Cash flow in basic terms can be seen as the difference between the immediacy of demands of creditors and suppliers; and the rate in which trade debtors extinguish their liability to a business. There are a number of different ways to formulate an examination of a businesses’ cash flows. However, most of these are geared in favour of investors and they fail to fairly account for important long-term qualitative factors that may drive up the value of a start-up enterprise.
A business that is growing can be simply seen to have an ever-increasing rate of disposal cash over a given period of time. This is irrespective of whether that cash is well or badly spent. The problem entrepreneurs have, and the trap they often fall into, is the period over which they allow investors to evaluate aggregate cash flow, or other stock evaluation methodologies. These can be too short to give factor in the long-term potential of the business. This allows investors or funders to buy their shares on the cheap.
Let’s throw in a hyper-simplistic example. Let’s say the purchasing power of a start-up commodity supplier, moving the commodity from a miner to a distributor, is set to increase over a ten-year span.
This is due to an increase in usage of the commodity by an emerging technology. The commodity supplier fails to evaluate the rate of growth of the market for the emerging technology. It does not properly anticipate the price of its product over a ten-year period, neither does it properly anticipate the likely competition in its purchaser’s market that will drive up the price. It also fails to fully appreciate the relationship between growing aggregate demand in the end purchaser’s market and its own corporate strategy to control pricing through incremental supply.
Yet it needs investment to place itself in a pole position with respect to the miner in relation to purchase contracts and licences. It advertises for investment, and it is subject to one of the usual formulaic methods, such as discounted cash flow. Yet, as most of these methods are rooted in the present behaviour of the business, they present themselves a significant bias in favour of the investor. The start-up has been undermined in its valuation as a result of its knowledge of how markets that create demand of its movable commodity arise, grow or shrink.
The market entrenchment of valuation methods presently makes sense if one takes a small regard to their provenance. These methods are mainly conceived of by banks and investors, and the rapid growth of the start-up entrepreneur market in the post internet world means that founders of start-ups haven’t been able to conciliate a valuation method in their favour. Ideally, one that would differentiate between those with viable market prospects and those that are not. These maybe through taking justifiable qualitative evaluations as to the prospect of a given start-up to basic concretisation of those qualitative valuations on quantitative terms.
Our commodity supplier is thus subjected to playing a valuation game not on its terms, but on the investor’s terms, from the very start of its process. It thinks rightly, or wrongly, though probably wrongly, that the primacy is of acquiring the contract with the miner rather than acquiring cash on cheapest terms possible. Not doing the latter, however, will have significant implications down the line. It may hinder the start-up’s ability to raise further capital to pivot between markets, whether to move into a viable new one or to move rapidly out of an existing one with minimal exit costs.
The problem of the bargaining asymmetry, or unfairness, between investors and entrepreneurs that has arisen is a fairly recent phenomenon. It arises from the rise of the internet based joint-stock company that is now dominating higher risk portions of venture capitalist funding since the 2000s. Yet it brings about a more existentialist question of whether ownership of such entities should lie predominantly with pre-internet generation capitalists, or newly emerging ones, or the entrepreneurial horsemen who ride into the unknown.
The latter have to evaluate and create better entrepreneurial adventures for their time and effort, should they wish to reduce the bargaining disparity between themselves and their funders. How to inform them and create more fairness and symmetry in the market for bargaining for start-up capital is a fairly novel space. It may be a while before the market corrects itself through start-up founders being more ruthless with market analysis and corporate strategy. In turn they may be able to field more longer, and prospective, cash-flow cycles of their business to increase their bargaining scope with the investor.
This would also favour the investor.
For there is considerable waste of capital in the start-up space, caused by investors often buying meaningless stock on the cheap. What needs to occur is a shift in the long-term desire of both parties in an investment contract from just doing a deal for the sake of investment to one where the core issue of whether the business actually succeeds becomes the goal of primacy of such agreements.
At the moment the methods of valuing the companies have little or nothing to do with business prospects, hence the now accepted truth that the more funding a start-up gets the more likely it is to fail.
Dr Abhijit Pandya
CEO, Pandya Arbitration Global
21st July 2021.
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