I was reading Danielle Morrill’s blog post on whether one’s “Startup Burn Rate is Normal.” I highly recommend reading it. I love how transparently Danielle lives her startup (& encourages other 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 perspective on 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 and 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 and also it signals to potentially new investors both how quickly you need to raise (ie 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 / 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, that doesn’t always mean you should.
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):
- We’re going to ramp up the team (with no detailed explanation of how and whom)
- We’re going to start aggressively 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 & 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 < 5% of your revenue and your renewals rates are > 90%. That is why these businesses are often valued more highly than other types of businesses.
2. Growth vs. Profitability
But it turns out the answer is more complex than just Gross vs. Net Burn. I have long tried to raise awareness of the trade-off between growth & 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 this article I outline the difference between gross margin & net margin. Gross margin in 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%) 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. But some industries work well with players who have low gross margins. In startup world this almost always equals death which is why many Internet retailers have failed or are failing (many operated at 35% gross margins).
Many software companies have > 80% 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 to 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 / 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.
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: a lot of cash in the bank) burn.
If you have strong VC support 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 (> 3 years of cash remaining) providing you are growing fast enough to justify burning $12 million / year. Your value creation must be at least 3x the amount of cash your burning or you’re truly wasting money.
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.
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” and 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 $250 million+ valuation 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 every dipping below 6 months of cash in the bank. Take cash balance and net out receivables & 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.
Understand how venture debt might shorten your projections
* Note if you have raised venture debt you might have even less time. Most venture debt lines have “covenants” that restrict you from going below a certain amount of cash in the bank.
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 if / when you run out of cash.
If you have raised VC make sure you’re open & plan with your VC the right level of burn & 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?
If you truly are a “growth company” & 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.
(Cross-posted @ Both Sides of the Table)