The Hierarchy of Funds

Backing entrepreneurs that want to “take over the world” is out and building profitable business is back in vogue. There’s a waterfall of cashflows that companies should aspire towards 1) Internally generated, 2) Debt, and finally 3) Equity. This might seem like a simple premise but I’ve been having some really productive conversations with entrepreneurs recently where they’re manifesting this hierarchy with their plans.

When I was having lunch with a friend the other day (a very successful entrepreneur), he mentioned that as he has started to raise a subsequent round, when an investor asked him what his end goal with the company was, he responded “To make a cash cow.” To which, the investor responded, “That’s the best answer I’ve ever heard.”

The desire to create a cash cow is driven from the challenging experiences that he has had raising cash from investors and an awareness that when the business is generating cash, he is no longer subject to the whims of the fundraising market. It wouldn’t have been too long ago that investors would have shunned an entrepreneur that wanted to create a cash cow and wasn’t thinking of world domination.

Investors used to favor entrepreneurs that were building a massive platform that would require millions or tens of millions of dollars in capital before it would eventually reach economies of scale and start to generate free cash flows. This makes it difficult for entrepreneurs in Southeast Asia when platforms need additional cash to continue building out the long-term vision but the benefits (i.e. cashflows) from doing so haven’t started to really flow through yet. This tends to force entrepreneurs to focus on opportunities that might deviate from building the platform but bring some more immediate cash flows or revenues from services – the opposite of the kinds of businesses that VCs typically want to fund.

The Hierarchy of Funds

The rationale that entrepreneurs should use when considering where they should source cash from is simple. 1) If they can generate the cash from sales, then they are selling a service. 2) If they raised debt, then they are effectively selling a portion of the future cash flows that the business will generate. If they are unable to fulfil their obligation to the creditors, then they might have to forgo some or all of the equity in the business to the creditors in a restructuring. 3) If they sell equity, then they are selling a portion of the businesses future cashflows in perpetuity.

Funding rounds are generally celebrated because of the trials and tribulations that an entrepreneur needs to go through to be able to raise external funding. It’s difficult sitting on the other side of the table, as an investor, when an entrepreneur is coming to you to explain how much cash the business is going to generate but they are enthusiastically trying to sell a portion of that business. If the business really is that profitable, then why would a rational person sell a stake so early? I can understand if there’s a necessity to be able to scale quickly to deter potential competition but that is seldom the case with the opportunities that I see in Southeast Asia.

Too often, entrepreneurs have no interest in building a business that generates cash flows from which they can pay for the flourishes that a corporate life entails. Having a nice office, that’s decorated with art is a function of a business that has been able to generate stable and growing cash flows. Buying art and nice fitting with investor capital, does not automatically translate into a successful business.

Conclusion

As far as the funding market is concerned, building global platforms is out and building businesses that generate immense amounts of cash is back in. Founders are starting to think about how they can build businesses without needing additional capital from external investors. Overall, this is going to be positive for the eco-system. A lot of startups that have been created in Southeast Asia in the last few years, likely have interesting premises but challenging business models. If they are forced to achieve some level of revenues immediately, we are going to see the eco-system focus on the real problems that need solving and generating healthier companies as a whole.