How to Optimize Your Startup’s Burn Rate and Runway
Whether you’re a self-funded company or an venture-funded company, as you grow, you’ll be managing budgets that support 10, 20, 50, 100, 300, 500 full-time employees. You’ll always be recalculating your burn rate and identifying ways to minimize outgoing expenses and optimize runway. After all, the official cause of death of many startups is insufficient funds.
Before delving deeper into the subject matter, it’s important to first lay out the difference between ‘gross burn’ and ‘net burn’. A startup’s gross burn rate is the average amount of capital it spends (or ‘burns’) every month, regardless of the revenue it generates. Whereas a startup’s net burn rate is its monthly loss — the outgoing expenses minus the revenue generated.
Gross burn = average monthly expenses
If you spent $500,000 in one year, your gross burn would be $41,667.
Net burn = monthly expenses (gross burn rate) — monthly revenue
If your average monthly expenses totalled $41,667, but you were generating $25,000 in revenue per month, your net burn would be $16,667.
Burn rates are usually discussed in relation to venture-funded startups because after a significant capital raise, startups can lose sight of what’s necessary — i.e. what will maximize return on time, money and effort — and overspend on new resources.
Mark Suster, Partner at Upfront Ventures, points out in an article that large funding rounds don’t just lead to massive wage inflation and rent inflation, but can also inadvertently encourage ‘bad behavior’, especially if a competitor raises a significant amount of capital at the same time. In such circumstances, “the ‘winner-take-all’ mentality forces growth over margins”.
Put simply, it’s really hard to build a strong company when all of your competitors are giving away free shit fueled by venture capital chasing winner-take-all returns. — Mark Suster
That’s not to say that investors turn a blind eye to founders who spend excessively with no apparent strategy in place.
If a startup burns a large amount of capital, both gross and net, investors will get anxious and may start interfering. Why? They’re stuck with you.
As Fred Wilson, co-founder of Union Square Ventures, points out, “In public equity when you (as an investor) get nervous about a stock, you can usually sell the position and move on. In private equity, you are stuck with the investment.” Unlike banks, venture capitalists can’t come after you for your personal assets.
In 2014, a series of tweets by Bill Gurley, Partner at VC firm Benchmark, spawned a public discussion about startup burn rates, with many high-profile investors like Wilson, Marc Andreessen and Mark Suster weighing in on the matter. Most agreed with Gurley’s view that venture-funded startups are spending too much money — or at least, much more than they’re gaining from customers.
This trend isn’t unprecedented, however. Today, the software sector has an inherent trade-off of growth versus profitability.
Software-as-a-Service (SaaS) companies, in particular, face the unique challenge of having to spend all of their money on acquiring a customer before they can gain that cost back from the customer and make a profit. As such, a SaaS company’s initial burn rate could appear alarming.
Scott Kupor (Managing Partner at Andreessen Horowitz) and Preethi Kasireddy (Partner at Andreessen Horowitz) explain this in their article ‘Understanding SaaS: Why the Pundits Have It Wrong’:
Instead of purchasing a perpetual license to the software, the customer is signing up to use the software on an ongoing basis, via a service-based model — hence the term “software as a service”. Even though a customer typically signs a contract for 12–24 months, the company does not get to recognize those 12–24 months of fees as revenue up front. Rather, the accounting rules require that the company recognize revenue as the software service is delivered (so for a 12-month contract, revenue is recognized each month at 1/12 of the total contract value).
Yet the company incurred almost all its costs to be able to acquire that customer in the first place — sales and marketing, developing and maintaining the software, hosting infrastructure — up front. Many of these up-front expenses don’t get recognized over time in the income statement and therein lies the rub: The timing of revenue and expenses are misaligned. — Kupor & Kasireddy
Let’s say a SaaS company with seven full-time employees has a gross burn of $100,000 per month and has $5 million in the bank from a recent Series A round. That would mean the company has a runway or run rate of four years and two months at its current burn rate ($100,000 x 48 months = $4.8 million). That’s very good.
However, four years is a long time to expect the burn rate of any startup to be consistent. Along the way, the startup will be investing in more resources to help manage and accelerate growth. The burn rate may increase and the run rate may decrease (especially if there’s no incoming cash from customers), so continuously recalculating and restrategizing is a must.
How does burn rate apply to self-funded startups?
Borrowing from Bijoy Goswami’s definition of bootstrapping, Ash Maurya, creator of the Lean Canvas, says building a low-burn startup involves taking the right action at the right time.
At every stage of the startup, there are a set of actions that are ‘right’ for the startup, in that they maximize return on time, money and effort. A lean/bootstrapped entrepreneur ignores all else. (Ash Maurya, Running Lean, 2012 p. 173).
Although burn rates are discussed in relation to venture funded startups, it’s just as relevant to self-funded startups. It’s just that founders that are self-funding their business are forced to be resourceful — they have to find ways to minimize their burn rate because cash is a very limited resource.
If you’re an early-stage startup founder who has just launched a Minimum Viable Product (MVP) — that is, a product with just enough features to gather validated learning about customers and the product’s continued development — a handy metric to keep in mind is cash zero date, which is a rough calculation of the date you will run out of cash.
The following formula will allow you to measure this:
Current Date + (Cash in Bank at Current Date ÷ [Monthly Gross Burn Rate x 3] x 91 days) = Cash Zero Date
Example:
Tuesday, March 22 + ($500,000 ÷ [$25,000 x 3] x 91)
Tuesday, March 22 + ($500,000 ÷ $75,000 x 91)
Cash Zero Date = Tuesday, March 22 + 607 days
Cash Zero Date = Sunday, 19 November 2017 (calculated via TimeandDate.com)
It’s important to note that this formula does not take into account the revenue you might generate or the fact that you, as a startup, will experience extreme contraction and expansion throughout your lifecycle. It is, however, a good metric to keep in mind in case you need to raise capital externally, which can take four to six months.
Not too little, not too much. What burn rate is just right?
In 2011, Wilson published a blog post ‘Burn Rates: How Much?’ in which he suggests what the maximum burn rate should be for a startup:
A good rule of thumb is multiply the number of people on the team by $10k to get the monthly burn. That is not the number you pay an employee. That is the ‘fully burdened’ cost of a person including rent and other costs.
If a startup has five full-time employees and is spending $100,000 a month, then by Wilson’s formula, it is spending twice as much as it should.
Another rule of thumb is to spend less than 10 percent of your last capital raise per month. If you raised $1.5 million, then you should spend less than $150,000 per month. However, keep in mind that spending 10 percent would give you a runway of 10 months before you need to raise another round of funding. A more specific number would be 5 to 9 percent, depending on how significant the amount raised is.
In an Entrepreneur article, angel investor Martin Zwilling writes, “If your runway is less than a year, it’s time to either begin looking for a new cash infusion or defining and implementing a Plan B to assure survival. Your goal is that magical break even point and hockey-stick profit-growth curve. Raising money from professional investors, even friends and family, takes time. Count on six months from beginning the funding process until a new check is cashed.”
The truth is there is no exact formula that can be applied easily and universally to identify the ‘right’ burn rate, because not all burn is created equal. There are many variables that need to come into consideration such as opportunity costs, speed of growth and so forth.
Two companies with identical burn rates can be worlds apart in terms of their status in the market. Two companies with identical value propositions can have burn rates that are worlds apart.
Burn rates don’t take strategy and results into account.
Scott Nolan, Partner at Founders Fund, even thinks burn rate is a vanity metric. In a TechCruncharticle, he suggests we focus less on how much a startup is spending and more on what impact it’s having on execution. He adds burn rates should be broken down into ‘speed of execution’ and ‘efficiency of execution’ (see image above).
… burn rate says very little about whether a startup is on track. Only by evaluating a company’s use of cash and long-term strategy can high burn be diagnosed as good or bad. In many cases, the low burn ideal is actually dangerous.
At Founders Fund we avoid investing in companies unless they are consuming cash. We’re here to invest when doing so will bring about positive progress faster, which often manifests as the conversion of cash into assets and increased burn. Cash-flow-positive businesses are usually past this inflection point, or simply don’t have enough ideas about what valuable things to do with more money.
Suster thinks it’s impossible to know what the right burn rate is for a company without factoring in the founder’s risk tolerance — and that’s difficult enough to measure, let alone apply to the burn rate equation.
Quite simply — some people would rather “go hard” and accept the consequence of failure if they don’t succeed. Other people are more cautious and have a lot more at stake if the company doesn’t succeed (like maybe they put in their own money or their family’s money).
Some companies may be able to become “cockroaches” or “ramen profitable” but cutting costs and staff substantially and getting to a burn rate that last 2 years. But that could impact the future upside of the company. So you might have a company that is “medium valuable” in the long-run because with no capital it was hard to innovate and create a market leader. That’s ok for some entrepreneurs (and investor) and not for others. — Mark Suster
As vague as it sounds, it’s worth reiterating that optimizing burn rate is about taking the right action at the right time, to maximize return on time, money and effort.
When you’re a self-funded startup, you should only grow as fast as you can reasonably manage. It might mean you have to do some consulting that’s related to the industry your startup is operating in or that you have to license a piece of your technology or that you have to teach workshops in the evenings.
When you’re a venture-funded startup, you’ll be expected and encouraged to grow fast — at least 100 percent year-on-year — which means you’ll need to invest more heavily in things like sales and marketing.
But when money is core to the equation, you’ll always need to find a balance (or an appropriate middle ground) between growth and margins, even if that means resisting external pressures (to an extent).
If you’re too strict about how you spend, you won’t be able to exploit the opportunities you need to grow fast. After all, opportunities cost money’ and a startup’s high gross burn rate may be directly related to its ‘hockey stick growth’ (see image below). It’s also worth taking into account the cost of missed opportunities and slow growth. Will your startup survive the time it takes to achieve profitability if you’re not investing in growth?
This is not to say that you can throw money around like it’s an abundant resource. A nice quote to remember is one from the book Lean Thinking: Banish Waste and Create Wealth in Your Corporation:
Waste is any human activity which absorbs resources and creates no value. — Daniel T. Jones and James P. Womack.
Ask yourself: What value will your investment bring? How is it relevant to your short and long term goals as a company? How will you measure the return on your investment (ROI)?
How do you know when to invest in growth?
In theory, the answer is pretty simple. First and foremost, you need to find a strong product/market fit before you invest heavily in growth. You need to be able to prove that you have a product that fits the needs of the market.
Ask yourself: Does your product solve a significant-enough pain that customers are willing to pay for it? Or is your product is addictive enough that not using it triggers withdrawal?
In his book Hooked, Nir Eyal explains that products can become habits when associated with a particular trigger — e.g. boredom, loneliness — and how not using the product when the trigger is present creates a craving that turns into actual pain if it’s not satisfied. So even if you’re not solving a significant customer pain, you could still be introducing something valuable that fundamentally changes the way people live their lives for the better.
If you’re a SaaS company, metrics like monthly recurring revenue, churn rate, customer acquisition cost, customer lifetime value and so on, will help you decide when is the right time to scale your growth faster.
If you’re an aspiring SaaS company, you’ll need to measure usage and engagement, and have a strong sense of when you will be able to monetize your user base before you consider embarking on any aggressive marketing mission.
Your goal will always be to be as lean as possible.
How to optimize your burn rate
On burn rate optimization, consider the following:
- Spend no more than 5 percent of your budget on things outside of salaries.
You should not be spending more than 10 percent of your budget on anything outside of salaries, tax, equipment and rent. For example, if you have a $50,000 monthly budget, then you shouldn’t allocate more than $2,500 on search engine marketing or Facebook ads.
- Test marketing channels before investing heavily in marketing.
The best marketing channels for your startup are those that are the lowest-cost (i.e. has the lowest customer acquisition cost), attract the highest volume of users, and are the best performing (i.e. has the highest conversion rate). (Learn how to test channels here).
Keep in mind, your business model is working if your customer lifetime value is three times higher than your customer acquisition cost (CAC). You should also recover your CAC within one year to grow sustainably.
- Invest in people only if you need to.
People are your most expensive resource. You need to make sure you’re hiring new people because their expertise is a genuine need and will bring significant value to your business.
Ask yourself: What skills are missing in the business? What areas of the business are being overlooked or improperly cared for due to a skills shortage? Is it cheaper and more efficient to outsource that area of the business or to hire someone internally?
Don’t stockpile talent just to create a certain perception or to outhire your competitors. That’s just irresponsible — remember how that turned out for the now dead Clinkle?
- Don’t overestimate your market opportunity; dominate small markets first.
How big is the opportunity really? According to Startup Genome, an analysis of a dataset of 100,000 startups, premature scaling is the number one reason startups fail.
Many startups make the mistake of targeting the mainstream market too early in their lifecycle. They spend as if they’re chasing a multibillion dollar opportunity, when in fact it’s just a fraction of it.
I’ll demonstrate with an extreme example. Founder X wants to build the one-stop-shop for online shoppers. The global business-to-consumer (B2C) ecommerce industry generated around US$2 trillion in revenues last year. Founder X may see this as a multi-trillion dollar opportunity. But where should she focus her marketing efforts? While the internet allows startups to capture large markets fast, Founder X can’t expect to capture the entire internet. Even two percent of the trillion dollar pie is ambitious. She’ll have to do what Ruslan Kogan is doing with his ecommerce empire Kogan: expand from one niche to another.
That’s not to say that you, as a founder, can’t have a global mindset. But when you take a closer look at some of today’s most successful technology companies, you’ll realise that they grew by dominating small customer segments, one at a time. PayPal focused on eBay users before dominating the ecommerce world, Facebook targeted students at Harvard University before expanding to other colleges and user segments, and Airbnb launched in San Francisco before entering other cities.
This strategy not only allows you to test the market, but also grow at a rate you can manage.
- Grow at a rate you can manage.
What is a manageable growth rate? Perhaps the easiest way to figure this out is by calculating your run rate. At the current rate of expenditure, how long will you last with the money you have now?
If it’s less than 12 months, you’re spending too much on growth. Focus your efforts on improving gross margins.
- Shorten your cash conversion cycle.
In strong execution, every dollar counts. You want to have short cash conversion cycles — that is, every dollar dollar you spend should come back to you as quickly as possible — and reinvest that cash into the growth of the business.
Computer technology company Dell actually had a negative cash conversion cycle. It’s only after customers ordered and paid for Dell products online that the company would start working with vendors to build out the hardware. All payments were taken upfront. Professor John Mullins, who wrote The Customer-Funded Business: Start, Finance, Or Grow Your Company with Your Customers’ Cash, calls this the ‘scarcity model’.
Appster’s co-founder Josiah Humphrey and Mark McDonald are both proponents of the customer-funded business model. Josiah says this model can have a strong positive impact on your growth because you’re able to accelerate your cash conversion cycle. You’re able to invest the cash that customers have already paid upfront into sales, marketing and product development, rather than invest in inventory that’s going to sit on the shelves gathering dust and cobwebs until you sell it.
Even if you’re a SaaS company, you can encourage users to pay for the service for the year upfront by providing a discount (the ‘subscription’ model). This will also help reduce your drop-off rate.
- Form strategic partnerships.
Forming strategic partnerships isn’t easy, but is worth the effort if executed well. The process typically involves identifying where synergy is possible with other businesses, persuading those businesses of the value of a partnership, and executing a strategy where all parties benefit.
As an early-stage startup founder with limited reach, you can really benefit from leveraging the user base of more established businesses that have complementary products to you.
For example, if you sell kitchen knives online, you can partner with a company that sells electronic kitchen appliances and say “I’m going to pay you 20 percent of all profits I make from selling kitchen knives to your customer base.”
Or if you’ve built booking management software for hotels, you can leverage the user base of a site that sells flights and holiday packages, and offer some form of payment for every successful sign-up if it’s sustainable.
- Combine sales, marketing and product development in a singular function.
B2B startup sales consultant Whitney Sales says it’s not most effective to think of product development, sales and marketing as being on a linear timeline. Instead, they’re more like a Venn diagram with each element interacting with the others.
Many startups today are bringing product development, sales and marketing together in a singular function.
It’s a form of ‘growth hacking’ that effectively reduces the cost of acquiring a customer compared to, say, running campaigns externally (e.g. social media, public relations, SEO, SEM, etc.).
‘Growth hacking’ isn’t just a cool new word for marketing, despite what sceptics may have you believe. The term was coined by Sean Ellis, Founder of GrowthHackers.com, who defines a growth hacker as “a person whose true north is growth. Everything they do is scrutinized by its potential impact on scalable growth”.
Traditional marketers promote products after they’ve been built. The growth hacker’s job, on the other hand, is to find ways to adapt a product to fit the needs of the market to boost its adoption.
In essence, the growth hacker is a tech-savvy marketer who finds and leverages opportunities to help companies grow their customers/users — whether it’s through product tweaks like share buttons, distribution automation, influencer marketing, referral marketing or something else.
Investing in an expert growth hacker may be a good idea if you’re uncertain about how the intersection of product development, sales and marketing would work in practice.
- Use ‘future cash’ strategically today.
If applicable, you should negotiate with vendors to stretch the payables period. This would mean they deliver the services when you need it but you pay on net 30 or net 60 or net 90 day terms.
What this allows you to do, and admittedly it’s a very complex cycle, is invest the cash coming into your business on growth, instead of having to pay vendors right away. If you execute this well, you’ll be attracting new customers and generating more revenue before your invoices are due.
You can also give employees equity in lieu of a higher salaries in the early stages, then offer them a pay rise once the business can afford it.
- Know your break-even point and get to it if you have to.
Break-even is the point at which your startup’s revenue matches its expenses.
First of all, you’ll need to decide whether you’re willing to do what is required to get to your break-even point — this could be the only way to ensure your startup’s survival.
As a founder, you will have to decide what’s more prudent — growth or margins. You’ll have to carefully examine your essential and optional expenses and make some difficult decisions — like ramping down investment in product development or marketing, reducing your personal salary, firing people, moving to a cheaper city and overall working harder to improve gross margins. On the upside, profitability will allow you to invest in initiatives that eventuate in high growth — you might just need to shift your priorities in the mean time.
Also, try to eliminate one-off expenses as much as possible, and focus on variabilizing your fixed ongoing costs. Can you negotiate flexible software licenses? Can you use free tools and put your subscription to enterprise-grade software on hold? Tools like Google Docs, Slack, Mailchimp, Wave Accounting, Squarespace, Skype, and many more allow you to have an operating startup for free.
- Learn to love your numbers.
Always make business investment decisions based on how it will impact your cash flow. When you’re on top of your budget, balance sheet and burn rate, you will feel empowered. You’ll have a clearer mental picture of where you startup is headed and that’s what’s really exciting.
This article was originally published on AppsterHQ.com.
