One of the hardest decisions entrepreneurs make when they start a company and raise outside capital is figuring out what an acceptable “burn rate” is. That is, how much should your company be willing to lose in cash every month as you make investments in staff and equipment that funds technology, sales, marketing and management.
Of course there is no right answer but it’s a function of how much capital you have raised, your prospects for raising more capital in the future, your growth rate and your company’s risk tolerance.
As a VC, burn rate is one of the most discussed topics I have with teams who are pitching me for raising capital and it is one of the most common discussions points I have with founders in companies that I’ve backed. So let me walk you through the discussion points I have with founders.
The starting point — the 101 — is knowing the difference between gross burn and net burn. Gross burn is your cost base and net burn is the difference between your revenue and costs. In short, it’s the amount of cash you’re burning every month (vs. GAAP Net Income, which at times isn’t a good reflection of cash burn).
The main reason to know your burn is to arrive at a quick calculation of how many months cash you have before you run out of cash. Usually when an investor is asking you your burn rate he or she is referring to net burn — what cash are you consuming.
Growth vs. Profits
Yesterday I wrote about the trade-off between growth and profits. I wasn’t advocating for any specific actions because sometimes the right action is for companies to accept short-term losses in exchange for faster growth and capturing market share and many times it makes sense to grow more pragmatically or even profitably.
In the article I made the point that VC investors seldom value profitability if it comes with slow growth so forcing yourself to be profitable is wise in three specific scenarios:
- You have a business that never wants to raise (more) venture capital
- You can be profitable and growing at a steady enough clip to attract (more) venture capital
- You don’t believe you can raise venture capital so your best strategy is to become profitable so you can “control your own destiny”
But a certain amount of burn rate in startups is often desirable if it comes with commensurate growth and if ones prospects for either raising capital or failing that cutting costs and hitting profitability seem achievable.
How Much Capital You Have Raised / Your Runway
In general I recommend that in early-stage startups you try to raise at least 15-18 months of runway.
In general you should allow yourself 4–6 months of time to fund raise (longer if you’re later stage and require a much bigger round) so calculating anticipated burn rate is pretty easy. You start from the basics, which is if you raise $2.5 million you should have a burn rate of about $140–165k / month on average. If your revenue grows you can afford to increase your cost base. If you burn $200k / month you’ll be out of cash in a year.
If you assume 4–6 months to raise your next round then with a year of runway you really only have 6–8 months to show progress on your previous round of financing, which is why I prefer an 18-month runway.
Equally, when a company that is burning $175,000 / month tells me they’re raising $10–15 million it sets off alarm bells because even if I assume you’ll double your burn rate it still implies 2.5–3.5 years of cash runway, which is too much for a startup.
So either you will massively increase your cost base (nobody ever seems to raise a big round and then still spend like you raised a small round) or you will have such a long runway that it takes the urgency out of your daily actions because you feel like you have tons of time to show progress.
I know as an entrepreneur you prefer as long of a runway as possible — I’ve never heard an entrepreneur argue for the opposite. But in my experience having a healthy tension of NEEDING to show progress / hit milestones has a forcing function of getting companies hyper-focused on results.
Your Prospect for Future Fund Raising
The simplest answer I give to companies in which I’m an investor in is that if your company is growing very fast and if your inbound interest in funding your company is sufficiently large then you “earn the right” to have a slightly higher burn rate. If at any point we have a hard fund raising event or a blip in our growth or a sense that perhaps our last round valuation may have been too high and we need time to “grow into our valuation” then I swing very quickly towards reducing burn.
Sometimes, of course, reducing burn means cutting costs which usually means cutting staff. Sometimes it means spending less on marketing or not adding new bodies so that revenue can catch up with expenses and thus reduce burn through revenue growth.
But here’s also a good rule of thumb for you. Understand your existing investor base very well and their ability to fund you internally if capital markets change or of the external markets simply aren’t able to fund you.
If a group of 3 VCs have each written $6 million into a company ($18 million total) and the company is showing strong prospects and good growth but isn’t an obvious “home run” success and external funding becomes hard then the question of internal financings may come up. If you are burning $250k / month then you need $3 million to fund a year or $4.5 million for 18 months. Each investor would need to write $1–1.5 million to “turn over more cards” and see if you make enough progress. This is just 16.67–25% of their initial check. Equally, an outside investor could fund you with a relatively small check of $3–5 million.
If on the other hand you let your burn rate go up to $600k / month now it’s $7.2 million for 12 months and nearly $11 million for 18. That’s $2.4–3.6 million per investor or 40–60% of their original investments.
In my experience often investors will try to preserve value in scenario 1 above and often won’t in scenario 2. So understanding whether the follow-on check would be a lot or a little for your existing investors is very important.
Your Company’s Risk Tolerance
Finally, I should mention that burn rate is also a function of “risk tolerance” or how willing you are to let your company hit a brick wall if you’re not able to raise.
Some teams are very conservative and would rather keep an artificially low burn rate and 2+ years cash to avoid that dreadful feeling of the ticking time bomb that is that “cash out” date. Others spend willfully at high levels and seeing rapid growth results and just assume it will all work out.
So burn rate at times comes down to one’s risk tolerance but you should also be mindful to check the risk tolerance of your existing shareholders before making final decisions yourself. After all, the results affect the ownership for all parties involved.
But Wait, There’s More …
If you want to read more on the topic of burn rate from me I’ve written about it before.
There also were excellent posts by other VCs this week on the topic including
- Fred Wilson — Should Your Company be Profitable
- Brad Feld — Lessons from the Internet Bubble and importantly The Rule of 40% for a SaaS Startup (this influenced my thinking a great deal)
Photo via Visual Hunt
(Cross-posted @ Both Sides of the Table)