I was reading Danielle Morrill's blog post today on whether one's "Startup Burn Rate is Normal." I highly recommend reading it. I love how transparently Danielle lives her startup (and encourages others to join in) because it provides much needed transparency to other startups.
Danielle goes through some commentary from Bill Gurley, Fred Wilson and Marc Andreessen about burn rate and then goes on to discuss her own burn rate and others publicly weigh in.
But what IS the right amount of burn for a company? Turns out like most things there are no simple answers. Let's set up a framework. Here's overall what you need to know.
1. Gross Burn vs. Net Burn
Burn rate in case you don't know is the amount of money a company is either spending (gross) or losing (net) per month. (It is also the title of a fabulous book from Internet 1.0 by Michael Woolf that is worth any startup founder reading to get a sense of the reality warp that is startup world during a frothy market such as 1997-1999, 2005-2007 or 2012-2014. I also highly recommend Boo Hoo by Ernst Malmsten, which is a similar story but told from a European startup. It's equally brilliant in its insightfulness, mockery and perspective setting of just how crazy times are again).
Gross burn is the total amount of money you are spending per month. Net burn is the amount of money you are losing per month. So if your costs are $500,000 per month and you have $350,000 per month in revenue then your net burn (500-350) is equal to $150,000. The reason that most investors quickly zero in on net burn is that if you have $3 million in your bank account and have a net burn of $150,000 per month you have more than 18 months of cash left provided your net burn stays constant. Conversely, if you're burning $600,000 per month (yes, some companies do) then you only have 5 months of cash left.
It's what signals to existing investors how quickly their teams need to be fund raising and the level of risk the company is facing. It also signals to potentially new investors both how quickly you need to raise (i.e. you have less leverage if you're in a rush) as well as how much cash you'll need if they fund you.
I often see companies burning $100,000 per month (net) looking to raise $6-8 million. My first question is, "If you're only burning $100k per month why on Earth would you raise so much money now?" Whatever answers they have manufactured the only thing I hear is, "Because we can."
By the way, "because we can" doesn't always mean you should. There are many times when being overly capitalized before you're ready is a negative.
At a minimum I encourage you to spend some time preparing for that question, which phrased another way is, "What do you plan to do with $6-8 million when you raise it?" The following are not really acceptable answers to potential investors (all of which I hear often):
- We're going to ramp up the team (with no detailed explanation of how and whom).
- We're going to start aggressively spending money on marketing our product.
- We want a strong balance sheet. (Um, ok. but that's our firm's money on your balance sheet. if you have a good use for it and we're excited about your company--fine. otherwise I prefer to invest less and risk less.)
- We want money to make some acquisitions. (Investors would prefer to fund M&A if they know specific deals--not to encourage bad behavior. Plus, most early-stage M&A fails so this isn't likely a good use of capital for a young company.)
But while Net Burn is the more critical figure at first blush and what most investors will focus on, Gross Burn is not irrelevant. In a world where the economy only heads in one direction (read: 2009-2014) most investors and entrepreneurs forget to pay attention to gross burn. But those of us with longer memories remember that the revenue line can move south very quickly when the market overall turns south. You are particularly vulnerable if:
- You have revenue concentration (few customers each providing a large total of percentage of your revenue).
- You have a large number of startup customers (because when markets crash they have a funny way of going bankrupt quickly or cutting burn precipitously).
- You are reliant upon ad revenue (this is a variable spend which corrects quickly during a market correction).
- You are discretionary spend (aspirin) versus necessary spend (prescription medicine).
This is why investors really like SaaS software companies where you have recurring revenue and your largest customer accounts for less than five percent of your revenue and your renewals rates are greater than 90 percent. That is why these businesses are often valued more highly than other types of businesses.
2. Growth vs. Profitability
The answer is more complex than just Gross vs. Net Burn. I have long tried to raise awareness of the trade-off between growth and profits as outlined in this much read blog post on the topic (and please forward to your favorite journalist who often simply report that companies that aren't profitable are bad).
In that article I linked to I outline the difference between gross margin and net margin. Gross margin (GM) is the amount of profit you make per sale of your product or service taking into account your total costs of selling that product or service. If you have a very low gross margin (10-30 percent) it can be very hard to build a large, scalable business because you need to make a lot of sales to cover your operating costs. Some industries work well with players who have low gross margins but these tend to be industries with very large, well-established players and hard for new entrants to compete. In startup world low GM almost always equals death, which is why many Internet retailers have failed or are failing (many operated at 35 percent gross margins).
Many software companies have greater than 80 percent gross margins which is why they are more valuable than say traditional retailers or consumer product companies. But software companies often take longer to scale top-line revenue than retailers so it takes a while to cover your nut. It's why some journalists enthusiastically declare, "Company X is doing $20 million in revenue" (when said company might be just selling somebody else's physical product) and think that is necessarily good while in fact that might be much worse than a company doing $5 million in sales (but who might be selling software whose sales are extremely profitable).
But the biggest thing to know is this: companies who are scaling quickly in revenue and with a high gross margin often should invest as much capital in growth as they can manage responsibly because when you find a product/market fit, and your company is growing at a very fast scale you want to capture market share before competition sets in. Think DropBox, Airbnb, Uber, Maker Studios. Your goal is to invest in engineering (to maintain your product lead), new offices and locations (to capture markets before others), marketing (to capture consumer attention before others do) ... all of these activities consume cash often in advance of the revenue they generate.
For more than two years I had to listen to market pundits talking about Maker Studios "losing so much money" while we were growing greater than 200 percent per year compounded.
But this strategy great depends on point three.
3. Availability of Capital
The simple truth is that there is no one answer to the question "How much should a startup burn?" And thus the advice that Danielle gives in her post (which is very valuable if you're at her stage and have raised capital in they way she has) is really: "How much should a startup without a strong VC lead and without a strong balance sheet (read: not a lot of cash in the bank) burn?"
In these kinds of businesses I'm on the record as advising "Ring the Freakin Cash Register." Stay lean and only raise a big round if you DO find product/market fit and which point you want to loosen the belt quickly and raise the capital to do so.
If you have strong VC support now and a lot of cash in the bank you may be willing to accept a higher burn rate (say $300k or $400k per month) than a company with angel money and less cash in the bank. If you're growing very, very fast and you've raised $40 million it is not crazy to think you might burn net $1 million/month (more than three years of cash remaining) providing you are growing fast enough to justify burning $12 million/year.
Your value creation must be at least 3 times the amount of cash your burning or you're wasting investor value. Think: If you raise $10 million at a $30 million pre ($40 million post) that investor needs you to exist for at least $120 million (3x) to hit his or her MINIMUM return target his or her investor's are expecting. So money spent should add equity value or create IP that eventually will.
If you have a strong relationship with your investors, if you have a strong balance sheet (lots of cash), if you have a business that is growing nicely and if your performance is super strong, and you, therefore, believe you can raise more capital quite easily then you simply can tolerate a higher burn rate than somebody who can't tick off all of these boxes. Of course a lot of this also comes down to investor trust. The more you burn the higher your investor's leverage relative to you is if you start to run out of money and don't have options.
I wanted to call out special attention to valuation in this debate. I have long advised startup companies to "raise capital at the top end of normal." By that I mean it's OK for founders to want to raise at a high price (and thus minimize dilution), but if your valuation is completely out of whack with your underlying performance and if you ever need to raise more capital it becomes VERY difficult to raise more cash. Simply put--down rounds are very hard to achieve psychologically because insiders fight against them (rightly or wrongly) and outsiders have a mental gap that if your valuation is going down your company is forked up and they often just pass.
So a large part of your personal assessment on how much you can afford to burn also has to be your current valuation. If you were able to raise at a $50 million post-money valuation and have $2 million in the bank and the markets turn you better be sure that your valuation warrants raising at at least $50 million even in a tough market or I'd be more cautious about a higher burn. If you're raised at more than $250 million valuation, be even more cautious.
A Framework to Guide You:
So putting it all together, you should always be mindful of your personal circumstances and market conditions. There is no "right" amount of burn.
Pay close attention to your runway.
Be careful about ever dipping below six months of cash in the bank. Take cash balance plus the net of your receivables and payables to get "net cash." Divide net cash by your monthly net burn rate as an approximation of how many months of cash you have. You really need to subtract the final month. It's like when the red light comes on in your car. You technically have more gas left but you never know if some unexpected circumstance causes you to run out of gas. And you risk "trading while insolvent" which has legal implications.
Understand how venture debt might shorten your projections.
If you have raised venture debt you might have even less time. Many venture debt lines have "covenants" that restrict you from going below a certain amount of cash in the bank (in normal times they are more common--in better times they are less common). Obviously if you have venture debt your runway would be longer provided you haven't called it yet while if you have spent the venture debt you have a much bigger obligation as cash winds down.
Please also note that many VCs will feel very uncomfortable with you spending venture debt towards the end of your cash balance unless they have already decided they would be willing to bridge you. The reason is that no VC wants to see the venture debt provider get burned if you become bankrupt. So while the VC might not have a financial obligation to cover the debt lost they would feel a moral obligation and/or recognize that if they do allow the less then their next company might not be able to raise venture debt.
In short--it's complicated and make sure you talk openly with your investors about how they feel. I have been relatively supportive of the companies I invested in taking venture debt (on a case-by-case basis) while other people feel less comfortable. Best to make sure you're aligned closely with your investor on this topic.
If Pre-VC be mindful that in tough times capital can take longer to raise.
If you have raised a limited amount of money from angels, accelerators or seed funds be very careful about having a high burn rate. I am not suggesting these are bad sources of capital--they are not. I am simply saying that these sources of capital often have a harder time bridging you quickly or writing larger checks if / when you run out of cash and especially in hard times. They tend to have many more investments than a concentrated VC and thus can't cover all their bets as easily. On the other hand, exits at lower prices are easier with these providers of capital.
If you have raised VC make sure you have open communications on funding and plan with your VC the right level of burn and runway.
If you have raised venture capital and you feel your runway (number of months cash left) is looking low have a conversation with your VC. Would they be willing to put a bridge loan in place if need be? Do they think you ought to be cutting back on expenses to give you a longer runway to raise cash? Ask other portfolio companies how your VC acted when / if they got in a cash pinch. Better that you know early.
If you truly are a "growth company" and well positioned then go for it. Just make sure you're still able to pull the rip cord if need be.
If you have a large amount of cash in the bank + an untapped credit line + a rapidly growing revenue line + large, supportive VCs + a reasonable valuation then you may consider keeping burn rate slightly higher than you might normally as a way of expanding your business while your competitors can't due to cash limitations. I call this using your balance sheet as a strategic weapon.
Just know the game you're playing. Know that if market conditions change you may have to scale back quickly, too. If your costs are mostly variable (ie can be lowered quickly) then you can assume more risks. If your costs are largely fixed (equipment, offices, inventory) then be extra careful. High fixed costs + high debt rates killed many great companies in Dot Com 1.0.
This article was originally published on Mark Suster's blog, Both Sides of the Table.