Financing Perpetual Growth: The Rise of a New CFO
The Family Notes
By Nicolas Colin (Co-Founder & Partner) | The Family
Last Tuesday, I gave a talk at The Family’s Paris office on corporate finance and the role of CFOs in the digital economy. It was an issue of our Barbares attaquent le management series, or “BAM!”. The idea behind BAM! is to explore how startups handle corporate functions such as marketing, communication, human resources, procurement, and finance.
We’re not consultants, so we don’t aim at telling traditional companies how they can change the way they manage their own business. But since we invest in startups, we can at least explain to corporate executives why startups reinvent various corporate functions to match their specific needs, and how they end up with radically different organizations and processes as they grow and morph into large tech companies.
My talk revolved around three major themes. First, I explained to the audience what a tech company is and why it is so different from a traditional company. This is crucial for understanding the key role of venture capital and the importance of radical innovation in the digital economy.
Second, I reminded them how far corporate finance goes in its efforts to kill innovation. As written by Clayton Christensen, misapplied discounted cash flow, margining on fixed and sunk costs, and a myopic focus on earnings per share all contribute to impairing innovation efforts in established companies.
Third, I detailed how startups and large tech companies reinvent corporate finance in many dimensions, including fundraising, resource allocation, P&L management, financial communication, profit distribution, and acquisitions. I also tried to devise what lessons could be drawn for non-tech companies.
Amazon was mentioned many times, as it is my favorite example when it comes to explaining the digital economy to a skeptical audience. A key feature of Amazon’s business model is how it uses its cash flow to finance its radical innovation, which in turn enables Amazon to keep on growing and to generate even more cash flow. The graph below is an attempt at explaining it all (this is a new one—feedback welcome).
This is the point that provoked the most pushback. How can Amazon generate such a high level of cash flow? Well, it’s because of their negative cash conversion cycle and their impressive growth. And won’t Amazon be forced to slow its growth at some point? Well, maybe, but it will be a mortal danger for a company that literally feeds on growth.
The resulting discussions on Amazon, its growth, and its cash flow made me even more comfortable in putting forward the following ideas.
Amazon’s cash flow is a byproduct of its exponential growth. If Amazon stops growing at the current exponential rate, it ultimately dies. This point has been made in this highly-recommended paper by McKinsey & Company: “Grow Fast or Die Slow”. It has also been discussed by Timothy Green in an article in which he criticizes Amazon’s dependance on growth-induced cash flow, pointing out that “this extra cash flow is a good thing, but it’s not sustainable. It exists only as long as Amazon keeps growing.”
Interestingly enough, Green quotes Warren Buffett on this. I have the utmost respect for Warren Buffett, who was a major inspiration when we founded The Family three years ago. Buffett made his fortune investing mostly in mature businesses with high profit margins (insurance, tobacco). In his own words 30 years ago, cash flow numbers are meaningless because they miss the need for assets “to be replaced, improved or refurbished”. But in fact, they mean a lot in the digital economy because they reveal the capacity of a tech company to finance the continuous reinvention of its business model and thus signal what really counts in this new world: perpetual growth. High-rate growth is a permanent feature of tech companies’ business model.
The way we think about business has been distorted by the legacy of the Fordist economy. We see growth as a transitory state, and plateau (and high profit margins) as a perennial state for most companies. In this paradigm, the challenge that a corporation has to tackle on the long term is, to quote Warren Buffett again, “to hold their ground in terms of both unit volume and competitive position.” Yet in the digital economy, reaching a plateau (= ceasing to grow) and focusing solely on holding ground essentially equals death, however slow it may be. This is what Dion Hinchcliffe dubs the “Red Queen Hypothesis”.
Hence the fact that growth tends to become a perpetual state in the digital economy, with its frightening corollary: constant reinvention of the company’s business model, and cash flow to finance that effort. When their initial market is not large enough to enable further growth, tech companies have to reinvent themselves and to explore new markets. This is why, following The Economist, giant tech companies are “at each other’s throat in all sorts of way.” Cash flow, innovation, business model reinvention are critical inputs for any tech company, but growth is actually the key outcome.
We’ve been taught to think that corporations last forever—even if they never actually did. In the current failure age, we have to accept that corporations are indeed mortal, and that the key to any tech company’s survival is growth fueled by radical innovation and cash flow. When that kind of growth, not resilience and margin consolidation, becomes the top strategic priority, the innovation killers that have been deployed for decades by corporate CFOs cannot be tolerated anymore. No wonder why corporate finance, too, has to go through radical change!
(While “The Family Papers” series is made of long-form stories, this “The Family Notes” series presents shorter reactions and highlights related to current events. Thanks to Gregory Edberg, Kyle Hall, and Marc Nardo.)
