The Number One Bankruptcy Cause All Ventures Want to Avoid (and How to Fix It)
Sure-fire formula to hell: negative free cash flow and huge debt
No entrepreneur starts a business dreaming of bankruptcy. Yet, many fall into a deadly financial trap that can quickly destroy even the most promising venture. The recipe for financial disaster? A toxic combination of massive debt and negative free cash flow.
Free cash flow (FCF) is calculated by subtracting capital expenditure from operating cash flow. Capital expenditure includes fixed asset purchases like equipment needed to maintain operations. FCF represents the remaining cash that can be used at your discretion. Crucially, FCF is typically the only source available to pay off debt.
When your free cash flow turns negative, you’ve essentially run out of financial oxygen. No cash resources mean no way to service your debt, and that spells the end of your business.
The most common yet dangerous scenario
The most dangerous scenario occurs when companies accumulate significant debt by acquiring loss-making businesses. Our case study: SFX Entertainment, Inc., an EDM (Electronic Dance Music) live event hosting company that perfectly illustrates this financial cautionary tale.
Founded in 2012 and going public in 2013, SFX Entertainment crashed into bankruptcy by 2016, victim to a classic startup mistake. The company was riding the wave of the EDM boom in the early 2010s, aggressively acquiring events and increasing sales. However, their growth strategy was fundamentally flawed.
They spent enormous amounts acquiring events, financing these purchases with substantial debt because they had no accumulated cash from free cash flow. While sales increased quickly, losses continued to mount, and the acquired events generated no profit or positive cash flow.
This reflects a typical venture business mindset: the belief that increasing sales will automatically resolve all financial challenges. Investors might be misled by the rapid sales growth, seeing it as a promising trajectory and continuing to invest more in the company, despite the lack of profitability.
Or they believe that by increasing sales, economies of scale will kick in, ultimately making the business profitable by reducing costs. However, this assumption falls apart when examining the business’s cost structure—in this case, economies of scale simply do not apply.
When it comes to concert events, the total cost rate remains unchanged even as sales increase. If a single concert event is unprofitable, hosting more concerts will only amplify your losses. Each event is essentially independent. If you can’t make one event profitable, you can’t make the entire business profitable.
Even when you expand and increase event capacity, associated costs rise proportionally:
- Venue rental fees increase
- Staffing costs grow
- Artists demand a fixed percentage of profits
The mathematics of their business model was brutally simple: more events meant more losses. Despite rapid growth and increasing sales, the company was digging a deeper financial hole with every concert.
Ultimately, the inevitable cash crunch led to bankruptcy, serving as a stark warning to other entrepreneurs about the dangers of debt-fueled, unprofitable expansion.
How to Avoid the Trap
1. Ensure Profitability for Each Business Unit
When analyzing a company’s financial health, pay close attention to its Profit and Loss (P&L) statement. In SFX’s case, critical red flags stood out: excessive selling, general, and administrative (SGA) expenses and an bloated workforce.
A key metric to evaluate operational efficiency is sales per employee. In 2014, SFX’s main competitor, Live Nation, achieved $869,000 in sales per employee. In contrast, SFX managed only $566,000 – a stark indicator of inefficiency. This suggests that many employees were not contributing meaningfully to the company’s revenue.
Venture businesses with initial momentum often become dangerously complacent about costs. They convince themselves that hiring excess employees is acceptable because they anticipate rapid business expansion. Leadership rationalizes that these ‘extra’ employees will become crucial as the business grows. They create a speculative narrative: ‘We’re hiring ahead of our growth curve. These employees will be essential when we scale up’.
This thinking leads to consistently overstaffing operations, creating excessive costs that inevitably result in financial losses.
And the harsh reality is simple: if you can’t generate profit now, increasing sales tenfold won’t magically solve your problems in businesses where economies of scale don’t apply. Hiring more people to support unprofitable sales is a road to financial ruin.
Here are solutions to address this:
ⅰ. Cut Out Unprofitable Businesses
Do not acquire businesses that don’t generate cash flow or make a profit. If you have such a business, close it. Downsize your operations, narrowing down to only profitable ventures. This will leave some employees nothing to do because you’ve cut out the loss-making business units, allowing you to fire them and reduce salary costs.
ⅱ. Strategic Hiring Practices
Only hire new employees when they are 200% necessary. Don’t settle for 80% or even 100% necessity. I mean entrepreneurs often panic about future capacity and hire prematurely. This situation is called hiring them for 80% necessity. You should handle most tasks yourself as much as you can. Only hire when you’re absolutely certain the new employee will generate cash flow far exceeding their salary—that’s the 200% necessity benchmark. Simply supporting existing unprofitable sales (which might seem like 100% necessity) is not a valid reason to hire. Cut the loss making business operations first.
ⅲ. How to know which events are profitable beforehand?
They had more than 800 events in 2013, which is a sufficient data point. They should have analyzed the data to identify the characteristics of profitable events, and then only host events that match those profitable characteristics.
2. Avoid Buying Unproven Businesses with Debt
This approach is dangerous, quickly leading to negative free cash flow and massive debt. Instead, seek out established businesses with predictable future cash flow that well exceeds investment, and buy them at the lowest price possible.
If you must invest in an unproven business, use accumulated cash from existing cash flow. Even if the new venture fails to generate cash flow, staying debt-free improves your survival chances.