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Sequoia Capital is arguably one of the most famous VC firms in Silicon Valley with a historical investment portfolio that includes the likes of Apple, Cisco, Google, Instagram, LinkedIn, PayPal, WhatsApp, and Zoom to name a few.
They have released an incredible guide focused on the value of Free Cash Flow and the need to focus on it. This guide was built to share with founders in their portfolio companies but it's a great perspective for any CFO.
The environment of recent years has not rewarded a lot of thought around the path to free cash flow. The environment that we're heading into is going to demand it.
The premise of this guide is the acknowledgment that the economic winds have shifted from growth at any cost to a focus on profitability and Free Cash Flow.
Sequoia crowns Free Cash Flow as being the very definition of a great business: "Free cash flow defines a great business."
They caution start-up founders to think about how they can improve and/or generate Free Cash Flow. They refer to revenue as outside of the founder’s control and costs as within the founder’s control. You can only forecast revenue, but you can directly control costs.
"These are things that need to be baked into your product, your pricing, your packaging, and your distribution model. These things weren’t necessarily top of mind over the last years as we were operating in an environment of abundance. They should be top of mind as we head into an environment of scarcity."
They provide further advice on how to develop Atomic Units of Investing to develop Free Cash Flow. In their example, there are three units: The Customer is the baseline unit to capture Free Cash Flow. For smaller companies, all focus should be on ensuring that Client Acquisition Costs do not exceed Revenue at the client level. As clients become profitable and generate Free Cash Flow, they should roll up to an Operating Unit. The Operating Unit can be a region, product, or other logical grouping. The last step is to roll the Operating Units into the Company Unit. It’s at the Company Unit where Free Cash Flow is really secured.
Sequoia also cautions on how to think of an investment vs an expense: "The difference between an investment and an expense is that an expense yields no future benefit and investment yields a future benefit."
Sequoia provides an interesting take on the formula for building a great business. It begins with a story that must produce positive metrics which in turn can convert to financials. This combination will lead to the company's valuation.
Another interesting concept they address is Risk On and Risk Off. They use these terms to label investment environments. When times are good, VCs are more willing to take bets which results in Risk being On. Under this environment, companies can be funded simply based on the story or a dream of what it could become.
Sequoia cautions that we have entered a Risk Off environment where investments will be made in reality instead of dreams. During a Risk Off environment, the focus will be on the financials, and you guessed it - on Free Cash Flow.
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