Next in our series is the new balance sheet. And the key takeaway here is that balance sheets are for Amazons.
Starting with the sample case of a SaaS start-up
As a SaaS start-up that is run as frugal as Jack Bezos would run a start-up, and as clean as it should be, your balance sheet should contain exactly three items.
- Retained Earnings/Losses
Why is that? Well, what is there in a balance sheet?
- Long-term fixed assets: Start-Ups don’t own land, property and equipment. Maybe laptops, but why not lease them from an IT service provider? Phones? Part of contracts and could be immediate writeoffs anyway. Furniture in the area of fully furnished co-location offices are rented.
- Software and infrastrucutre is all aaS
- Accounts receivable: Well, everything is paid via credit card, so no accounts receivable.
- Accounts payables: Well, you should pay your bills quickly. No accounts payables.
Of course, there are likely more than that. But that isn’t the point.
The only big concern of such a start-up is one thing: equity. If equity becomes zero or lower, you are entering insolvency. So the only thing that the modern entrepreneur has to manage in the balance sheet – if you ignore working capital as above – is sufficient funding to maintain a positive equity balance.
Of course there can also be short-term or long-term debt (e.g. founder debt is very common, as founders contribute cash for the business as debt rather than equity when it goes beyond the minimal reserves). And maybe mezzanine portions. Or crowd-funding tools enjoy using mezzanize or forms of debt – very bad for the balance sheet guys, you are balance sheet insolvent the moment you spend that money beyond your equity contribution!
And yes, people prefer buying laptops. Because requirements for maintenance and reliability are not high enough to warrant the lease vs. the purchase. That typically happens. And yes, sometimes people lease offices and buy furniture to do corporate branding to compete in the talent wars. Those are the few exceptions to the rule.
But even beyond the initial days of the start-up. When should a start-up start building balance sheet items?
- AS you grow, leasing laptops becomes more relevant.
- Office furniture can help you build some balance sheet power especially if your depreciation schedule is realistic and the furniture lasts for 15 years. Aka. the indestructible furniture.
But beyond that? What is there? Maybe you put aside money for bonuses. Could be best practice. But why else would you build balance sheet items?
The rationale of purchase vs. rent is that if the excess service in the rental agreement is not needed and the company is reasonably believing to have a longer life cycle of the asset at equal or higher return on asset compared to the lease that purchasing is the better option. But is it really?
- The cash flow effect is immediate and independent of D&A.
- The option to shift Depreciation schedules to manipulate your changes in equity and get some tax impact are irrelevant at the beginning untill you are net income positive.
The only time it makes sense to invest in assets and capex is when (a) something has been completely validated to be a lasting going concern for the company, (b) the scale of such going concern capex items is sufficient to have an internal operator managing the position, so that (c) this is cheaper than rental.
If it was proven that the asset has a critical impact on the company, it has a decent life cycle vs. rental and the cost of insourcing maintenance and management to the extent necessary isn’t killing the benefit of going ownership vs. rental.
The new understanding of assets
But the business case for insourcing capital vs. renting the capital becomes increasing less viable untill two key precedent conditions are checked off:
1. You really have massive scale in capital requirements where every cent starts to matter.
2. And you are able to source the talent to keep operational cost of managing capex to a competitive minimum.
Let’s look at Amazon Web Services. It must be really hard to replace all the work into penetration testing, infrastructure maintenance and operations, updating and capability development/R&D for most companies that don’t run a lot of very large datacenters. In that case, where internal resources and capability are present, the cost saving and tailoring of services with tailored acceptable risk profiles might be worth it. But then you get the employee risk association with an insourcing decision. Training requirements, managing lack of motivation and incentivization to perform and learn to increase performance becomes an overhead. So things get really messy and on the long run you need to be a really big organization to justify insourcing.
The next insight comes from the market plays at work that are replicating the Amazon Web Service Model to other capital positions.
Let’s look at real estate infrastructure. Companies become more and more able in sourcing locations/space and utilizing that space very efficiently at scale, while maintaining operational security and safety of the space and while becoming increasingly capable of adapting to individualization demands of key accounts. IF this sector progresses well, and it will, office purchases and lease agreements become inreasingly less attractive even for large organizations. Reducing the need for PP&E for most software companies to be built into their balance sheets. This might not be the case for industrial manufacturing with proprietary manufacturing equiptment, but maybe we see this vanish, too, under the emergence of new paradigms of provisioning and supplying game changing manufacturing equipment. Or the requirement for having complex production chains decreases as one-stop-shop manufacturing equitments – e.g. 3D printing – starts to replaces the entire concept of parts manufacturing and shifts the needles to more OEMs that do not require any supply chain. We don’t know.
As with financial holdings, we might also move completely away from financial intermediaries and hence from actual financial instruments towards basic features of providing different risk return profiles against specification without any intermediary or broker and we move to real time re-alloction of financial risk positions of companies. We might even go as far as having no financial holdings any more as markets become increasing liquid by new technologies and any excess unused capital simply moves off the balance sheet and can be acquired later on. In essence, it makes no sense to have reserves invested into financial holdings to retain that cash and have it as an asset in a balance sheet if you live in a new world where this just doesnt exist and financing technology factors the absence of such positions into the financing opportunity mix. Why hold 20 billion in pension reserves if you can get the cash for payments when you need it and your company overall is a going concern that is able to raise cash.
This is of course a bit utopic and too much forward-looking. But this mindset must exist in the new CFOs head. The decision to run and build balance sheets for equity value on the balance may sooner than expected no longer be relevant for providing a case for solvency and this mindset of challanging the balance sheet should at least be present in ones head. In the end, every balance sheet item represents a partially frozen asset and doesn’t fit the concept of a highly connected real time world.
We will talk about time in a later article. But if a frozen asset is part of the balance sheet and its frequency of turnover – moving into and out of the balance sheet – is low, it has an impact on the frequency of the organizational planning. Or it is simply disaligned with that frequency and hence less manageable.
I think this is a less important aspect in our series. But since Balance sheets are easily overlooked in the start-up world – apart from their relevance for cash flow predictions and working capital management (both higher frequency items that are too slow if you manage them via balance sheets), I wanted to cover it at least in some part.
The takeaway is that balance sheets are smaller than usual for early stage and growth stage start-ups and start to become more relevant as scale is reached. This reflects the triump of flexibility and transactional liquidity over building long-term assets in the context of capital itself becoming a victim of the as a Service paradigm.
And turning this around and looking at this from an investor perspective. Scrutiny should be applied about the risk a company takes when balance sheets are growing in an early stage start-up. And looking at public or late stage companies, attacking efficiency of resource efficiency and operational management efficiency can start from looking at the balance sheet.