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Due diligence scoring - cash flow evaluation

Paul Clark
Paul Clark
Last updated: January 17, 2024
Venture south fallback

If you’re still with me, these posts were prompted by a member’s question about cash flow. The company we had been working on scored a 0.0 on “cash flow”, on our -2 (terrible) to +2 (amazing) scoring metric. It was the weakest score in the report, and our member was wondering how bad that is relative to other companies we see and to the other criteria.

Cash flow analysis is the second lowest average score across our dataset, at a mean of 0.49 overall. (By comparison, “concept” scores 1.67 – because companies with bad concepts don’t get through screening.) Why is that score so poor?

Startup company cash flow models typically show investment today, “burn” of the capital over 12-18 months, and achievement of a milestone at the end (enough traction to attract venture capital, or, better for southeastern angels, getting cash flow positive or acquired). This is inherently an unattractive profile – which is why banks don’t lend to startups! Most of our members run businesses with a much more attractive cash flow situation, so find it challenging to give positive scores for something that would be a major problem in their businesses. This suggests we don’t do a great job “calibrating” scores on this metric to what we would typically see in early stage companies - something we (as group operators and educators) can improve.

But there is more to it. Positive scores on cash flows require a thorough understanding of opaque concepts. From basic financial concepts (margins, unit costs), to startup-specific company metrics (burn rate, CAC, LTV), to accounting concepts (cash vs. profit), to sophisticated excel modelling – many of which are often lacking from small entrepreneurial teams. These are crucial at the VC level – read Mark Suster’s recent post for example – but angels understand them too, of course.

A slick deck and dynamic team doesn’t impact cash flow score: what does is a robust, convincing short-term projection model; a complete grasp unit economics and sales channel ROIs; and a team clearly focused on making sure the “minimum cash position” never reaches 0. These things are much harder to pick up without training, and almost impossible to “bluff,” so generally scores lower than other areas.

In case you’re wondering, 0.0 was in the bottom 30th percentile on this metric. Low scores appear often when a high burn rate is caused by senior team members taking generous salaries: angels are not thrilled about paying entrepreneurs above average salaries with no guarantee value is being added to the company or that this investment will see a return. Startups companies are high-risk for investors, and should be for entrepreneurs too.