Putting Capital to Work in the Space Sector

In my work with companies in the space sector I am increasingly seeing what I think is a serious issue that is impairing the growth of companies that seem to have all the factors in place to be successful.

Typically, these companies are competently managed by founders with vision and passion. They have developed a useful product and have found at least some traction with the market. Usually they are, in fact, generating revenue – and often profits as well.

Yet, they are running out of cash, and they struggle to raise enough to continue to simply operate, much less grow. They, and their potential investors, lenders and government funders all see them as marginal or even failing. They are certainly seen as risky or underperforming.

And yet they are not.

At least, not from my perspective. In fact, they are doing most things right. If there is one thing they could be doing better it is, frankly, accounting. Which might not be surprising for a startup company and a first-time founder. 

More surprising to me is that the investors and lenders are also missing or maybe misinterpreting some key financial facts about these companies that should really make them much more attractive than they seem to be. It seems to me that there is a basic disconnect that stems not only from the typical founder’s relative inexperience with the financial services sector combined with the relative inexperience of that sector with the nature of the space business.

I believe that there is currently a significant un-met need for business services that provide the necessary advice and “translation” to mediate between new space companies and financial service providers.  While I think this is niche market – it is one that would be easy to dominate because it is currently empty.

Let me explain what I think is happening. From what I see the proximate problem is what I am going to call “working capital.”

Now, the “text book” definition of working capital as defined on Investopedia is:

“Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts.”

Which is a very, well, accounting definition. Because I am not an accounting professional, I am going to use the term a bit more loosely. I am going to use it to mean the capital that is necessary to operate the business efficiently. In other words, it is the capital necessary to take in and process orders using the company’s existing infrastructure.

I use it in that way to separate it from what I would call “growth capital” which is the investment that is needed to grow and expand the company by adding new infrastructure such as equipment or facilities or people.

The distinction is important because for founders that are just coming out of the “start-up” phase of their companies and, frankly, for the investors that often support them, growth capital can be a bit of a pre-occupation. This is especially true in the world of venture-based investing where rapid scaling and “massive growth” are important – or even critical – success factors, but where efficient execution is often less of a concern.

To some extent I think maybe this ordering of priorities stems from the fact that in the “deep tech” sectors that have typically been the focus of venture investment, the financial model is one where sales essentially fund themselves. The classic example of this would be a software company which may spend a significant amount of capital on developing and testing their application – and even on building a sales and distribution channel. But, once the application is released, the amount of effort required to take an order, deliver the product, and collect the payment is really pretty small. In fact, it may only take, literally, the click of a button to accomplish all those things.

In this environment, rapid growth really is a matter of building ever larger infrastructure to both reach and serve a wider market. But the space business is not like that. Or rather a significant portion of the space market is not like that.  In the space market it is not uncommon for companies to be delivering custom products or services to pretty much every customer they serve. While it is often a goal to create an “off-the-shelf” product that can be sold to a wide market of customers, that is rarely the way the space market works. This is especially true for companies involved in making or supporting hardware that actually goes to space.

The space sector is much more like the aerospace and defense market where almost every end-product is customized to one extent or another. This is because it is an environment where the difference between success and failure, technically, can be very small and performance “budgets” of all kinds (weight, power, size) are very closely managed. In this environment it is difficult for a supplier, especially a small supplier, to demand that the customers should conform to their product’s specifications. It is far more common for large, demanding, customers to expect suppliers to conform to their requirements – even if it means doing custom engineering.

Now, on the other hand, such customers are entirely used to paying a premium for such custom engineering and the prices they are willing to pay will reflect that. So, such custom engineering work can be very lucrative, especially for small agile companies.

The problem is timing.

And it’s not only timing, but also accounting.

Let me explain.

As I said, customers that work in this sector are not unhappy to pay a premium for custom solutions.  They are not unhappy to allow for the time required to design and build those solutions. They are used to that. They are not, however, comfortable with the idea of paying for that work before the product is delivered. And by that, I mean that a fully tested and verified product has been delivered.

In other words, the time between signing a contract and cashing the customer’s cheque may literally be months – sometime many months.

This, of course, is going to be an issue for any company – especially a small company for whom cash flow is always an urgent issue. But I honestly believe that many small space companies make it even harder on themselves because of the way they do their accounting.

OK – so here is the bit where we get into some accounting. If you are not an accountant – stick with me for a minute. If you are an accountant try not to use too many unkind words in response to my “non-financial professional” descriptions.

We do have to talk accounting because the issue stems from the way the concepts of Revenue, Expense, Profit and Cash – and to a lesser extent the concept of assets are understood.

This may seem like a funny thing to say given that these concepts do not appear to be particularly difficult to grasp. After all, the definitions can be obtained with a thirty second internet search. Surely anyone involved in running a business will understand these basic concepts.

And they do. Certainly, founders who have gotten to this stage of running a business do. They understand that revenue is the value of the products or services that the business produces; that expenses are what those goods and services cost to produce, and that profit is the difference (hopefully positive) between the two. 

And cash, well cash is what they have in their bank account.

All of this is perfectly true. So, what’s the problem?

Well, again, the problem is timing.

In most of our lives we are used to using what accountants would call the “cash accounting method” which basically means that an event occurs at the time that it affects your bank account.  Buy something – cash goes out. Get paid, the cash comes in. Measure the difference and you know if you made money or lost it this week.

But that isn’t how accounting is done in business. Usually business accounting uses the “accrual method of accounting” which is a way of estimating the impact of financial events when they actually occur, even if they are not immediately reflected in your bank account. This is necessary because events that make or cost you money frequently occur long before they appear in your bank account. If your employees show up and sign in you owe them money even though you may not pay them for a couple of weeks. If you complete a sale for an item that you have in inventory you have generated the revenue from that transaction even if you have not delivered the item yet, or sent the customer an invoice, much less collected their payment.

Those kinds of accrual accounting are pretty straightforward. For businesses that are selling things off the shelf, it may never be much more complicated. Where it starts to get complicated is when you take orders for things you have yet to make – or for work you have yet to do.

In such a case you will certainly start incurring and accruing expenses as soon as you start working on the order. You will be buying parts and material to make the product. You may be paying employees to do design, testing and validation – long before you even begin assembling the product. You will certainly pay them to actually produce it. Then you will pay them to test and verify if before shipping it.

As already noted, it is conceivable that you may be accruing these expenses for months before you deliver the product – or even reach an interim milestone for which you can bill the customer.

But when do you record the revenue that is generated from this transaction? You certainly don’t want to wait until you receive the cash from the customer – that could be, literally, months after the work is completed.

Even waiting until you can send the customer an invoice will mean that you may record several months of apparent losses – as you track your mounting expenses without any revenue to offset them.

In fact, you don’t have to wait. The truth is that if you have a signed contract for a defined piece of work from a customer then you can begin accruing revenue as soon as you start work on fulfilling that contract. The only thing you have to do is to have a way of estimating how much of the work required to fulfill the contract has been completed. 

Now, I say THAT as if it’s a simple thing. It isn’t. In fact, volumes and volumes have been written on the subject of how to track “earned value” but there are established ways of doing it. So long as you use an accepted method of tracking your progress there is no reason why any financial professional is going to look at your books and conclude that you are not earning revenue.

The point being that it is absolutely normal and acceptable accounting practice to begin earning revenue on an order as soon as work begins on that project. Heaven knows you are going to start accumulating expenses on the project. If you do not also accumulate revenue your financial reports will show that you are losing money. Your bank account will certainly show that you are spending cash.

If you add those two things up (generating losses, spending cash reserves) they are not the hallmarks of a well-managed enterprise. 

They are also, frankly, not reflective of reality. 

In fact, a company that is accruing expenses and spending cash to deliver a product that will be worth much more than it costs to make – is making money. This is actually the situation that small space companies should want to be in.

But because founders often do not understand the nuances of accounting they don’t keep their books this way. I know this because I have asked them.

In fact, founders will often describe their companies as “Pre-Revenue” even though they are working full time on completing a customer’s order. Some will even say they are pre-revenue after they have delivered the product if their cash flow is negative because they have not yet collected their payment.

And, so, inevitably when such companies start searching for ways to raise more cash to finance their operations they end up presenting themselves as being un-profitable and running out of cash. They will also likely have to admit that growth is slower than they had hoped because their constrained cash flow is preventing them from starting or taking new orders because they lack the cash to start the work.

Not surprisingly this is a picture that is not particularly appetizing to either lenders or investors.

But the problem really is one of timing. If those same companies had managed to get their customers to pay up front – or even to make a substantial down payment, they would be showing that they had revenue and cash coming in – not going out. They would see themselves, and be seen by others, as being profitable and thriving.

Now, as I said, expecting customers in the space sector to pay up front for mission critical items before they have been tested, verified, and delivered is, well, unrealistic. But I would maintain that even absent the cash payments if companies tracked the revenue a function of progress made on their orders their books would look exactly the same – at least in terms of profit. They would still have a cash flow issue, but they would be presenting themselves as an enterprise with a growing revenue stream from which they are extracting significant profits.

They would, also, approach conversations with lenders and investors with a different and much more confident mind set – instead of feeling that they must be failing in some way. But because they do not fully appreciate the nuances of accrual accounting and also because they don’t have access to high quality financial advice, they continue to see themselves as struggling startup companies that are in need of more investment. Instead, they should be seeing themselves as having crossed the line into an operating company that requires working capital to finance their on-going operations.

This is a problem for founders who either fail to secure the funding they need, or who agree to deals which significantly undervalue their company. Those founders need to understand that what they really lack is the quality advice necessary to understand not only how the financial services industry will view their situation, but also the assistance to implement the changes needed to change those perceptions.  Often these changes will not be costly, but they will require advice from someone who both understands how the financial services industry works – and who understands the realities of the space market.

This I why I believe there is a massive opportunity for lenders and investors, and financial professionals. I believe that companies like this represent a lucrative market for lenders and investors who actually understand their true financial position – purely because it is an underserved market with a lot of pent-up demand. 

Maybe more to the point I also believe there is an interesting opportunity for financial professionals who can help these companies by understanding their true situation and helping them make the changes needed to make them more attractive to investment and financing.

Editor’s note: If you like this column you should read Iain’s six part series The New Space Revolution.