scenario — as well as any one-time payments before you look for yield. Be conservative and remember that maturity matters!
Some Cash Comes With Strings Attached
Now that you have a forecast for the cash needs of your business, can you use all of your cash in the same way? No! This is where financing cash flow — specifically cash resulting from raising debt versus equity — needs to be treated differently from the operating cash flow that was generated by business operations. For start-ups, debt is best used to finance predictable future cash flows, and equity for the unpredictable. Equity, of course, is the most expensive form of cash (given the permanent ownership to new investors, which is dilutive and has a higher required return rate), but has more flexibility around use. Equity investors also may have some governance over spending, especially on large purchases, depending on the terms of their investment.
In the longer-form credit agreement, the use of proceeds from debt will be limited to specified activities. Debt is often used to fund operations (e.g., hiring, software licenses, office space), growth (e.g., sales and marketing) once the company has repeatable traction, and M&A, as well as to buffer the balance sheet or extend runway. Debt should not be used to finance unpredictable outcomes, like unproven products. If you lend to customers, you could consider setting up debt in a special purpose vehicle (SPV) structure off-balance sheet to fund new originations. This may require some equity depending on the terms, largely the advance rate.
If you do choose to raise a debt facility, the type you should raise also depends on maturity, as we have previously written about, and the type may unlock different amounts of cash. Working capital-oriented financial products (e.g., cash advances, charge cards, factoring, and other forms of receivables financing) typically have shorter durations (under a year) and turn over quickly. They are commonly funded using venture debt or warehouse facilities. The cash will be recycled back at a faster rate compared with longer-dated assets like personal loans, which could have a three-year payback period. Longer-duration assets will tie up capital for a longer period of time and cannot be relied upon for working capital needs.
How to Manage a Liquidity Crisis
If, for some reason, you end up in a crisis situation without enough cash, don’t panic. You still have some options for digging yourself out. First off, what you can do depends on if your problem revolves around a short-term or long-term issue. If you know you’re going to run out of cash to run the business months in advance — a long-term issue that is in the nature of start-ups — you can raise more equity, sell your company, carve out part of the business to sell, wind down your operations, or find a way to cut your cash burn and get to profitability.
Your options are more limited if you have a sudden, short-term issue, which is usually what founders find themselves unequipped to answer. You may need to make decisions that will impact growth in the near term — such as abruptly stopping the extension of loans to your customers, or shutting off a product — and that’s okay! There are a few short-term lenders that may be able to provide a demand note or quick solution; however, these options will be costly and can come with higher interest rates and/or warrants.
You can also look to your existing shareholders for support in the form of a convertible note or debt-and-warrants structure to bridge the gap for the next few weeks until you are able to secure additional financing. This would be short-term bridge financing or a demand note that would convert into equity at some point in the future. It could take longer to raise capital depending on market conditions, so you should always have conversations as early as possible.
Conclusion
Cash management should be a top priority for CEOs. To stay alive, right now more than ever, companies should know: 1) how much liquid cash they have at any given point, and 2) realistically how many months of runway they have. With a strong command of the timing of cash needs and active runway management, a company can save itself a lot of time and heartache around a painful cash crunch or — worse — death
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