The importance of a well-sorted working capital structure for a D2C company is immeasurable. Here’s why.
Amongst all the cash flow numbers that a startup has to deal with, an unhealthy amount of attention goes to equity capital raised (& the valuation). Revenues & margins come after, while profitability only sometimes comes into the picture, but working capital requirement is never mentioned.
At Secocha Ventures, one of our focus areas is D2C consumer products. Invariably, during a pitch meeting, I’ll latch on to supplier relationships and payment terms, much to the surprise of the founders, who were geared to spend time chatting about TAM, revenue, LTV/CAC, gross margins etc. that they are laser focused on.
When investing in a Seed or pre-Series A round, we’d evaluate the founders approach towards standard KPIs, with the intent to make sure that they have a sound knowledge and approach towards it, since we expect that many of those are still to be figured out by testing alternate strategies. However, I personally believe that founder should have, above all, a firm grasp of cash flow engineering to be able to scale a consumer products business effectively.
I recently posed a question to a set of co-founders, who were planning to use 50% of their equity raise (2nd round) for inventory, about their relationship with a key supplier, and whether there may be room to negotiate payment terms to allow for a neutral or negative working capital position —questions the founders admitted that they had never considered nor had any other VC asked them. I further explained my rationale that giving up a bit of gross margin (in the short run) may be worth it for longer credit terms, which led one of the co-founders to ask me whether I would encourage them to grow at any cost including profitability. That made me pause. Were they confusing P&L with cash flow?
What is Working Capital (WC)?
Investopedia defines it as the capital of a business which is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities.
Most mature businesses will have payment terms from their suppliers and will have credit terms for their customers. Hence it’s the balancing act between Receivables & Payables (plus inventory carrying cost) that companies have to achieve. They’ll use a credit line from banks to finance their WC, in addition to negotiating payment terms (with suppliers & customers) to minimize cash requirements. That’s challenging for a young startup to achieve, but we are seeing more and more suppliers willing to work with startups and provide them the necessary float after their initial relationship building days.
Negative Working Capital
In a D2C environment, where the end-consumer pays upfront, if you can get your vendor to give you X days of credit (where X = number of days of inventory you carry), you are in negative working capital territory, excluding cash on hand (for simplicity). In this scenario, if you are at 50% gross margin, you are able to use part of your revenues to finance your inventory growth. This frees you up to use equity capital solely for business development (marketing, hiring etc) i.e. using long term capital source for long term development only.
One of our D2C CPG companies has achieved negative working capital by introducing Just-in-Time inventory, producing the product AFTER receiving payment from the consumer, and paying the supplier 60 days after the product has shipped. This relieves them of the constant need to raise capital to fund inventory growth.
At Secocha, we strongly believe that venture scale in a CPG business is achieved through exceptional cash flow management, often through a combination of supportive vendor terms, inventory financing, and innovative supply chain. Without it, we see founding teams unnecessarily dilute themselves and ultimately slow growth down. After all, you can’t keep raising equity capital to fund inventory.
Sanket Parekh is Managing Partner at Secocha Ventures, a Miami-based Investment Firm focused on early-stage consumer products & services, fintech & healthcare technologies.
This post was first published on Secocha’s blog and was republished with permission.
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