Does your company pass the Turing Start-Up Test?
Feb 01, 2022Alan Turing’s portrait now adorns the £50 note. This is a welcome and long overdue acknowledgement of his many achievements, from helping crack the enigma code at Bletchley Park during the Second World War, through to his revolutionary work on computing. It’s shame that it is the £50 note as these notes are rare, and we seem to be taking giant strides towards becoming a cashless society. Only 23% of payments in 2019 were made using cash, a 60% decline over the previous decade. Covid has further accelerated this trend, with ATM withdrawals down by up to 81%. As retailers and small businesses have quickly adopted e-payment technologies, it is unlikely this trend will reverse any time soon.
One of Alan Turing’s most interest contributions to computer science was the Turing Test of artificial intelligence. This posited that a computer can only be held to be intelligent if it can convince a human that it wasn’t a machine. The test mechanic is a human questioner sits in another room asking questions on a terminal. They know that these questions will be answered both by a computer and another human. At the end of the test, they have to say, based only on the answers they have read, which respondent was human. The test is passed if a human mistakes the computer more than 30% of the time, following a series of five-minute keyboard conversations.
Although the Turing Test has limitations (why should machines think and reply exactly like humans?), passing it has become the holy grail for AI engineers. No one has achieved it yet. In 2014 a programme called Eugene Goostman came close, when it fooled one out of three judges with a chatbot simulating a 13-year-old boy from Ukraine. In 2018, Google Duplex voice AI booked a hairdresser appointment without the caller realising they were talking to a machine. Neither met the full test criteria. You sense it won’t be long before a computer does.
How about our own thought experiment: if Alan Turing were alive today, what would be the Turing Test for start-ups? What would start-ups have to do to convince themselves that they were viable, or investors that they were worth a punt?
It would have to be simple and elegant. For all the complexity of the mechanic, the test for artificial intelligence is simple in conception: to be seen to be human you must communicate like a human. It was called the ‘imitation game’.
The answer to this is the £50 note. Cash. Start-ups can pass the Turing Test when they can prove to themselves (or others) that they can make cash. Since start-ups are neo-businesses, they must prove that they can imitate successful businesses. The principal measure of this, is generating cash.
Investors want to know that a start-up will have a way of making money in the end. Generating cash, or what is called free cash flow (FCF), is the best measure of this. It is one of the most common terms used in valuation circles. But it is also a concept that many Founders are less familiar with, compared to revenue, gross margin, profit or the arcane EBITDA. Let’s walk you through it.
FCF measures how much cash is generated by a business after capital expenses such as buildings and equipment have been paid for. It is the amount of cash you have generated that you can reuse. FCF is thus similar to retained earnings, although retained earnings are calculated on an accrual basis, whereas FCF is calculated on a cash basis.
You can use FCF for reinvesting in business expansion, paying down debt, or paying additional dividends to shareholders. If you have a small business, then there is no discernible benefit to calculating free cash flow. Just stick to the bookkeeping basics. If you manufacture or distribute products, measuring FCF is important, because there will be a lot of cash volatility in your business. Once your business is growing, and in particular once it is scaling, FCF becomes relevant for all businesses:
FCF provides your business with growth opportunities. If you’re looking to expand operations or even invest in another business, FCF facilitates this. It can also provide you with the means to add additional locations, expand your current operation, or recruit more staff. Also, the more FCF, the less you need to raise from external investors, which always comes at the cost of diluting your own equity.
FCF plays a key role in attracting investors. FCF shows exactly how much cash a company currently has to use and expects to generate. Investors are going to be drawn to a companies that have greater abilities to pay down debt, buy back stock, or pay dividends. FCF is a great indication of future potential earnings, so it forms the basis of many of their investment calculations, such as IRR (the internal rate of return) and any DCF (discounted cash flow) valuation. The greater the FCF, the more attractive the investment opportunity.
FCF also provides a definitive measure of financial and overall business health. Consistent FCF shows that a business is stable and will remain in business. Remember, businesses only fail when they run out of cash. FCF growth is the surest sign that the business model is working, and the business has not just the potential to scale, but some money to help finance it.
How do you calculate free cash flow?
Your company’s financial reporting should already include a statement of cash flows. There are several methods for calculating FCF, but the most common method is also the easiest calculation:
Cash flow from operations - capital expenditures = free cash flow.
It is the money you are generating after paying all business expenses, less the money you are investing (CAPEX). As an example. Bertie owns a small business that manufactures high end chopsticks. For the financial year 2019, Bertie reported operating cash flow of $774,000 on his annual cash flow statement. In that same period of time, Bertie also spent $295,000 on two new machines for the business. Hence, FCF = $774,000 - $295,000 = $479,000. That means that Bertie has $479,000 in FCF that can be used in his business.
So to know your FCF, you also need to know your CAPEX. This is investment in fixed assets, like machinery, technology or real estate. Typically, because FCF can be volatile, you'll find that it's best to measure and monitor over a period of a few years rather than a single year or quarter. Investors will use a 3 to 5 year FCF forecast.
What is your FCF is negative? If you are a start-up, this is fine. Just as investors want to know that you can eventually generate cash, they certainly don’t expect you to be generating much cash early. They care far more about growth, as this is the measure that you have built something of value that people care about. As Paul Graham says, business models can come later. Clubhouse hasn’t even started to work out its monetisation model yet and is still worth $4bn, because people love it and they have generated fast growth. Investors, as a rule, want to invest in fast growth in the early stages, as they know that this should yield FCF returns later. And growth costs money, driving up operating costs and reducing FCF. This is the reason why most start-ups seek investment: to help them accelerate their growth beyond the limits of their FCF.
If you are a more mature or established business, then still don’t panic. Just about every growing business has faced this scenario. If this is a short period because of exceptional costs, such as the need to invest in growth, then this is not something to worry about, providing you have enough working capital. But consistent low or negative FCF indicates that your business is not performing or losing money. You should look at your business model and restructuring costs to get on to a better path.
So get your calculator out and see if your business passes the Turing Start-Up Test. When you have the numbers, divide them by 50, and you will know how many of those delightful £50 notes you have to reinvest in future success…
UP AND TO THE RIGHT.
Further reading:
https://www.bankofengland.co.uk/quarterly-bulletin/2020/2020-q4/cash-in-the-time-of-covid
