This the fourth installment in the series on An Entrepreneurial Space. If you have not read the previous articles you may want to take a moment to do that before reading this one. So far in this series we have talked about the general features that define entrepreneurial space businesses. We have talked about The Founders of those businesses and the journey they take from having a great idea to having a viable business and we have talked a bit about Investors, and they are, usually, an essential part of that journey.
But we also talked about the fact that while investors and founders both want the business to succeed, they may have different ideas of what success means, and how to get there.
One thing that Investors and Founders will agree on is that the business needs to grow. However, what growth means, how it is to be achieved, and critically, how it is to be funded are all questions about which discussion will almost certainly be required. None of these questions are simple, the answers to most of them will change over time as the nature of the business changes. So, before looking at the options available for funding growth, let’s quickly take a look at why that funding might be needed.
The need for capital to fund growth is going to vary dramatically depending on the type of business. At the low end of the capital intensity scale would be a business that has created a product that is mature, and that requires very little effort or material to produce new copies of the product.
The classic example of this kind of business would be a business selling “shrink-wrapped” software – particularly once the software has been developed and released. The important thing to note about this business is that the time lag between making a sale and seeing the cash from that sale is very short. So a business in this situation is not only able to generate revenue, but since that revenue requires relatively little input cost they should be able turn that revenue into profits, and those profits should appear with relatively little delay as cash in the company’s bank account.
The cash generated is therefore almost immediately available to reinvest in generating growth. The need for such funding may be substantial – particularly if it is important that the company grow quickly in order to establish a dominant market position against established competitors or ahead of new companies following it into the market. That desired rate of growth may exceed what can be funded by operations and that may generate a desire to raise funds in other ways. But, the important point, though, is that, at this end of the scale, there will always be a rate of growth that can be achieved based solely on on-going operations.
At the other end of the capital intensity scale is a business that does not yet have a product that it can sell, and which requires cash to continue to finance the development of that product. These companies are often referred to as being “pre-revenue.” To be fair, it should be noted that while such a company may not have a finished product to sell, it may still be able to generate some money from its operations. The classic source of such funding would be from government programs.
By the way, It should be noted, for the non-finance professionals in the audience, that I am specifically avoiding the term “revenue” to describe such funding. This is because, for reasons too arcane to go into detail about here, much of this kind of funding does not qualify as “revenue” to a financial professional. For that reason such funding is normally referred to in the Entrepreneurial and investment community as “non-dilutive funding” – meaning that it is cash that the founders obtain without having to borrow it from a lender or from selling more of more of their company – but it is not viewed as “revenue” or “sales” derived from a “real” customer.
Nonetheless, even if the company is not strictly “pre-revenue” it is certain that its requirement for capital in order to grow will far outstrip its ability to generate cash from operations. Therefore, the growth rate of these kinds of companies will be throttled by their ability to access capital, pure and simple.
This, of course, is the situation that is common to very many Entrepreneurial Space companies. Space is a capital-intensive business. Even compared to other sectors such as aerospace and defense, the barriers to entry into the space market are high. The highest barrier, of course, is the need to demonstrate spaceflight heritage of any technology that is going to be used off-planet.
Now, the size of this barrier has been steadily decreasing as the cost of launch has dropped, and as miniaturisation of many critical technologies has reduced the size and complexity of satellites. But there are other costs associated with working in space that have nothing to do with simply the bill of materials of the spacecraft and cost of getting it physically into space. This isn’t the place to discuss those topics in detail, but it is important to note that regardless of the launch-mass cost, space is going to continue to be an area which is capital-intensive because of the challenge of making technology work reliably in the environment of space comes with costs that are and will remain high compared to other sectors.
So, that covers the two extremes of the requirement for capital to fund growth. Mid way between these two extremes is a third type of business. This is what I am going to call a “working-capital” intensive business model. Now financial professionals may believe that I am using the term “working capital” a bit loosely here, but I think it is still a useful way of describing the situation.
These are businesses that have developed their technology and are able to sell it. They are generating revenue. Hopefully, they have refined their processes well enough that they are making a profit on every order they deliver. These profits eventually turn into cash in the company’s bank account. All of this is good.
However, there is a catch. To complete each order, and secure the cash from the customer, these kinds of companies require significant funds up front. This can be because they are manufacturing a product that requires significant raw material. It can also be due to the fact that their products require significant work by trained staff to produce them.
The point being that for companies in this situation, there is significant time lag between receipt of an order and delivery of the product. Over this time, the company will incur significant expenses that must be paid up-front. This is a situation that confronts many Entrepreneurial Space Companies.
The growth of these kinds of companies is throttled by access to “working capital” because they need cash to do the work that is required for them to make the profits from their sales. Now, since they are profitable and should be generating cash, they can fund new orders from the cash they receive from the last order. But this will normally limit the growth severely. Obviously, the problem will be worse the longer the sales and delivery cycle for their product is.
It is safe to say that if a company in this situation has been backed by investors who are looking for that 10x growth in 7 years – they won’t be able to get there by simply financing their growth organically. Meaning they will need to look for an outside source of capital if they want to meet their expectations of their shareholders.
So, roughly speaking the spectrum of “capital intensiveness” runs from companies with relatively low input costs who are already generating revenue and profit and who may want capital to scale and accelerate growth, to companies with relatively high input costs and long cycle times who need capital to achieve desirable growth rates, to companies that have not yet completed their product development and who require capital to get to the point where they can generate enough revenue to cover the cost of their operations.
So, with that spectrum of companies in mind, let’s turn our attention to possible sources of capital.
Once again, while the financial professionals in the audience will see this as a gross oversimplification but I am going to say that if you are space entrepreneur who needs money, there are three ways you can get it debt, equity, or sales. In other words, you can get it from the bank by taking out a loan; you can get it from investors by selling part of your company; or you can get it from your customers by selling them your products.
We have already dealt to some extent with the second option. The first option brings a new player to the stage – The Banker, but we are going to leave them standing in the wings for the moment as they are usually (hopefully) only a bit player in this drama.
And so, finally, by a roundabout route, to the last major character in our list of dramatis personae, The Customer.
In fact, other than the Founder, The Customer is the only other character that need ever appear on stage in the story of a business. It is quite possible to found and run successful – and even large – businesses without ever needing to find investors and without having to borrow significant sums of money. All you really need are customers who are willing to pay you more for your products than it costs you to make them.
It may seem surprising, but it is possible for founders to lose sight of this fact. This is especially true for founders that spend a lot of time with venture investors and who become tightly focussed on rapid and/or massive growth. Because building a business through operations and sales will never be as quick as building a business through successive rounds of investment the “organic growth” option can be downplayed or devalued in the venture community where “market momentum”, “time to market”, and “rapid scalability” are seen critical factors in the success of a company.
But, such investment based, market momentum, strategies are far from universally applicable. They are also far from universally successful. The fundamental problem is that, eventually, no matter how many rounds of funding a business raises, the customer will eventually be the one paying the bills. All of the bills.
This is because, in truth, only the customer provides cash to a business with no strings attached, no obligations, and no future risk. Consider this – however complicated, complex, or lengthy a sales transaction is to complete, once it is complete the customer has the company’s product and the company the customer’s money. On the other hand, no matter how friendly and supportive an investor or a banker may be, when a company takes their money it also takes on an obligation. Which means that the company takes on the risk that it may fail to meet that obligation in the future. And that failure may have dire consequences for the business and the founder.
No, truly, the safest way to make money is still, as the saying goes, to do it the old-fashioned way – to earn it – from your customers.
Oh! If it were only that simple. Just because earning money from your customers is the safest way to make money doesn’t mean it is the easiest way to do it. Finding customers that allow the company to generate the cash that is needed, when it is needed Is a problem that, frankly, dominates the lives and decision making cycles of the founders of almost every business. All the time.
This is true firstly, because speed does matter. For many companies it’s simply not possible to finance the growth that is required purely from the proceeds of operations. There are many reasons why a certain pace of growth may be a requirement. The company may need to establish a market position before potential competitors catch on and catch up. Or the Founder may need to satisfy the expectations of investors who have expectations on seeing a return on their investment within a finite period of time. Either way, the need for speed is often very real. So, there will almost certainly always be a tension between focussing on customer-driven organic growth and investment-driven fundraising which catalyses more rapid scaling of the business.
The second challenge that arises from trying to grow a company based on customers is, frankly, finding the right number of them, at the right time. Naively, It might seem like a business can never have too many customers, but that is actually not true. It is certainly true that having too many customers is less of an issue than having too few of them, but either situation is actually a problem.
The issue with having too few customers is pretty obvious and doesn’t really require much more comment. The problems of having too many customers are more subtle. The first problem that can arise from having too many customers is that the business may seriously and permanently disappoint some of those customers.
This can be because the business simply can’t supply those customers when they have requirements. In that case some of those customers who could have used the company’s product will find other ways to satisfy their needs. Having found an alternate source of supply they may never return. This not only deprives the company of their business permanently but may also provide critical support to competitors which the company may live to regret.
There is also the significant risk that because of being stretched to the limits of its capacity, or beyond them, the company may fail to satisfy customers because of poor quality or service. This will result in disappointed customers who vow not to return. Perhaps more seriously, it can also result in significant reputational harm as disappointed customers relate their experiences to other potential customers. Because the space community is small, such reputational harm could very well be a significant liability.
The other issue with having too many customers is that it is a condition which may be temporary or even momentary. Companies, desperate to avoid the negative outcomes described above, when confronted with an increase in demand may well add capacity through extra infrastructure and added staff. This means that the “baseline” rate of sales required to support the company then rises. If demand falls off suddenly – even if that decrease is back to a level that was previously sustainable – the company will find itself with the problem that it can no longer sustain its operations on that level of business.
All of which is to say that irregular or inconsistent growth in sales can end up being more of a challenge than growth that is slower than desired. By the way, for my friends in government who often act as early customers for such companies, this is a point which is particularly important to note. But more on that in a future article.
For now, suffice it to say that for almost any business attracting customers at the right rate to fund growth is essential, but having a good forecast of when and in what quantity those customers will arrive, is even more critical in order to stay in business.
The final challenge posed by customers is much more subtle. In simple terms this is the challenge of finding the right kind of customers. On the face of it this seems like an odd statement. Surely any customer who is willing to pay is a good customer. Well, no. The wrong kind of customer can actually put companies out of business as surely as having too few customers can.
I will admit, though, that there is some subtlety here that will require a bit more exploration, so we’ll leave the bulk of the discussion to the next installment in this series.
The short summary is that “the right kind” of customers are those that want to buy what the company is good at making, meaning the company can produce the product efficiently. Those customers should also see excellent value in the company’s product, meaning they will pay a premium for it. The combination of these two factors will allow the company to be profitable. The third feature of “the right customer” is that they should want to buy a product that many other customers will also want to buy.
In other words, the right customers are those that are, seamlessly, part of a wider market. Thus, the effort required to sell to these customers leads the company directly to more customers – continuing the cycle of efficient production followed by high value sales.
It should not surprise anyone in this audience to hear that finding the right kind of customer is not a simple matter. In fact, many companies never really figure it out. So, for the next installment, let’s discuss why “One Customer Does Not A Market Make.” And why that matters so much.
Editor’s note: This is the fourth article in a six part series focused on entrepreneurial space.