The Importance of Building Companies with a Long-Term Focus on Free Cash Flow
“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.” - Jeff Bezos, Founder & CEO of Amazon
When thinking about building companies and making investment decisions, I always go back to Jeff Bezos who is one of the strongest long-term thinkers and company builders / investors that we have in the 21st century. The above quote from Bezos says it all. Bezos is great at creating strong mental models that enable himself and other Amazon employees to quickly determine the right decision to make. [Side note: One of my favorite Bezos mental models is the Regret Minimization Framework which led to his decision to leave his high-paying hedge fund job and start Amazon]. Amazon’s mission is to be “Earth’s must customer-centric company” and the company will always maximize long-term absolute dollar free cash flow per share. For more great quotes from Bezos and learnings from them, I suggest reading Tren Griffin’s post about “A Dozen Things I Have Learned from Jeff Bezos”.
Why is Bezos so adamant of maximizing absolute dollar free cash flow and why is this relevant to startup founders across all stages? The reason is that for-profit companies are valued on their ability to generate free cash flow in the future. Absolute dollar free cash flow matters more than % free cash flow as it directly correlates to the amount of capital available to reinvest back into the business. As long as the business can expect operating leverage and high returns on capital, the more absolute dollars that can be reinvested in the business, the better. Stock prices even at the early-stage are based on the ability of the company to generate free cash flow in the future and discounting those cash flows back to arrive at a valuation. In recent years, this has not necessarily been the case with deep tech startups that have intrinsic value through the specialized knowledge that the team holds (security, machine learning, etc are areas where specialized knowledge has been purchased rather than “grown”). However, for other industries, this is the math that buyers are doing.
What’s so powerful about this Bezos mental model is the ability to drive rapid decision making at Amazon. If the team is approached with an idea for a new product line or business line, everyone is able to evaluate it on the premise of will this improve absolute dollar free cash flow and is it customer-centric. This mindset permeates the organization and allows everyone to know where they should stand on the decision and what the correct criteria is to evaluate the decision.
Maximizing absolute dollar free cash flow means not just focusing on big revenue deals but focusing on efficiency and customer / user loyalty. This is a key advantage when building companies. Essentially it encompasses the unit economics of the business without using that direct terminology. Yes, gross margins are important, but a large deal that is lower gross margin is still good for the business if the long-term prospects of that deal are greater. So for example, a large enterprise may expect a pricing discount to purchase a 3-year contract. This discount combined with the lengthy sales cycle and large upfront S&M cost may look like a poor decision. However, the key variable here is lifetime value or how loyal will that customer be. If the product has been thoroughly vetted and will be integrated into that enterprise’s various systems, it is likely that the customer will be purchasing the product repeatedly for awhile which maximizes the absolute dollar free cash flow even if the gross margin looks weak.
Another important point to this is infrastructure. Companies are constantly making the tradeoff between growing and improving efficiency. However, there may be tweaks below the surface that could increase customer loyalty and be beneficial for the long-term business even if it doesn’t necessarily increase efficiency (commonly measured by CAC ratios, magic numbers, and margins). Growth and high gross margins are what VCs and investors like to see as it makes it easier in the short term to estimate potential future free cash flow. However, improper infrastructure may damage long-term absolute dollar free cash flow by turning off users / customers from a product even though it may result in lower gross margins or operating margins in the short-term. In Reid Hoffman’s Master of Scale podcast, he talks with Mark Zuckerberg about the early days of scaling Facebook. Facebook has a storied mantra of “Move Fast and Break Things” which again is another mental model to encompass test rapidly and innovate above all else. What Zuckerberg found as Facebook grew was that “breaking things” was not exactly conducive to long-term growth as it was damaging the user experience. He changed Facebook’s motto to “Move Fast with Stable Infrastructure” letting all the employees know that it was still good to rapidly test new products but they had to be able to run within the larger platform without causing issues (and hence detrimentally affecting the user experience).
This brings me to my larger point. As Founders & CEOs, some of the most important decisions made are centered around capital allocation and recruiting talent. Capital Allocation should stem from the mental model of maximizing absolute dollar free cash flow for the long-term which means focusing on customer loyalty and worrying less about near-term margins, but rather evaluating each decision on its eventual contribution to cash flow. This can help prevent the pitfall of startups growing too fast ahead of their infrastructure or growing rapidly without the right unit economics (which could manifest itself by growing ahead of the right team in place to ensure customers stay). In terms of recruiting talent, having strong mental models in place that focus on the long-term make it so that the team understands the necessary tradeoffs in business decisions and is able to focus on what they believe will increase the startups long-term value. It increases the velocity of decision-making and correspondingly can help the velocity of capital being reinvested in the business which directly correlates to higher future absolute dollar free cash flow.
I’ll leave you with this last quote from Bezos on the advantage of focusing on the long-term:
“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.”
It’s easy to say well large companies can do that because they have the luxury of having capital available. I would remind the reader that Amazon just 10 years ago was a much smaller company with huge capital constraints. Bezos’ focus on long-term absolute dollar free cash flow and the customer allowed Amazon to grow to its current scale. His capital allocation decisions always centered around improving the customer experience (or the customer LTV) and increasing free cash flow even at lower margins.
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