10 ms·

Games people play with cash flow

389 points by kalonis 6y ago

jpm_sd 6y ago
This is a pretty good article but missed an opportunity to comment in more detail on the 2020 startup/unicorn ecosystem. "Malone’s entire strategy was built around a single fact: that you have to pay up front for cable systems, but then earn back your money via a stable stream of cash for years and years afterwards. Notice how this extreme demand for capital drove Malone to embrace debt, over other sources of capital. Now notice how closely this resembles the Software as a Service (SaaS) business model, which is the primary business model in today’s startup world." Gotta spend money to make money. But I wish he had commented further on businesses that do this incorrectly, based on wishful thinking. He talks about the strengths of TCI, with an engineered "loss" that saves them money on taxes, or Amazon, whose decades of "unprofitability" helped them to build a long-term-profitable empire. But what about Uber or DoorDash? Burning investor cash, chasing long-term revenue that will never come? How on Earth are they keeping this scam going? Why do people believe in it?
- gumby 6y ago
  This is an important point. For this to work, step 0 is: have a functioning business. That’s what gives you the opportunity to then change the curve on your cash flow. Another factor is your vendors. The cable business expanded (and expanded into) an existing ecosystem: tv mfrs, film studios etc. The restaurant already had vendors it could afford to lend 300K up front knowing that they would deliver reliably over the next four months. Also an operating business. Likewise Amazon. But the Ubers etc start without a viable business. In fact they start by skimming the cream of an existing market. The problem is, you get good at what you do. If you don’t build a viable business it becomes harder and harder to move your company into that mode as the environment changes.
  - everythingswan 6y ago
    Yea, the functioning/viable business piece has a place in this discussion. I can understand why the author wouldn't include it but it serves us here. To take on debt like mentioned, you have to have some confidence in the business model and not be searching for product/market fit like many early-stage companies. If you already have cash flow then you can leverage it.
- impostervt 6y ago
  I forget where I read it, but some article described Uber's business model as "sell a dollar for 80 cents". You get a LOT of customers that way, and report huge growth, which brings in investors, and everything is great - until the pyramid scheme collapses.
  - bob33212 6y ago
    After a "collapse" you are still left with mindshare and a market. If you increase prices by 30% you'll still be the largest player. Maybe later investors are not making returns but you are not going bankrupt.
    - kgwgk 6y ago
      I agree for the mindshare, in some cases at least. Pets.com is still in the minds of many of us. And we will still remember MoviePass in 20 years. But, hey, WeWork still exists!
      - blackrock 6y ago
        Isn’t Chewy the new pets.com?
    - toast0 6y ago
      The thing is, if you have lots of takers for dollars for 80 cents, that doesn't tell you very much about how many takers you'll have for dollars for $1.04. If you charge too much for food delivery, you won't have very many customers. How much is too much, and does it leave you a profit is the big question. maybe they can make it work, but probably not in a lot of markets.
      - sushisource 6y ago
        In my experience as demand has increased due to the pandemic, prices are reaching the point where I'm not willing to pay them, and I make good money like most people on this site. If that's any indication of what's to come when they need to stop bleeding cash... not looking great.
- mbesto 6y ago
  > Why do people believe in it? Amazon FOMO. Investors are so butt hurt they didn't believe other investors about Amazon's razor thing margins and now its a 1T company. I think Uber/DD are VERY different though. I don't see the potential either.
- vasco 6y ago
  Uber or DoorDash are just extreme examples of the same line of reasoning. You're just moving cash flows not only across time but based on probability. You start by trying to create a business that moves the most cash possible to generate float. Now you might say, that this doesn't work because if you sell $1 for $.80 you'll run out of money. But that's not true, you just have a drag on your timeline that pulls you to zero without further capital inflows, or until you sort out your margins. In a world with very low interest rates (now, and past few years), capital doesn't have many useful places to go. And as we've seen, it has flown a lot into equities and a lot into private funding. That is the inflow of capital that keeps extending Uber and DoorDash's timeline, such that even with a 20% drag, you still have another fool to pull in and keep the party going. If the music stops everyone cries, but if it keeps going long enough, you actually increase your chances of remaining alive. For one you might outlive your competition, but there's many more things that can happen. You can improve your margins (Uber's pipe dream with self driving), you can can have a shift in consumer demands in your favor, or a pandemic that shifts consumer spend super fast, etc. You basically keep growing and extending the timeline and you may get a big pay out. Or as some would call it, growth investing.
- petra 6y ago
  DoorDash is interesting. Sure they don't have subscription like predictability for their revenues. But they have a lot of data, and machine learning, so they may get pretty close in predicting how many people will order steak next month. And let's say they partner/own a chain of ghost kitchen restaurants who offer a large variety of food(which is a much more competitive business model than restaurants). And that chain can suddenly get steak(and the other stuff), for half the price ?
- SuoDuanDao 6y ago
  I think it's harder to draw the line as to who's doing it incorrectly than it seems, without the benefit of hindsight. Give an example from the telecoms world - I had a friend who worked for a telecoms startup, bootstrapping for funding and undercutting the local incumbent by using better technology. The incumbent responded by offering free service for a year to all the startup's customers if they switched back. An unsustainable move but hardly a bad decision - it had very deep pockets, and my friend's employer ran out of money first. If Uber didn't have any competition, it could raise prices to profitability today. Investors still believe in it because they believe that Uber, like the Telecoms incumbent in my anecdote, can bankrupt the competition and then have its way with the consumer. Investors in Uber's competitors presumably have their own reasons for a similar thesis.
konschubert 6y ago
The logical fallacy in the original post discussed is simply here: > Therefore: startups shouldn’t raise money. The therefore doesn't apply. The original post makes a good argument that there is a certain detriment to raising money. But he doesn't actually proof that this detriment outweighs the benefits of raising money.
chris_wot 6y ago
Once you have less skin in the game, it is easier to make bad decisions. Surely that is a proposition that might not be entirely correct?
- bluGill 6y ago
  I caught that too. It is false in several ways that destroy the rest of the argument. First because less skin in the game doesn't make you make bad decisions, it just makes it easier. As such every argument following this point is destroyed by "assume we make good decisions anyway", which is just as valid as "assume we make bad decisions from now on". Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger. Most founders (at least in the early days) have invested enough of their own money AND time (more valuable than money to founders!) that they have enough skin in the game as to not find it easier to make bad decisions. Third, because the investor now has skin in the game and has incentive and leverage to prevent you from making bad decisions. You can be forced to make better decisions because of this. There are many reasons to not take investors, that is a complex trade off decision. However your less skin in the game is not one of them.
  - inglor_cz 6y ago
    "Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger." But the dimensions of the game grow as well, and that is where mistakes can be made. Some founders are probably better bosses/managers in a collective of five than in a collective of fifty. If the company grows slowly, they may improve their skills/catch up. If it grows in a sudden leap, which is well possible with a large injection of cash, the space for making bad decisions from ignorance or lack of experience grows as well.
    - bluGill 6y ago
      That is one of many reasons that I alluded to why it might be a bad idea to take investors.
peterwoerner 6y ago
There is an important point about reasoning here which is worth stating explicitly. You can reason perfectly about the things you have thought of and know, but they things you didn't think of and don't know might still change the correct answer.
dade_ 6y ago
Don't raise money with equity is the message in the blog post he referred to. Equity is expensive and these days, debt is cheap. Know your WACC. https://www.investopedia.com/terms/w/wacc.asp https://www.investopedia.com/terms/w/wacc.asp
- syntaxing 6y ago
  Debt is not only cheap but almost “free” nowadays. It’s so interesting how the people I work with take advantage of this on a personal level as well. They leave the interests on their debt and leave and extra income on other avenues (stock market, real estate, etc). Another interesting idea is that tax is (relatively) low. So it’s smarter to invest in a Roth IRA rather than a 401K to take advantage of the tax rate.
YuccaGloriosa 6y ago
Just some thoughts. TCI wasn't a startup. So it can't be compared to 2020 startups in this way. Because...you are starting the comparison at a different point in the companies life. This is comparing markets almost 50 years apart. Motives and reasoning just aren't what they used to be. TCI had assets to borrow against. TCI had a monopoly in their areas, and existing customer base. They gamed the tax system for profit. They weren't looking for over valuations from Wall Street with a view to selling out for the $$$ Ok I'm bored now
- valuearb 6y ago
  You just described a startup SAAS.
impostervt 6y ago
The bit about TCI (a cable company with a lot of debt in the 70s) is super interesting. I've read before about how companies don't always see debt as a bad thing, and how they can move money around, but it always seems like magic. From the article - "And indeed, Malone’s strategy required TCI to show a loss for pretty much forever; for the next 25 years, it was never in the black". As the article mentions, Amazon followed a similar strategy for a long time. It reminds me of a quote by the WWI French field marshal Foch - "My center is giving way, my right is retreating, situation excellent, I am attacking."
- thaumasiotes 6y ago
  This sort of thing is one reason you might want to tax revenues over profits. Compare https://en.wikipedia.org/wiki/Hollywood_accounting https://en.wikipedia.org/wiki/Hollywood_accounting , in which all movies show a formal loss and the concept of "profit" as opposed to revenue exists only to scam parties who agree to be paid out of profits.
  - valuearb 6y ago
    Or you might prefer not to tax corporations at all, only distributions to shareholders. “Profits” or “cash flow” kept in the corporation is reinvested capital. It’s creating jobs and growing businesses, even if it’s kept in an interest bearing bank account.
    - hpoe 6y ago
      So I've always been confused by this argument of just start taxing the money that goes to shareholders because the business will reinvest it and create jobs and what not. What keeps the company from reinvesting in the form of company luxury cars for the executives, a company home that they let the CEO live in, and executive compensation. Essentially redirecting the money that would've at least gone to index holders to the shareholders that we felt were getting too much of the pie to begin with. Can someone explain this to me? EDIT: just to clarify I don't mean they actually sign over the deed to the house to the ceo but rather the company maintains the house as an "executive" hq that the CEO just happens to live in, and the company doesn't give the execs luxury cars they have company cars that the executive just happen to have they keys to and only the execs. Things like that, the company claiming as corporate assets that are really only used by execs. And I am sure there are baskc laws to try and prevent something like this but there are also highly motivated CFOs to find loopholes.
stevespang 6y ago
The reason why many startups take venture capital is an attempt to scale very rapidly, hoping that they can achieve this before the huge tech companies get them on their radar and crush them by offering a similar product.
mrfredward 6y ago
This post is making an error, or at least a poor choice in terminology, when thinking profit only means GAAP accounting or taxable profit. Malone cut costs by reducing tax liability, getting better prices on programming, and increasing the subscriber base (revenue). What's that word for revenue minus expenses again? A more honest explanation: Accounting depreciation != the actual change in value of things, and the cash flow statement can let you know when GAAP accounting isn't giving an accurate picture of success. And about Malone's insight on leverage: Leverage ups your return on investment (when things don't blow up). Paying interest doesn't help you hide money from the tax man any better than setting dollar bills on fire would, but leverage can make big things happen from small amounts of investment.
dissidents 6y ago
I am unconvinced that "first-principles thinking" is the problem here. Surely one can refute the original argument without having to debunk axiomatic logic itself. For example, one could argue something like this: Even though increased access to other people's money can cause founders to make irresponsible decisions, raising money has other advantages that tend to offset this.
- rossdavidh 6y ago
  I think the idea is, when you argue from first principles, you are implicitly assuming that you know all of the relevant first principles. Since you're human and imperfect, there is always a chance that you don't. How to know? Well, empirically, check whether the conclusions you get, seem to hold up to reality. The author's experience was that taking investment $$ was necessary (or at least often useful) in a startup, so this put him on the lookout for what missing first principle would explain this. It doesn't mean axiomatic logic isn't useful, it means that just because the logic seems sound, doesn't mean the conclusion is reliable, because there could be missing axioms (in this case, that profitability is the objective of a company, when cash flow is a more fundamental fact and profit is often either present or not depending on how you do the accounting).
  - dissidents 6y ago
    Thanks Ross for the reply. I believe that this is a misunderstanding of how propositional logic works. If the propositions or axioms that you start with are sound, and if you correctly apply all inference rules, then the propositions that you derive will also be sound. "Missing axioms" that you did not use do no matter, regardless of their soundness.
    - tunesmith 6y ago
      A "missing" axiom, in my experience, is not truly a missing axiom that otherwise has no impact on other axioms. A "missing" axiom is one that exposes a bad assumption in another axiom currently being relied upon. For instance. Socrates is a man, all men are mortal, therefore Socrates is mortal. But then you discover that a couple of eons have passed and Socrates is still alive. Clearly there must be a "missing" axiom. And after some investigation you realize that Socrates is a Venusian man, and Venusians are immortal. "Socrates is Venusian" is a missing axiom, but really the problem is that "All men are mortal" is actually false, since it had implicit assumptions that "All men are human" (false) and "All humans are mortal" (true).
JackFr 6y ago
There are three excellent blog posts here, but mashing them together does not a coherent argument make.
ihatethissite 6y ago
The author creates a false dichotomy when they write that business is either about making profit or managing cash flow. Making a profit requires cash flow management, but managing cash flow does not require making a profit. This article does talk about managing cash flows in a way that involves never making a profit. First, and tangentially, it's interesting that real estate developers do this all the time. Second, it's interesting that this article shows not only why cable companies regional monopolies are extant, but also that their continued existence relies on the preservation of those monopolies. These and other companies that rely on a strategy of unfettered subscriber growth, in this case leveraged as a marketing tool to creditors to acquire additional debt, is no different than a Ponzi scheme. It makes the fatal assumption that subscriber growth can continue ad infinitum. But, similar to the amount of free energy in a system, the number of potential subscribers remaining is finite. Eventually, cash flows will fail to meet the projections sold to creditors and established as assumptions in their financial models. Thus arises a situation that remains tenable only as long as subscribers remain subscribed for as long as is required to service the debt outstanding at the time the growth stopped. Because the debt didn't go anywhere. It hasn't disappeared. Today that debt is sitting on the balance sheet of every one of America's cable providers: the direct result of a flawed line of thinking promoted by the author. Consider the implications. To remove the regional monopolies of the cable companies is to not only destroy their subscriber base, and thus their cash flows, but also the cash flows promised to their legion creditors. Every one of these creditors now has a vested interest in the preservation of those monopolies, having themselves extended and received credit based on said promises of payment. I propose that, contrary to the statements of the author, the proof presented by their friend is not "framed incorrectly". Rather, it shows something the author doesn't wish to see.
- deleted 6y ago
  [deleted]
- dalbasal 6y ago
  I don't think he's presenting a dichotomy at all, false or otherwise. To paraphrase heavily, he's delving into the fact that these are simply different things. Profit, free cash, EBITDA, etc. These have different implications. Particularly, they translate into capital very differently. Ability to borrow. Ability to raise equity. Pay dividends. This translates into radically different trajectories and outcomes. In 2020 terms, you might also include growth rate, MAUs or the current trendiness of the startup. This also, essentially, translates into real world effects. Big ones. Most people, including many "business people" don't quite realize the implications of a positive or negative float. The difference between a -20 day float to a +20. With a positive float, growing itself is cash generative. With a negative float, growing is cash consuming. A business might grow, produce less profit but more cash. Outside of accounting, there's a tendency to dismiss this nuance as trivial and convergent in the long term. In reality, the future never comes. It's always the present.
bob33212 6y ago
Great Article. A lot of people don't understand how important cash flow is. Even Elon pointed out that having factories close to customer is very important for a fast growing company like TSLA because if you grow too fast you'll be putting so many cars on boats before they are paid for that you will have no cash. I disagree with the framing of both articles somewhat. The question should be "What is limiting your growth?" Is raising money going to distract you from making a product customers need and love? Then skip it. If being too small for enterprises to take you seriously is a blocker then you'll need to raise money.
- kgwgk 6y ago
  Musk definitely understands the importance of (incoming) cash flows. Being paid upfront for functionality that may or may not be ever available is genius. Edit: /s
  - bigbubba 6y ago
    Genius, like selling a bridge you don't own.
    - twic 6y ago
      See, that's illegal. But creating cash-settled bridge derivatives and selling those, now that's perfectly fine.
      - nceqs3 6y ago
        Matt Levine would be proud.
  - ashtonbaker 6y ago
    Is it really genius? Especially when you put it quite so bluntly? I've been wondering if a class action lawsuit around this could end up being a significant risk to Tesla. edit: woosh
- orky56 6y ago
PKop 6y ago
The linked article "How First Principles Thinking Fails" [0] , which states "..But I think there's a more pernicious form of failure, which occurs when you reason from the wrong set of true principles. It is pernicious because you can’t easily detect the flaws in your reasoning. It is pernicious because all of your base axioms are true...In other words, the only real test you have is against reality. Your conclusion should be useful. It should produce effective action." reminds me of the quote by Eric Zemmour: "When principles are in contradiction with society’s survival then the principles are false, for society is the supreme truth." [1] [0] https://commoncog.com/blog/how-first-principles-thinking-fails/ https://commoncog.com/blog/how-first-principles-thinking-fai... [1] https://www.theamericanconservative.com/dreher/eric-zemmour-blockbuster-speech/ https://www.theamericanconservative.com/dreher/eric-zemmour-...
nickreese 6y ago
Most useful article I've read probably this year. After selling our last company I was surprised that the acquirer went on an even bigger spending spree just months after acquiring us. As a bootstrapper this blew my mind. This article helps shine a light on how they pulled it off. They acquired us for the free cashflow the company threw off (uncommon in our industry) and the leveraged that to further their expansion. I've always looked at accounting as "backwards facing" (meaning it looks at what has happened vs where a company is going) but this article has changed my perspective dramatically.
- crdrost 6y ago
  If you liked this article, you might like the book The Goal or its application to the “project context” that software companies find themselves in, Critical Chain. They define a lot of business thinking as being focused on controlling costs, when in fact you want to first maximize revenues, and the kind of funky idea of measuring “dollar days” that one eventually gets to is an attempt (which I actually don't think is successful, but maybe it is approximately okay) to start to bring cash flow ideas to consciousness. I believe The Goal is where I first read about this idea about cash flow being more important than revenue, in a way that can be easily explained to anybody: you have bills, you have a certain amount in the bank, and then you have in accounting a set of invoices that you have sent out to customers but they have not yet been paid. So that money is “as good as earned” on paper but it’s not yet in the bank. And the problem is not revenue, the problem is cash flow. If you don’t have enough in that bank account, then after paying for your materials and rent for your building and whatever else, you suddenly come up short on payroll. “Please forgive me,” you tell your employees, “we have the money and your paychecks will just be a week late, we are so sorry, this never happens normally.” Good way to lose a lot of your best minds that really make your money—your best salespeople, your best engineers, your hardest workers. They got rent to pay. In The Goal I believe the book points out that most companies that go under don’t have a revenue problem but a cash flow problem, the money isn’t coming in fast enough to pay to keep the company running even though it is coming in eventually. there are a couple of other ways to look at it that may be helpful to the broader community, one of them is that your interest rate on debt actually sets a time scale for your “indefinite future.” If you have credit card debt at 36%/year compounded monthly that’s 3%/month, flip that to (1 month)/(.03) = 33 months. Now if I ask you “hey, how much is that $20 per month subscription worth to you in terms of present value?” you can answer: that subscription runs out into the indefinite future so it gets multiplied by this time scale and it is worth $660 to me right now. Which is another way to say equivalently that if I bought something right now for $660 I would pay $20/month for the indefinite future. Lots of people don’t realize how much present value they can unlock by just canceling out old subscriptions like that, because the cash flow is not there immediately, but it’s true. Similarly, I ran into cash flow issues at the beginning of this year in my personal finances. With COVID-19 hitting at around the same time my auto loan asked me if I wanted several months deferral. Are you shitting me right now? Yes, the added productivity and lack of stress from having a floating several hundred dollars in the bank and therefore being able to set up auto-pay (and not incurring late fees on all my accounts) pays for itself and then some. Thank you so much! (Of course the bank is a bank, this is cold hard calculus to them, so I don't feel too bad. Imagine that, too, though! Imagine that if you are in a good cash flow position, as the bank is as covid starts, your reaction might actually be to turn away cash flow: you are a sort of landlord collecting rents and you need to mitigate the risk that all your tenants go broke, they need to be able to keep their jobs for your wellbeing. And then you think of the actual landlords and you realize that the system must have left them relatively strapped for cash if they’re not similarly absorbing some of the shock. And that launches into interesting questions about feedback mechanisms in complex systems and their modes of resilience.)
syntaxing 6y ago
Wow what a great read. The other article about where first principles fails [1] is absolutely amazing as well. The debate about experience vs first principle is a heavily recurring theme in the tech industry. I couldn’t structure my thoughts about it in words and the article perfectly sums it up in a succinct manner. [1] https://commoncog.com/blog/how-first-principles-thinking-fails/ https://commoncog.com/blog/how-first-principles-thinking-fai...
sna1l 6y ago
This article is great and actually comes to one of the core tenets from the book "The Outsiders." If you had to choose a single core task for the CEO of a company, it is to create free cash flow and decide best how to spend it, aka capital allocation. Book Source: https://smile.amazon.com/Outsiders-Unconventional-Radically-Rational-Blueprint/dp/1422162672/ref=smi_www_rco2_go_smi_4368549507?_encoding=UTF8&%2AVersion%2A=1&%2Aentries%2A=0&ie=UTF8 https://smile.amazon.com/Outsiders-Unconventional-Radically-...
root-z 6y ago
echoing the common opinion, this is a great article at both practical and theoretical levels. The discussion on cash flow is insightful but the summary about the flaws of first principle thinking is what makes it complete.
draw_down 6y ago
This is a great post. Really, really fantastic. The post it's based on is ok, but super abstract, and really just spends a lot of time dancing around the fact that reality really doesn't care about your big brain and how hard it thinks. You can go super elaborate on hypothesizing if you like, but the brunt force of reality is exactly the same regardless.
tunesmith 6y ago
I think the argument he's knocking down is more flawed than he's letting on - specifically, just because the extra cash makes it easier to make bad decisions doesn't mean that those bad decisions will be made. The argument treats those as inexorable. If the argument had been passed through a truth checker and given a few more eyeballs, that flaw would have been obvious. That particular inner syllogism just doesn't inexorably flow from the truth of its lemmas. More generally, the "flaw with first-principles analysis" is generally as you'd expect. Your premises might appear true when they're not, or your inner reasoning structure might appear valid (logical definition) when it's not, or you might be making assumptions (in the omission of other premises) that are false. It's just really hard. So that's where a slow painstaking process of repeated review will help you. And it's also not a panacea - first-principles analysis does not guarantee your solution, it's more a process that helps you surface your assumptions and learn your argument.
- pge 6y ago
  Agree - and a related is that because you don’t have 100% ownership, you have less skin in the game. The reason to tkae money is that you believe that the 80% of the company you still own will be worth more than 100% of the company without funding. So you end up with more value at stake, not less. And more incentive not to make bad decisions (and of course more people around the table with skin in the game that are motivated to help you avoid bad decisions).
- dalbasal 6y ago
  IDK... In theory, choices are good and you can just choose the better one. In practice, the financial dynamics of a business tend to create head or tail wind forces that become a part of the company's character. All else equal (including the decision maker), a positive float business will tend to be more growth oriented than a negative float business. In theory, not so much. Float is just a type of capital (working capital). In practice, it's different. Other people's money businesses will tend to take more risk. Publicly listed companies tend to be risk averse and quarterly report focused. These aren't carved in stone. Some publicly listed companies (eg amazon, tesla) have sailed against this wind. But, the wind is still there. For a personal example, take the difference between having a trainer vs exercising yourself. It's theoretically possible to do the same training and have the same results, or do better. The tendency though, is meaningful, and when you pay a trainer there's a tendency to be disciplined. Returning to the "friend's argument," it is observably true that structural constraints affect business owners.
fghorow 6y ago
As a working scientist, I read the OP with great interest (no pun intended). In essence from my perspective, the axiomatic approach is like "theory" and the operational approach is like "experiment" or "observation" in the sciences. There's a very good reason why experiment/observation trumps theory in the scientific method.
- dalbasal 6y ago
  Good point. That said, the more distance from hard science you have, the likelier this is to go wrong. If you're dealing with psychology, economics or such experimental observations can have the exact same problem. They're true in this case, at this level of abstraction or otherwise "not really wrong but not — but not as useful or as powerful as some other framing". Framing is the key point here. What's in model or not. What questions are your trying to answer. etc. The harder the science, the less flexibility scientists have in framing.
supercanuck 6y ago
The author is describing the time value of money https://en.wikipedia.org/wiki/Time_value_of_money https://en.wikipedia.org/wiki/Time_value_of_money The reason to to take the money now from venture is because it is more valuable now than it is later. The way this author is describing this though reminds me of the folksy, whimsical way some business books are written which makes this article so applealing: e.g. The Goal, How to Win friends and influence people, etc.
munificent 6y ago
There's a simpler failure mode to pay attention to that the author gets close to but doesn't notice. The original claim is "Companies should not raise capital." Any time you see a "should" claim, try adding this to the end: ", and should instead do X." Now, when evaluating the pros and cons of the "should not" half, you have an actual relevant benchmark to compare to. It doesn't matter how awful an idea it is to raise capital in some absolute terms. What actually matters is whether it's worse than what you'd have to do instead. Almost all decisions are about choosing one from several options, so if you find yourself making an absolute evaluation, that's a sort of "decision smell" that you should instead be doing a comparative analysis.
bluejellybean 6y ago
If you liked this article and want to learn more about the games played in corporate finance, I would strongly recommend a book a colleague of mine recommended, "The Quest For Value". This single book had completely changed my view of the business world more than any other, and it gives one a much clearer understanding of the massive debt load that the United States operates under. I grew up and lived through the 08 financial crisis, losing a home in the process, and hated debt of any sort. Now that I've read this book cover to cover multiple times, my view has completely shifted, and my understanding of stock valuation and cash flow analysis has done nothing but improved.
deleted 6y ago
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burnte 6y ago
The proposition can be disproved very early in the chain of logic, actually. 1. Startups are risky. True. 2. Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all). Arguable, but not a given. Raising capital does not eliminate risk, especially if one has their own money in it, and/or are using it as a job. Just because someone else invested doesn't necessarily reduce my incentive. I lose money, time, face, and opportunity with or without investment. 3. Once you have less skin in the game, it is easier to make bad decisions. The author argues this is due to a) having a capital buffer to cushion you, and b) having more time to waste. 100% false. It is no easier or harder to make bad decisions with outside money. It is ALWAYS easy to make bad decisions, having more money simply makes it easier to make costlier bad decisions faster. Buying real estate in late 2006 was a bad idea regardless of whose money you used. If anything, having that outside money means you have people to be accountable to, people to run decisions by, and thus it's HARDER to make a bad decision.
- foldingmoney 6y ago
  Having more money can also increase the set of (good) choices available to you.
  - 1propionyl 6y ago
    It can also (at the same time) vastly increase the set of _bad_ choices available to you. How many stories of startup founders blowing money on booze, cocaine, prostitutes and lavish parties do we need to read before we realize that startup founders are humans and behave, well, like humans always have?
jplr8922 6y ago
The article is very good, but to me it is normal finance. Many points raised by the author are discussed in undergraduate business classrooms every year. Very good application of existing theory. https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theo...
TameAntelope 6y ago
Maybe a basic question, but is cash flow a concrete expression of the time value of money, a concept taught (abstractly) in intro econ courses? I didn’t understand the value of either until this article, but they seem related.
anonymousDan 6y ago
Had to stop reading, could the author be any more pretentious? The obvious flaw in the reasoning is step 3, having more capital results in you making worse decisions. Uhm, no, having more capital can also give you more options, allowing you to make potentially better decisions sooner.
- lowdose 6y ago
  I quit after 2 because doing a startup means you have all eggs in one basket thus skin in the game is not reduced. > Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all Peoples most scarce resource is the time they are investing and I have yet to meet a founder that doesn't do 80 hour week to make the wave next week.
SerLava 6y ago
Oh man, the conclusion doesn't even follow from the argument, and it's pretty obvious on its face. The only correct conclusion from those axioms is: There are advantages to not raising money.
monkeydust 6y ago
Nice piece. If you have the basis of a business that can prove strong cash flow then you should definatley look at financing with debt over equity. In startup land its not really the done thing but in this long term low rate environment I suspect thst might change.
tuatoru 6y ago
I think the article is itself an example of broadly correct but for the wrong reason. the problem with the argument from first principles that the article attempts to refute, is that the "first principles" given carry an implicit assumption that the minimum viable product is a a null product. If in reality the mvp or, later, the infrastructure for growth take more to create than the resources you command, you need to raise capital. The "first principles" also ignore time to market and competitive pressures. They are more "spherical cow on a frictionless plane" principles than actually useful ones.
highfrequency 6y ago
Could someone explain the core example about prepaying restaurant vendors? (Kokonas again): That’s what I said! I went, “I’ll pay you $20 if you tell me why.” And he said, “Well, it’s very simple. I have to slaughter the cows, then I put the beef to dry. For the first 35 days I can sell it. After 35 days there’s only a handful of places that would buy it, after 60 days, I sell it $1 a pound for dog food.” So his waste on the slaughter, and these animals’s lives, and the ethics of all of that, are because of net-120! Seems like someone should have figured this out! As soon as he said that, everything clicked, and I went “We need to call every one of our vendors, every time, and say that we will prepay them.” It seems like the value to the beef vendor is not from actually receiving the cash flow earlier, but rather from just knowing the order quantity in advance to optimize inventory.
- bob33212 6y ago
  I assume the beef vendor doesn't have much cash on hand. So he can take the prepayment and give it directly to the cow farmer who also doesn't have a lot of cash and is happy to prioritize the preorder.
- ameetgaitonde 6y ago
  Part of the reason is because it's a set order. Consider that in pricing his beef normally, the vendor has to account for three things: 1. Beef that sells within 35 days at regular price 2. Beef that sells within 60 days as a discounted price 3. Beef that sells after 60 days for a loss. The beef's regular price has to be somewhat higher than in an efficient market because some of it will be sold at a loss. Getting an order for a set amount per week allows him to disregard the losses he normally has from beef that has to be sold for dog food, because the purchaser is guaranteeing their quantity, smoothing their expectations on how much beef to purchase in the future. It's possible that at $18 a pound, without any waste, he's making the same margins/profit as he would at $34 with some waste.
  - highfrequency 6y ago
    Right. So the value add here is not actually about moving cash flow forward in time through reservation deposits, but rather just having a predetermined order size. Am I misunderstanding, or is this a complete non-example for the point of the article?
pmayrgundter 6y ago
A related study I did. This sheet compares cash flow for Build to Order (BTO) vs Build to Stock (BTS) for a very popular widget sold at $100. BTO is not sensitive to Cost of Goods Sold (COGS); BTS is. If, for example, your COGS approaches half your unit price and you use BTS, you'll have almost no chance of getting your business off the ground. But with BTO your cash flow explodes. https://docs.google.com/spreadsheets/d/15JZyPEYJxNHEWTPFmxOIoWmo6XS_WXRLGC-csZLhlVM/edit#gid=0 https://docs.google.com/spreadsheets/d/15JZyPEYJxNHEWTPFmxOI...
nraynaud 6y ago
Funny, I had a boss do the converse. We were a very young company with zero customer, and we had a small net 30 bill to pay. The boss said: I have to put a reminder to pay it. Well, without any hope of earning money in the mean time, there is no point in trying to optimize the cash flow pay now and be done with it. Free your brain and don’t adopt complex behavior if the reason is not here.
2Gkashmiri 6y ago
I have a question. Interest payments. Unless you have a high enough revenue stream to cover the cost of interest, arent you eroding your capital ?
- deleted 6y ago
  [deleted]
zuhayeer 6y ago
What I got out of this is that you shouldn't deal in absolutes. There are ways to successfully create businesses with and without outside capital.
blackrock 6y ago
This may be true for small lifestyle type businesses. But some problems can only be solved with VC money. Because of time limitations. You may only have a small window of opportunity to capture a certain market. If you grew linearly, and built up product idea A, in order to fund product idea B, in order to fund product idea C, then by the time you’re done with product idea B, a decade may have passed by. You’ve also grown older, and may not have the energy of your younger self anymore. Also, a competitor, one with a larger funding pool, may have jumped in and captured that market, right in front of you.
- fishingisfun 6y ago
  I agree. I can use the example of flappy bird for this. Overnight development teams pumped out 3d versions of his game with better controls than the original. Sometimes timing is important for small players because other teams can take your idea and execute better and faster once they know the market is there for such a program or product.
BonnieBrown 6y ago
Like many others in this thread I thought this was an incredibly well written and elucidating article. I just happened to be trying to learn more about David Friedberg before stumbling upon this article and I watched this lecture he gave on entrepreneurism which I think complements the contents of this article incredibly well. Highly recommend for those looking to learn more https://youtu.be/m2sj-U2QSHs https://youtu.be/m2sj-U2QSHs
simonebrunozzi 6y ago
> But those who actually run businesses know that running a business is all about managing cash flows. This is the golden line. The richest person on Earth (Jeff Bezos) followed this principle religiously since Amazon's inception (or should I say, Cadabra's inception?).
solatic 6y ago
Great article. One thing that it made me think about - instant payment clearing will have an enormous impact on cash flow, and thus on the wider economy, if the US can ever get it together and finally deprecate ACH.
wyiske 6y ago
I used to be afraid of debt, but understood this principle ever since an accounting friend told me about a luxury cruise liner he worked for. It was started buy an immigrant, and quite successful (pre Covid). I was confused how anyone could launch a cruise company when the cost to buy (or even lease a cruise liner) must be 100s of millions. When I asked my friend about their debt, he said “don’t worry, they’re doing just fine”. It was at that point I realised it’s not the debt that matters, but the rate (time wise) at which you can repay it, i.e., debt itself is fine so long as you have sufficient cash flow, and debt can be cheap. Unfortunately I’m just a software engineer, who has never been able to put this in practice.
knighthack 6y ago
That was an amazing article. Especially the breakdown on raising capital from first principles.

389 points by kalonis 6y ago

This is a pretty good article but missed an opportunity to comment in more detail on the 2020 startup/unicorn ecosystem. "Malone’s entire strategy was built around a single fact: that you have to pay up front for cable systems, but then earn back your money via a stable stream of cash for years and years afterwards. Notice how this extreme demand for capital drove Malone to embrace debt, over other sources of capital. Now notice how closely this resembles the Software as a Service (SaaS) business model, which is the primary business model in today’s startup world." Gotta spend money to make money. But I wish he had commented further on businesses that do this incorrectly, based on wishful thinking. He talks about the strengths of TCI, with an engineered "loss" that saves them money on taxes, or Amazon, whose decades of "unprofitability" helped them to build a long-term-profitable empire. But what about Uber or DoorDash? Burning investor cash, chasing long-term revenue that will never come? How on Earth are they keeping this scam going? Why do people believe in it?

gumby 6y ago
This is an important point. For this to work, step 0 is: have a functioning business. That’s what gives you the opportunity to then change the curve on your cash flow. Another factor is your vendors. The cable business expanded (and expanded into) an existing ecosystem: tv mfrs, film studios etc. The restaurant already had vendors it could afford to lend 300K up front knowing that they would deliver reliably over the next four months. Also an operating business. Likewise Amazon. But the Ubers etc start without a viable business. In fact they start by skimming the cream of an existing market. The problem is, you get good at what you do. If you don’t build a viable business it becomes harder and harder to move your company into that mode as the environment changes.
- everythingswan 6y ago
  Yea, the functioning/viable business piece has a place in this discussion. I can understand why the author wouldn't include it but it serves us here. To take on debt like mentioned, you have to have some confidence in the business model and not be searching for product/market fit like many early-stage companies. If you already have cash flow then you can leverage it.
impostervt 6y ago
I forget where I read it, but some article described Uber's business model as "sell a dollar for 80 cents". You get a LOT of customers that way, and report huge growth, which brings in investors, and everything is great - until the pyramid scheme collapses.
- bob33212 6y ago
  After a "collapse" you are still left with mindshare and a market. If you increase prices by 30% you'll still be the largest player. Maybe later investors are not making returns but you are not going bankrupt.
  - kgwgk 6y ago
    I agree for the mindshare, in some cases at least. Pets.com is still in the minds of many of us. And we will still remember MoviePass in 20 years. But, hey, WeWork still exists!
    - blackrock 6y ago
      Isn’t Chewy the new pets.com?
  - toast0 6y ago
    The thing is, if you have lots of takers for dollars for 80 cents, that doesn't tell you very much about how many takers you'll have for dollars for $1.04. If you charge too much for food delivery, you won't have very many customers. How much is too much, and does it leave you a profit is the big question. maybe they can make it work, but probably not in a lot of markets.
    - sushisource 6y ago
      In my experience as demand has increased due to the pandemic, prices are reaching the point where I'm not willing to pay them, and I make good money like most people on this site. If that's any indication of what's to come when they need to stop bleeding cash... not looking great.
mbesto 6y ago
> Why do people believe in it? Amazon FOMO. Investors are so butt hurt they didn't believe other investors about Amazon's razor thing margins and now its a 1T company. I think Uber/DD are VERY different though. I don't see the potential either.
vasco 6y ago
Uber or DoorDash are just extreme examples of the same line of reasoning. You're just moving cash flows not only across time but based on probability. You start by trying to create a business that moves the most cash possible to generate float. Now you might say, that this doesn't work because if you sell $1 for $.80 you'll run out of money. But that's not true, you just have a drag on your timeline that pulls you to zero without further capital inflows, or until you sort out your margins. In a world with very low interest rates (now, and past few years), capital doesn't have many useful places to go. And as we've seen, it has flown a lot into equities and a lot into private funding. That is the inflow of capital that keeps extending Uber and DoorDash's timeline, such that even with a 20% drag, you still have another fool to pull in and keep the party going. If the music stops everyone cries, but if it keeps going long enough, you actually increase your chances of remaining alive. For one you might outlive your competition, but there's many more things that can happen. You can improve your margins (Uber's pipe dream with self driving), you can can have a shift in consumer demands in your favor, or a pandemic that shifts consumer spend super fast, etc. You basically keep growing and extending the timeline and you may get a big pay out. Or as some would call it, growth investing.
petra 6y ago
DoorDash is interesting. Sure they don't have subscription like predictability for their revenues. But they have a lot of data, and machine learning, so they may get pretty close in predicting how many people will order steak next month. And let's say they partner/own a chain of ghost kitchen restaurants who offer a large variety of food(which is a much more competitive business model than restaurants). And that chain can suddenly get steak(and the other stuff), for half the price ?
SuoDuanDao 6y ago
I think it's harder to draw the line as to who's doing it incorrectly than it seems, without the benefit of hindsight. Give an example from the telecoms world - I had a friend who worked for a telecoms startup, bootstrapping for funding and undercutting the local incumbent by using better technology. The incumbent responded by offering free service for a year to all the startup's customers if they switched back. An unsustainable move but hardly a bad decision - it had very deep pockets, and my friend's employer ran out of money first. If Uber didn't have any competition, it could raise prices to profitability today. Investors still believe in it because they believe that Uber, like the Telecoms incumbent in my anecdote, can bankrupt the competition and then have its way with the consumer. Investors in Uber's competitors presumably have their own reasons for a similar thesis.

konschubert 6y ago

The logical fallacy in the original post discussed is simply here: > Therefore: startups shouldn’t raise money. The therefore doesn't apply. The original post makes a good argument that there is a certain detriment to raising money. But he doesn't actually proof that this detriment outweighs the benefits of raising money.

chris_wot 6y ago

Once you have less skin in the game, it is easier to make bad decisions. Surely that is a proposition that might not be entirely correct?

bluGill 6y ago
I caught that too. It is false in several ways that destroy the rest of the argument. First because less skin in the game doesn't make you make bad decisions, it just makes it easier. As such every argument following this point is destroyed by "assume we make good decisions anyway", which is just as valid as "assume we make bad decisions from now on". Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger. Most founders (at least in the early days) have invested enough of their own money AND time (more valuable than money to founders!) that they have enough skin in the game as to not find it easier to make bad decisions. Third, because the investor now has skin in the game and has incentive and leverage to prevent you from making bad decisions. You can be forced to make better decisions because of this. There are many reasons to not take investors, that is a complex trade off decision. However your less skin in the game is not one of them.
- inglor_cz 6y ago
  "Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger." But the dimensions of the game grow as well, and that is where mistakes can be made. Some founders are probably better bosses/managers in a collective of five than in a collective of fifty. If the company grows slowly, they may improve their skills/catch up. If it grows in a sudden leap, which is well possible with a large injection of cash, the space for making bad decisions from ignorance or lack of experience grows as well.
  - bluGill 6y ago
    That is one of many reasons that I alluded to why it might be a bad idea to take investors.

peterwoerner 6y ago

There is an important point about reasoning here which is worth stating explicitly. You can reason perfectly about the things you have thought of and know, but they things you didn't think of and don't know might still change the correct answer.

dade_ 6y ago

Don't raise money with equity is the message in the blog post he referred to. Equity is expensive and these days, debt is cheap. Know your WACC. https://www.investopedia.com/terms/w/wacc.asp https://www.investopedia.com/terms/w/wacc.asp

syntaxing 6y ago
Debt is not only cheap but almost “free” nowadays. It’s so interesting how the people I work with take advantage of this on a personal level as well. They leave the interests on their debt and leave and extra income on other avenues (stock market, real estate, etc). Another interesting idea is that tax is (relatively) low. So it’s smarter to invest in a Roth IRA rather than a 401K to take advantage of the tax rate.

YuccaGloriosa 6y ago

Just some thoughts. TCI wasn't a startup. So it can't be compared to 2020 startups in this way. Because...you are starting the comparison at a different point in the companies life. This is comparing markets almost 50 years apart. Motives and reasoning just aren't what they used to be. TCI had assets to borrow against. TCI had a monopoly in their areas, and existing customer base. They gamed the tax system for profit. They weren't looking for over valuations from Wall Street with a view to selling out for the $$$ Ok I'm bored now

valuearb 6y ago
You just described a startup SAAS.

impostervt 6y ago

The bit about TCI (a cable company with a lot of debt in the 70s) is super interesting. I've read before about how companies don't always see debt as a bad thing, and how they can move money around, but it always seems like magic. From the article - "And indeed, Malone’s strategy required TCI to show a loss for pretty much forever; for the next 25 years, it was never in the black". As the article mentions, Amazon followed a similar strategy for a long time. It reminds me of a quote by the WWI French field marshal Foch - "My center is giving way, my right is retreating, situation excellent, I am attacking."

thaumasiotes 6y ago
This sort of thing is one reason you might want to tax revenues over profits. Compare https://en.wikipedia.org/wiki/Hollywood_accounting https://en.wikipedia.org/wiki/Hollywood_accounting , in which all movies show a formal loss and the concept of "profit" as opposed to revenue exists only to scam parties who agree to be paid out of profits.
- valuearb 6y ago
  Or you might prefer not to tax corporations at all, only distributions to shareholders. “Profits” or “cash flow” kept in the corporation is reinvested capital. It’s creating jobs and growing businesses, even if it’s kept in an interest bearing bank account.
  - hpoe 6y ago
    So I've always been confused by this argument of just start taxing the money that goes to shareholders because the business will reinvest it and create jobs and what not. What keeps the company from reinvesting in the form of company luxury cars for the executives, a company home that they let the CEO live in, and executive compensation. Essentially redirecting the money that would've at least gone to index holders to the shareholders that we felt were getting too much of the pie to begin with. Can someone explain this to me? EDIT: just to clarify I don't mean they actually sign over the deed to the house to the ceo but rather the company maintains the house as an "executive" hq that the CEO just happens to live in, and the company doesn't give the execs luxury cars they have company cars that the executive just happen to have they keys to and only the execs. Things like that, the company claiming as corporate assets that are really only used by execs. And I am sure there are baskc laws to try and prevent something like this but there are also highly motivated CFOs to find loopholes.

stevespang 6y ago

The reason why many startups take venture capital is an attempt to scale very rapidly, hoping that they can achieve this before the huge tech companies get them on their radar and crush them by offering a similar product.

mrfredward 6y ago

This post is making an error, or at least a poor choice in terminology, when thinking profit only means GAAP accounting or taxable profit. Malone cut costs by reducing tax liability, getting better prices on programming, and increasing the subscriber base (revenue). What's that word for revenue minus expenses again? A more honest explanation: Accounting depreciation != the actual change in value of things, and the cash flow statement can let you know when GAAP accounting isn't giving an accurate picture of success. And about Malone's insight on leverage: Leverage ups your return on investment (when things don't blow up). Paying interest doesn't help you hide money from the tax man any better than setting dollar bills on fire would, but leverage can make big things happen from small amounts of investment.

dissidents 6y ago

I am unconvinced that "first-principles thinking" is the problem here. Surely one can refute the original argument without having to debunk axiomatic logic itself. For example, one could argue something like this: Even though increased access to other people's money can cause founders to make irresponsible decisions, raising money has other advantages that tend to offset this.

rossdavidh 6y ago
I think the idea is, when you argue from first principles, you are implicitly assuming that you know all of the relevant first principles. Since you're human and imperfect, there is always a chance that you don't. How to know? Well, empirically, check whether the conclusions you get, seem to hold up to reality. The author's experience was that taking investment $$ was necessary (or at least often useful) in a startup, so this put him on the lookout for what missing first principle would explain this. It doesn't mean axiomatic logic isn't useful, it means that just because the logic seems sound, doesn't mean the conclusion is reliable, because there could be missing axioms (in this case, that profitability is the objective of a company, when cash flow is a more fundamental fact and profit is often either present or not depending on how you do the accounting).
- dissidents 6y ago
  Thanks Ross for the reply. I believe that this is a misunderstanding of how propositional logic works. If the propositions or axioms that you start with are sound, and if you correctly apply all inference rules, then the propositions that you derive will also be sound. "Missing axioms" that you did not use do no matter, regardless of their soundness.
  - tunesmith 6y ago
    A "missing" axiom, in my experience, is not truly a missing axiom that otherwise has no impact on other axioms. A "missing" axiom is one that exposes a bad assumption in another axiom currently being relied upon. For instance. Socrates is a man, all men are mortal, therefore Socrates is mortal. But then you discover that a couple of eons have passed and Socrates is still alive. Clearly there must be a "missing" axiom. And after some investigation you realize that Socrates is a Venusian man, and Venusians are immortal. "Socrates is Venusian" is a missing axiom, but really the problem is that "All men are mortal" is actually false, since it had implicit assumptions that "All men are human" (false) and "All humans are mortal" (true).

JackFr 6y ago

There are three excellent blog posts here, but mashing them together does not a coherent argument make.

ihatethissite 6y ago

The author creates a false dichotomy when they write that business is either about making profit or managing cash flow. Making a profit requires cash flow management, but managing cash flow does not require making a profit. This article does talk about managing cash flows in a way that involves never making a profit. First, and tangentially, it's interesting that real estate developers do this all the time. Second, it's interesting that this article shows not only why cable companies regional monopolies are extant, but also that their continued existence relies on the preservation of those monopolies. These and other companies that rely on a strategy of unfettered subscriber growth, in this case leveraged as a marketing tool to creditors to acquire additional debt, is no different than a Ponzi scheme. It makes the fatal assumption that subscriber growth can continue ad infinitum. But, similar to the amount of free energy in a system, the number of potential subscribers remaining is finite. Eventually, cash flows will fail to meet the projections sold to creditors and established as assumptions in their financial models. Thus arises a situation that remains tenable only as long as subscribers remain subscribed for as long as is required to service the debt outstanding at the time the growth stopped. Because the debt didn't go anywhere. It hasn't disappeared. Today that debt is sitting on the balance sheet of every one of America's cable providers: the direct result of a flawed line of thinking promoted by the author. Consider the implications. To remove the regional monopolies of the cable companies is to not only destroy their subscriber base, and thus their cash flows, but also the cash flows promised to their legion creditors. Every one of these creditors now has a vested interest in the preservation of those monopolies, having themselves extended and received credit based on said promises of payment. I propose that, contrary to the statements of the author, the proof presented by their friend is not "framed incorrectly". Rather, it shows something the author doesn't wish to see.

deleted 6y ago
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dalbasal 6y ago
I don't think he's presenting a dichotomy at all, false or otherwise. To paraphrase heavily, he's delving into the fact that these are simply different things. Profit, free cash, EBITDA, etc. These have different implications. Particularly, they translate into capital very differently. Ability to borrow. Ability to raise equity. Pay dividends. This translates into radically different trajectories and outcomes. In 2020 terms, you might also include growth rate, MAUs or the current trendiness of the startup. This also, essentially, translates into real world effects. Big ones. Most people, including many "business people" don't quite realize the implications of a positive or negative float. The difference between a -20 day float to a +20. With a positive float, growing itself is cash generative. With a negative float, growing is cash consuming. A business might grow, produce less profit but more cash. Outside of accounting, there's a tendency to dismiss this nuance as trivial and convergent in the long term. In reality, the future never comes. It's always the present.

bob33212 6y ago

Great Article. A lot of people don't understand how important cash flow is. Even Elon pointed out that having factories close to customer is very important for a fast growing company like TSLA because if you grow too fast you'll be putting so many cars on boats before they are paid for that you will have no cash. I disagree with the framing of both articles somewhat. The question should be "What is limiting your growth?" Is raising money going to distract you from making a product customers need and love? Then skip it. If being too small for enterprises to take you seriously is a blocker then you'll need to raise money.

kgwgk 6y ago
Musk definitely understands the importance of (incoming) cash flows. Being paid upfront for functionality that may or may not be ever available is genius. Edit: /s
- bigbubba 6y ago
  Genius, like selling a bridge you don't own.
  - twic 6y ago
    See, that's illegal. But creating cash-settled bridge derivatives and selling those, now that's perfectly fine.
    - nceqs3 6y ago
      Matt Levine would be proud.
- ashtonbaker 6y ago
  Is it really genius? Especially when you put it quite so bluntly? I've been wondering if a class action lawsuit around this could end up being a significant risk to Tesla. edit: woosh
orky56 6y ago

PKop 6y ago

The linked article "How First Principles Thinking Fails" [0] , which states "..But I think there's a more pernicious form of failure, which occurs when you reason from the wrong set of true principles. It is pernicious because you can’t easily detect the flaws in your reasoning. It is pernicious because all of your base axioms are true...In other words, the only real test you have is against reality. Your conclusion should be useful. It should produce effective action." reminds me of the quote by Eric Zemmour: "When principles are in contradiction with society’s survival then the principles are false, for society is the supreme truth." [1] [0] https://commoncog.com/blog/how-first-principles-thinking-fails/ https://commoncog.com/blog/how-first-principles-thinking-fai... [1] https://www.theamericanconservative.com/dreher/eric-zemmour-blockbuster-speech/ https://www.theamericanconservative.com/dreher/eric-zemmour-...

nickreese 6y ago

Most useful article I've read probably this year. After selling our last company I was surprised that the acquirer went on an even bigger spending spree just months after acquiring us. As a bootstrapper this blew my mind. This article helps shine a light on how they pulled it off. They acquired us for the free cashflow the company threw off (uncommon in our industry) and the leveraged that to further their expansion. I've always looked at accounting as "backwards facing" (meaning it looks at what has happened vs where a company is going) but this article has changed my perspective dramatically.

crdrost 6y ago
If you liked this article, you might like the book The Goal or its application to the “project context” that software companies find themselves in, Critical Chain. They define a lot of business thinking as being focused on controlling costs, when in fact you want to first maximize revenues, and the kind of funky idea of measuring “dollar days” that one eventually gets to is an attempt (which I actually don't think is successful, but maybe it is approximately okay) to start to bring cash flow ideas to consciousness. I believe The Goal is where I first read about this idea about cash flow being more important than revenue, in a way that can be easily explained to anybody: you have bills, you have a certain amount in the bank, and then you have in accounting a set of invoices that you have sent out to customers but they have not yet been paid. So that money is “as good as earned” on paper but it’s not yet in the bank. And the problem is not revenue, the problem is cash flow. If you don’t have enough in that bank account, then after paying for your materials and rent for your building and whatever else, you suddenly come up short on payroll. “Please forgive me,” you tell your employees, “we have the money and your paychecks will just be a week late, we are so sorry, this never happens normally.” Good way to lose a lot of your best minds that really make your money—your best salespeople, your best engineers, your hardest workers. They got rent to pay. In The Goal I believe the book points out that most companies that go under don’t have a revenue problem but a cash flow problem, the money isn’t coming in fast enough to pay to keep the company running even though it is coming in eventually. there are a couple of other ways to look at it that may be helpful to the broader community, one of them is that your interest rate on debt actually sets a time scale for your “indefinite future.” If you have credit card debt at 36%/year compounded monthly that’s 3%/month, flip that to (1 month)/(.03) = 33 months. Now if I ask you “hey, how much is that $20 per month subscription worth to you in terms of present value?” you can answer: that subscription runs out into the indefinite future so it gets multiplied by this time scale and it is worth $660 to me right now. Which is another way to say equivalently that if I bought something right now for $660 I would pay $20/month for the indefinite future. Lots of people don’t realize how much present value they can unlock by just canceling out old subscriptions like that, because the cash flow is not there immediately, but it’s true. Similarly, I ran into cash flow issues at the beginning of this year in my personal finances. With COVID-19 hitting at around the same time my auto loan asked me if I wanted several months deferral. Are you shitting me right now? Yes, the added productivity and lack of stress from having a floating several hundred dollars in the bank and therefore being able to set up auto-pay (and not incurring late fees on all my accounts) pays for itself and then some. Thank you so much! (Of course the bank is a bank, this is cold hard calculus to them, so I don't feel too bad. Imagine that, too, though! Imagine that if you are in a good cash flow position, as the bank is as covid starts, your reaction might actually be to turn away cash flow: you are a sort of landlord collecting rents and you need to mitigate the risk that all your tenants go broke, they need to be able to keep their jobs for your wellbeing. And then you think of the actual landlords and you realize that the system must have left them relatively strapped for cash if they’re not similarly absorbing some of the shock. And that launches into interesting questions about feedback mechanisms in complex systems and their modes of resilience.)

syntaxing 6y ago

Wow what a great read. The other article about where first principles fails [1] is absolutely amazing as well. The debate about experience vs first principle is a heavily recurring theme in the tech industry. I couldn’t structure my thoughts about it in words and the article perfectly sums it up in a succinct manner. [1] https://commoncog.com/blog/how-first-principles-thinking-fails/ https://commoncog.com/blog/how-first-principles-thinking-fai...

sna1l 6y ago

This article is great and actually comes to one of the core tenets from the book "The Outsiders." If you had to choose a single core task for the CEO of a company, it is to create free cash flow and decide best how to spend it, aka capital allocation. Book Source: https://smile.amazon.com/Outsiders-Unconventional-Radically-Rational-Blueprint/dp/1422162672/ref=smi_www_rco2_go_smi_4368549507?_encoding=UTF8&%2AVersion%2A=1&%2Aentries%2A=0&ie=UTF8 https://smile.amazon.com/Outsiders-Unconventional-Radically-...

root-z 6y ago

echoing the common opinion, this is a great article at both practical and theoretical levels. The discussion on cash flow is insightful but the summary about the flaws of first principle thinking is what makes it complete.

draw_down 6y ago

This is a great post. Really, really fantastic. The post it's based on is ok, but super abstract, and really just spends a lot of time dancing around the fact that reality really doesn't care about your big brain and how hard it thinks. You can go super elaborate on hypothesizing if you like, but the brunt force of reality is exactly the same regardless.

tunesmith 6y ago

I think the argument he's knocking down is more flawed than he's letting on - specifically, just because the extra cash makes it easier to make bad decisions doesn't mean that those bad decisions will be made. The argument treats those as inexorable. If the argument had been passed through a truth checker and given a few more eyeballs, that flaw would have been obvious. That particular inner syllogism just doesn't inexorably flow from the truth of its lemmas. More generally, the "flaw with first-principles analysis" is generally as you'd expect. Your premises might appear true when they're not, or your inner reasoning structure might appear valid (logical definition) when it's not, or you might be making assumptions (in the omission of other premises) that are false. It's just really hard. So that's where a slow painstaking process of repeated review will help you. And it's also not a panacea - first-principles analysis does not guarantee your solution, it's more a process that helps you surface your assumptions and learn your argument.

pge 6y ago
Agree - and a related is that because you don’t have 100% ownership, you have less skin in the game. The reason to tkae money is that you believe that the 80% of the company you still own will be worth more than 100% of the company without funding. So you end up with more value at stake, not less. And more incentive not to make bad decisions (and of course more people around the table with skin in the game that are motivated to help you avoid bad decisions).
dalbasal 6y ago
IDK... In theory, choices are good and you can just choose the better one. In practice, the financial dynamics of a business tend to create head or tail wind forces that become a part of the company's character. All else equal (including the decision maker), a positive float business will tend to be more growth oriented than a negative float business. In theory, not so much. Float is just a type of capital (working capital). In practice, it's different. Other people's money businesses will tend to take more risk. Publicly listed companies tend to be risk averse and quarterly report focused. These aren't carved in stone. Some publicly listed companies (eg amazon, tesla) have sailed against this wind. But, the wind is still there. For a personal example, take the difference between having a trainer vs exercising yourself. It's theoretically possible to do the same training and have the same results, or do better. The tendency though, is meaningful, and when you pay a trainer there's a tendency to be disciplined. Returning to the "friend's argument," it is observably true that structural constraints affect business owners.

fghorow 6y ago

As a working scientist, I read the OP with great interest (no pun intended). In essence from my perspective, the axiomatic approach is like "theory" and the operational approach is like "experiment" or "observation" in the sciences. There's a very good reason why experiment/observation trumps theory in the scientific method.

dalbasal 6y ago
Good point. That said, the more distance from hard science you have, the likelier this is to go wrong. If you're dealing with psychology, economics or such experimental observations can have the exact same problem. They're true in this case, at this level of abstraction or otherwise "not really wrong but not — but not as useful or as powerful as some other framing". Framing is the key point here. What's in model or not. What questions are your trying to answer. etc. The harder the science, the less flexibility scientists have in framing.

supercanuck 6y ago

The author is describing the time value of money https://en.wikipedia.org/wiki/Time_value_of_money https://en.wikipedia.org/wiki/Time_value_of_money The reason to to take the money now from venture is because it is more valuable now than it is later. The way this author is describing this though reminds me of the folksy, whimsical way some business books are written which makes this article so applealing: e.g. The Goal, How to Win friends and influence people, etc.

munificent 6y ago

There's a simpler failure mode to pay attention to that the author gets close to but doesn't notice. The original claim is "Companies should not raise capital." Any time you see a "should" claim, try adding this to the end: ", and should instead do X." Now, when evaluating the pros and cons of the "should not" half, you have an actual relevant benchmark to compare to. It doesn't matter how awful an idea it is to raise capital in some absolute terms. What actually matters is whether it's worse than what you'd have to do instead. Almost all decisions are about choosing one from several options, so if you find yourself making an absolute evaluation, that's a sort of "decision smell" that you should instead be doing a comparative analysis.

bluejellybean 6y ago

If you liked this article and want to learn more about the games played in corporate finance, I would strongly recommend a book a colleague of mine recommended, "The Quest For Value". This single book had completely changed my view of the business world more than any other, and it gives one a much clearer understanding of the massive debt load that the United States operates under. I grew up and lived through the 08 financial crisis, losing a home in the process, and hated debt of any sort. Now that I've read this book cover to cover multiple times, my view has completely shifted, and my understanding of stock valuation and cash flow analysis has done nothing but improved.

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burnte 6y ago

The proposition can be disproved very early in the chain of logic, actually. 1. Startups are risky. True. 2. Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all). Arguable, but not a given. Raising capital does not eliminate risk, especially if one has their own money in it, and/or are using it as a job. Just because someone else invested doesn't necessarily reduce my incentive. I lose money, time, face, and opportunity with or without investment. 3. Once you have less skin in the game, it is easier to make bad decisions. The author argues this is due to a) having a capital buffer to cushion you, and b) having more time to waste. 100% false. It is no easier or harder to make bad decisions with outside money. It is ALWAYS easy to make bad decisions, having more money simply makes it easier to make costlier bad decisions faster. Buying real estate in late 2006 was a bad idea regardless of whose money you used. If anything, having that outside money means you have people to be accountable to, people to run decisions by, and thus it's HARDER to make a bad decision.

foldingmoney 6y ago
Having more money can also increase the set of (good) choices available to you.
- 1propionyl 6y ago
  It can also (at the same time) vastly increase the set of _bad_ choices available to you. How many stories of startup founders blowing money on booze, cocaine, prostitutes and lavish parties do we need to read before we realize that startup founders are humans and behave, well, like humans always have?

jplr8922 6y ago

The article is very good, but to me it is normal finance. Many points raised by the author are discussed in undergraduate business classrooms every year. Very good application of existing theory. https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theo...

TameAntelope 6y ago

Maybe a basic question, but is cash flow a concrete expression of the time value of money, a concept taught (abstractly) in intro econ courses? I didn’t understand the value of either until this article, but they seem related.

anonymousDan 6y ago

Had to stop reading, could the author be any more pretentious? The obvious flaw in the reasoning is step 3, having more capital results in you making worse decisions. Uhm, no, having more capital can also give you more options, allowing you to make potentially better decisions sooner.

lowdose 6y ago
I quit after 2 because doing a startup means you have all eggs in one basket thus skin in the game is not reduced. > Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all Peoples most scarce resource is the time they are investing and I have yet to meet a founder that doesn't do 80 hour week to make the wave next week.

SerLava 6y ago

Oh man, the conclusion doesn't even follow from the argument, and it's pretty obvious on its face. The only correct conclusion from those axioms is: There are advantages to not raising money.

monkeydust 6y ago

Nice piece. If you have the basis of a business that can prove strong cash flow then you should definatley look at financing with debt over equity. In startup land its not really the done thing but in this long term low rate environment I suspect thst might change.

tuatoru 6y ago

I think the article is itself an example of broadly correct but for the wrong reason. the problem with the argument from first principles that the article attempts to refute, is that the "first principles" given carry an implicit assumption that the minimum viable product is a a null product. If in reality the mvp or, later, the infrastructure for growth take more to create than the resources you command, you need to raise capital. The "first principles" also ignore time to market and competitive pressures. They are more "spherical cow on a frictionless plane" principles than actually useful ones.

highfrequency 6y ago

Could someone explain the core example about prepaying restaurant vendors? (Kokonas again): That’s what I said! I went, “I’ll pay you $20 if you tell me why.” And he said, “Well, it’s very simple. I have to slaughter the cows, then I put the beef to dry. For the first 35 days I can sell it. After 35 days there’s only a handful of places that would buy it, after 60 days, I sell it $1 a pound for dog food.” So his waste on the slaughter, and these animals’s lives, and the ethics of all of that, are because of net-120! Seems like someone should have figured this out! As soon as he said that, everything clicked, and I went “We need to call every one of our vendors, every time, and say that we will prepay them.” It seems like the value to the beef vendor is not from actually receiving the cash flow earlier, but rather from just knowing the order quantity in advance to optimize inventory.

bob33212 6y ago
I assume the beef vendor doesn't have much cash on hand. So he can take the prepayment and give it directly to the cow farmer who also doesn't have a lot of cash and is happy to prioritize the preorder.
ameetgaitonde 6y ago
Part of the reason is because it's a set order. Consider that in pricing his beef normally, the vendor has to account for three things: 1. Beef that sells within 35 days at regular price 2. Beef that sells within 60 days as a discounted price 3. Beef that sells after 60 days for a loss. The beef's regular price has to be somewhat higher than in an efficient market because some of it will be sold at a loss. Getting an order for a set amount per week allows him to disregard the losses he normally has from beef that has to be sold for dog food, because the purchaser is guaranteeing their quantity, smoothing their expectations on how much beef to purchase in the future. It's possible that at $18 a pound, without any waste, he's making the same margins/profit as he would at $34 with some waste.
- highfrequency 6y ago
  Right. So the value add here is not actually about moving cash flow forward in time through reservation deposits, but rather just having a predetermined order size. Am I misunderstanding, or is this a complete non-example for the point of the article?

pmayrgundter 6y ago

A related study I did. This sheet compares cash flow for Build to Order (BTO) vs Build to Stock (BTS) for a very popular widget sold at $100. BTO is not sensitive to Cost of Goods Sold (COGS); BTS is. If, for example, your COGS approaches half your unit price and you use BTS, you'll have almost no chance of getting your business off the ground. But with BTO your cash flow explodes. https://docs.google.com/spreadsheets/d/15JZyPEYJxNHEWTPFmxOIoWmo6XS_WXRLGC-csZLhlVM/edit#gid=0 https://docs.google.com/spreadsheets/d/15JZyPEYJxNHEWTPFmxOI...

nraynaud 6y ago

Funny, I had a boss do the converse. We were a very young company with zero customer, and we had a small net 30 bill to pay. The boss said: I have to put a reminder to pay it. Well, without any hope of earning money in the mean time, there is no point in trying to optimize the cash flow pay now and be done with it. Free your brain and don’t adopt complex behavior if the reason is not here.

2Gkashmiri 6y ago

I have a question. Interest payments. Unless you have a high enough revenue stream to cover the cost of interest, arent you eroding your capital ?

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zuhayeer 6y ago

What I got out of this is that you shouldn't deal in absolutes. There are ways to successfully create businesses with and without outside capital.

blackrock 6y ago

This may be true for small lifestyle type businesses. But some problems can only be solved with VC money. Because of time limitations. You may only have a small window of opportunity to capture a certain market. If you grew linearly, and built up product idea A, in order to fund product idea B, in order to fund product idea C, then by the time you’re done with product idea B, a decade may have passed by. You’ve also grown older, and may not have the energy of your younger self anymore. Also, a competitor, one with a larger funding pool, may have jumped in and captured that market, right in front of you.

fishingisfun 6y ago
I agree. I can use the example of flappy bird for this. Overnight development teams pumped out 3d versions of his game with better controls than the original. Sometimes timing is important for small players because other teams can take your idea and execute better and faster once they know the market is there for such a program or product.

BonnieBrown 6y ago

Like many others in this thread I thought this was an incredibly well written and elucidating article. I just happened to be trying to learn more about David Friedberg before stumbling upon this article and I watched this lecture he gave on entrepreneurism which I think complements the contents of this article incredibly well. Highly recommend for those looking to learn more https://youtu.be/m2sj-U2QSHs https://youtu.be/m2sj-U2QSHs

simonebrunozzi 6y ago

> But those who actually run businesses know that running a business is all about managing cash flows. This is the golden line. The richest person on Earth (Jeff Bezos) followed this principle religiously since Amazon's inception (or should I say, Cadabra's inception?).

solatic 6y ago

Great article. One thing that it made me think about - instant payment clearing will have an enormous impact on cash flow, and thus on the wider economy, if the US can ever get it together and finally deprecate ACH.

wyiske 6y ago

I used to be afraid of debt, but understood this principle ever since an accounting friend told me about a luxury cruise liner he worked for. It was started buy an immigrant, and quite successful (pre Covid). I was confused how anyone could launch a cruise company when the cost to buy (or even lease a cruise liner) must be 100s of millions. When I asked my friend about their debt, he said “don’t worry, they’re doing just fine”. It was at that point I realised it’s not the debt that matters, but the rate (time wise) at which you can repay it, i.e., debt itself is fine so long as you have sufficient cash flow, and debt can be cheap. Unfortunately I’m just a software engineer, who has never been able to put this in practice.

knighthack 6y ago

That was an amazing article. Especially the breakdown on raising capital from first principles.