What it means
Most established businesses are valued on their earnings, cash flow and assets. A speculative company often has little or no profit, so investors value it on the potential of a product, a discovery or a new market.
Typical features include limited revenue, heavy spending on research or exploration, a short operating history and the need to raise fresh money regularly. Progress is often judged by milestones such as test results, permits or customer signings rather than by profit.
Each milestone can lift or crush the share price within a single day. For investors, the risk and reward are both large.
A single success, such as a drug approval or a mineral find, can multiply the share price, but a failure can wipe out most of the value. Finance teams look closely at cash runway, which is how many months the company can operate before running out of money.
If the runway is short, the company must raise cash by selling new shares, which dilutes existing shareholders, or borrowing, which adds risk. For managers outside finance, the lesson is to be careful when dealing with such firms as customers or suppliers.
Contracts may need prepayment or guarantees, and deliveries should be tied to payment. Regulators often require clear warnings about the risks, and professional investors tend to limit exposure to a small part of a portfolio.
Anyone considering such a company should read its filings carefully, paying special attention to going concern warnings and the notes on funding.
In practice
Real-world examples.
Example
An exploration company holds licences for a promising copper site but has not yet found enough metal to mine. Its share price jumps 80% after early drill results, then halves when the next results disappoint. Investors who bought after the jump lost money even though the company survived.
Example
A start-up developing battery technology has a prototype but no sales. Its investors accept losses of several million dollars a year because the technology, if proven, could be worth hundreds of times the investment. The founders have been told that funding will stop if the next test is missed.
Example
A building supplier considers selling on credit to a young renewable energy firm with no profits. The credit manager asks for 50% payment upfront and the rest on delivery, because the customer's survival depends on raising new funding. If the firm fails, unpaid invoices would rank behind secured lenders.
Formula
Calculation
Cash runway (months) = cash on hand / monthly cash burn
A biotechnology company has $6,000,000 in cash and spends $500,000 a month on research and salaries. Runway = 6,000,000 / 500,000 = 12 months. If a key trial will take 18 months, the company is short by 6 months, and at the same burn it must raise another 6 x 500,000 = $3,000,000 or cut spending before the results arrive. The figure also shows investors how much new share issuance to expect.Case study
Seen in the real world.
Skyward Fuels is an illustrative, fictional company developing a new type of low-emission aviation fuel. Its founders were scientists with no commercial track record. It had no revenue, $9,000,000 in the bank and a monthly burn of $750,000.
The runway was 9,000,000 / 750,000 = 12 months. The finance director knew that the pilot plant would not be ready for 20 months, so she began talks with investors after only six months of runway had been used. Raising money early is easier than raising it when time is short.
The illustrative company raised $15,000,000 by issuing new shares at a lower price than before, which diluted existing holders but kept the plant on schedule. Shareholders accepted the dilution because the alternative was running out of cash before the technology could be proven. The new money extended the runway by 20 months at the same burn rate, long enough to reach the plant opening.
Watch out
Common mistakes.
- Valuing a speculative company with the same measures as a mature business, when it has little profit to measure.
- Ignoring cash runway and assuming the company can always raise more money, when funding can dry up quickly if markets turn.
- Putting too large a share of a portfolio into one speculative company because of a convincing story, when a good story is not evidence of future profit.
Questions
People also ask.
What makes a company speculative?
Its value depends on uncertain future events, such as a new product succeeding, rather than on steady current earnings.
Can speculative companies become safe investments?
Yes, if they prove their technology, build revenue and become profitable, but many do not reach that stage. Those that do often become far less volatile as results become more predictable.
How should a supplier deal with one?
Ask for prepayment, deposits or guarantees, limit credit, and monitor the company's cash position closely. Stop supplying if payments start to slip.
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