Imagine some kids in your neighborhood got an entrepreneurial bug and wanted to start a lemonade stand. Well, for a child, a lemonade stand is a high capital business. They don’t have the money to buy 2×4’s to build the stand, the lemons and sugar to make their delicious beverage, or the cups to contain their tasty treat as they deliver it to their customers. They’ll probably turn to a parent to do the initial financing. In return, the stand would owe some of their profits back to the investor — dad can’t just shell out seed capital for a business without some promise of return. So the parent buys $20 worth of supplies to get the venture started, and the kids are off on their capitalist adventure.
The kids spend $10 to build the stand itself and the remaining $10 on supplies. After a weekend, they’ve had incredible success; their mix is just right and everybody in the neighborhood wants some! At $1 a cup, they’re able to sell 40 cups of lemonade — $40 generated from an initial investment of $10 (the $10 for the stand is property, plant, and equipment; this $10 is cost of goods sold). They write down their revenues ($40) and net income ($30), and then they come to their cash flow. Weeeeeell, some of the other kids in the neighborhood didn’t have $1 on hand, so they opened an IOU account. Some offered payment via trades in other goods (are baseball cards still valuable?) or services. When the lemonade stand owners count up their money at the end of the weekend, they find they only have $4, despite being massively “profitable.”
But that’s okay! They’re showing big profits and believe they can profitably expand the business, they’re just in a little cash crunch. They approach their investor again, show them the big profits, and tell them about their plans to continue and grow the core business. They’ve even thought about expanding into new business areas, like offering iced tea or building another stand in the next neighborhood over! This time, the investor raises a little eyebrow and wonders where the money went, but saw them selling lots of lemonade and still believes in the venture, so they offer some more financing… maybe at a higher interest rate though.
You can see where this is going, I’m sure. Without the cash flow to reinvest in the core operations, expand the business, and pay back investors, that investment money is going to dry up or come with major stipulations. Venture capitalists know how this process goes and take advantage of it. They’ve got the capital, and after a few cycles of fund requests, will tack on the condition that they’ll continue to invest but only if they gain an equity share in the company. In the end, they can acquire or control the business and turn it into a cash-generating machine once the owner is gone. This is also why large, mature firms will buy out smaller firms with growth potential. The large firms have cash but little opportunity for growth, and smaller firms are growth monsters but have no cash.
In short, the mark of a maturing business is sustainable free cash flows and balanced growth. Contrast this with fledgling businesses who have explosive growth opportunities but low liquidity. In one of his last quarterly meetings as CEO of Spirit AeroSystems, Jeff Turner mentioned that he believed they were positioned well and their programs were good ones to be on, but that they had expanded too quickly. Aha. Too much growth, too little cash. The replacement CEO’s primary focus became fixing that imbalance not only by tightening costs, but by reducing exposure to what he felt were less lucrative ventures, such as a lagging business center in Tulsa, OK. The “transition” the new CEO kept on about in his first months was to restore balance to the force growth and cash flow portions of his company by actually slowing down growth to get in a more favorable cash position.
A wise goal. It’s a cute lesson when your neighborhood kids run out of cash to buy lemonade, but it’s a little less cute when it’s a multi-billion dollar company.