What distinguishes positive and negative cash flow for VC returns?

1 Cash flow basics

Cash flow is the net amount of money that flows in and out of a business over a period of time. For a VC, cash flow can come from different sources, such as dividends, interest, royalties, or exit proceeds. Positive cash flow means that more money is coming in than going out, while negative cash flow means the opposite. Positive cash flow can indicate profitability, growth, and financial health, while negative cash flow can signal distress, inefficiency, or insolvency.

2 Cash flow and VC returns

VC returns are calculated by comparing the amount of money invested in a portfolio company to the amount of money received from it. The difference between the two is the profit or loss, and the ratio between them is the multiple. For example, if a VC invests $10 million in a company and receives $30 million from an exit, the profit is $20 million and the multiple is 3x. However, the multiple does not account for the time value of money, which means that the same amount of money received at different points in time can have different values. To account for this, VCs use the internal rate of return (IRR), which measures the annualized return on an investment.

4 Cash flow amount

The amount of cash flow also affects the IRR of a VC investment. The more cash flow a VC receives from a portfolio company, the higher the IRR, and vice versa. This is because cash flow represents the return on investment, and a higher return implies a higher IRR. For example, if a VC invests $10 million in a company and receives $30 million after 5 years, the IRR is 24.6%. But if the same investment yields $40 million after 5 years, the IRR increases to 32%.

5 Cash flow scenarios

Depending on the exit scenario, a VC can experience different cash flow patterns. The most common exit scenarios are IPO, acquisition, secondary sale, or liquidation. Each scenario has its own pros and cons for cash flow. For example, an IPO can generate a large amount of cash flow, but there is usually a lock-up period before the VC can sell its shares. An acquisition can provide immediate and certain cash flow, but it requires approval from the board, shareholders and regulators. A secondary sale can provide quick and flexible cash flow, but it implies a lower return and loss of upside potential. Lastly, liquidation is the worst-case scenario for a VC as it usually results in a negative or zero cash flow. It can be caused by various factors such as poor performance, market changes or legal issues.

6 Cash flow optimization

For optimal VC returns, a VC should have a clear and realistic exit strategy for each portfolio company, based on its stage, sector, and prospects. Additionally, it's important to diversify the portfolio across different companies, stages, sectors, and geographies to reduce risk and increase chances of positive cash flow. Furthermore, cash flow management is key; this involves tracking inflows and outflows, forecasting future needs, allocating capital efficiently, and maintaining a reserve fund to cope with unexpected cash flow shocks or opportunities. Finally, market trends and opportunities should be monitored in order to adjust the exit strategy accordingly.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?