There are three basic reasons why business growth eats cash:
- Building Capacity
- Feeding the Cash Cycle
- Buying Long Term Customers
Not all businesses experience all three types of cash-guzzling growth. And some don’t really experience any of these. Understanding which of these three applies to your business will help significantly in planning your funding future.
Some businesses require that you build before you get (more) customers. Capacity building can be in terms of:
- Physical space – retail stores, manufacturing space, office space may need to be acquired, outfitted, and maybe oversized for a while as your business grows
- People – in some businesses it takes time upfront to train and get new employees fully productive to deliver services or manufacture products, to sell services or products, and to service customers
- Equipment or software – as volume of business grows you may need “things to make and sell more things” such as manufacturing equipment, retail product displays, marketing infrastructure, or customer support infrastructure.
Some of these categories are lumpy. You can’t invest in just the amount needed to serve the exact number of customers you will have in, say, the next month, and then grow your capacity just a little more the next month.
Instead, you have to invest in a big lump of capacity that will be underutilized for the first few months. Think about buying a much bigger beer brewing system, or growing into a new and bigger restaurant space. It means the costs of that big lump of capacity are not initially supported by sales and gross profits. That means you need cash to cover those initial losses until you grow back into profitability.
Feeding The Cash Cycle
A business cash cycle, sometimes called the cash conversion cycle, traces how long it takes for cash at the beginning of the value creation process to turn into cash coming in from a customer.
For example, a manufacturing or retail business must pay for inventory, hold onto it for a while, deliver it to a customer on payment terms of 30 to 60 days (aka accounts receivable), then finally get customer cash.
Or a services business might have to pay employees every two weeks while a three-month project is delivered, and only collect customer cash months later. Or think about doctor visits and how long it takes for insurance to pay!
In many such businesses with a long cash cycle, working capital needs grow as revenue grows. Specifically:
- Inventory investment has to increase to be prepared for serving more customers, and to sell more and different things to current customers
- Accounts receivable increases as you get more customers who pay you in 30 to 60 days, and that cash has to come from somewhere to pay for the products or services customers receive ahead of payment
- Accounts payable may also increase with revenue, which is good for cash flow, but often not enough to counterbalance the growing inventory and/or accounts receivable.
Buying Long Term Customers
Many businesses build long term, profitable relationships with customers. It may be from recurring revenue, such as mobile phones or Software as a Service. Or it may be from multiple purchases over time, such as your favorite grocery store, or tax preparation service, or clothing brand.
And in such businesses it’s frequently the case that intense competition leads to a big marketing and sales expense, which leads to a high Customer Acquisition Cost (CAC). Typically the upfront CAC is bigger than the profit from the first month of doing business with a customer, or the first purchase, but the Lifetime Value (LTV) is much more than the CAC as those customers keep sending in their cash.
And while it usually takes some continuing investment in marketing, sales and customer service to keep these customers coming back over the long term, it is usually far less than getting them to become a customer for the very first time.
If you want to grow this type of business you need to invest in marketing and sales. Essentially you are “buying” these long-term customers, and the upfront investment will return a great profit over the long term.
And that requires cash.
When Growth Eats Cash: Feed or Diet?
Many entrepreneurs want to grow, but they must first face the cash gobbling demons of Building Capacity, Feeding the Cash Cycle, and Buying Long Term Customers.
Do they reinvest profits – what we call Be Your Own VC?
Do they seek debt or equity to feed the growth? (Grants are rarely a growth funding option)
Or do they put their business on a growth diet and choke back the demons?
Some types of businesses are fortunate that their cash gobbling demons are modest, their growth rates are moderate, or their free cash flow is ample for reinvestment.
What about yours?