Burn Rate 101 for Startups: A 15-Min Introduction

Originally published at http://www.appsterhq.com

More than 90% of all startups fail. Many studies suggest this high failure rate can be attributed to new companies’ inability to develop what Steve Blank calls “repeatable and scalable business models”.

In simple terms, startups close shop because they lack the economic resources to continue funding their operations, i.e., they run out of cash.

Founders must therefore continuously measure their business’ expenses and earnings. And maintaining sustainable cash flow requires understanding the key concepts of burn rate and runway.

In this article I’ll explain these and several related concepts in detail as well as outline various strategies for promoting long-term startup growth.

A Quick Word on Context

It’s important to recognize that a discussion of burn rate and runway is necessarily embedded in a larger discussion of the major concepts, strategies, and processes involved in making money as a startup.

Here at Appster we’ve written lots of detailed articles examining many different aspects of the relationship between money and growth.

Here are a few important dynamics to keep in mind whilst reading today’s piece:

  • Market dynamics ultimately determine whether you can generate enough money to scale your startup’s operations (see: 1, 2, 3, 4);
  • There are a number of tried and true monetization strategies that your startup should utilize where appropriate (see: here);
  • Make sure you take full advantage of viral marketing, including “viral loops” (see: here);
  • Startup equity is a tricky yet crucially important facet of making money as a startup (see: here);
  • There are various essential financial metrics that all startups should measure closely (see: here); and
  • Successful startups exploit cutting-edge business development strategies to the fullest (see: here).

Definitions: “Burn Rate” and “Runway”

Monetization”, i.e., transforming an asset or object into money or legal tender, resides at the core of all businesses.

If the amount of money that a business earns does not ultimately surpass the amount of cash that it spends (a state known as “positive cash flow”) then the business will inevitably become insolvent (see here).

Similarly, if the amount spent to procure a new customer (i.e., the “customer acquisition cost”) regularly far exceeds the value that new customer adds to your company (i.e., the “customer lifetime value”) then your startup will be unable to continue operations far into the future.

Positive and negative cash flow are aspects of your company’s “revenue model”, i.e., a framework for “how your business will earn income, produce profits and generate a higher than average return on investment.”

Burn and runway are also key components of your revenue model.

In a recent article, I provided the following basic description of these two concepts alongside a hypothetical example of how to calculate their values:

“Understanding your total cost is crucial because the amount of money your business spends impacts whether, and if so then when, you can turn a profit (and how much that profit will be).
Outgoing money (i.e., costs) also heavily influences the length of your startup runway, i.e., the amount of time for which your company can survive without bringing in stabilizing revenue.
You can calculate your runway by taking your cash balance, i.e., the amount of money that your startup has to fund burn, and dividing it by your burn rate, i.e., the monthly rate at which your business is losing money.
For instance:
Runway = cash balance of $125,000 ÷ burn rate of $25,000 per month
Runway = 5 months (until you run out of money)” (sources: 12).”

So, generally speaking, “burn” refers to the rate at which your company is losing money (i.e., spending cash that it does not recuperate) and “runway” — also known as “zero cash date” — is the length of time for which your business can operate assuming your current burn rate.

We can further clarify burn by distinguishing between:

  • gross burn” — i.e., the amount of capital you spend every month, regardless of the revenues you generate,
  • and “net burn” — i.e., the amount of expenses that remains after you’ve subtracted your revenue (i.e., your total loss once all incoming and outgoing money has been calculated).

Here’s an example:

  • If you spend $500,000 per year then your monthly gross burn (i.e., the total money spent) is $41,666.67: $500,000 ÷ 12 months = $41,666.67.
  • If you spend $500,000 per year but you generate $25,000 per month in revenue then your monthly net burn (i.e., the amount of money lost once earnings have been subtracted) is $16,666.67: $500,000 — ($25,000 x 12 months) ÷ 12 months = $16,666.67.

You can calculate your zero cash date, i.e., the approximate date on which your startup will run out of money and thus be unable to keep operating with your current expenses, by using the following formula:

Zero cash date = current date + (cash in bank at current date ÷ [monthly gross burn rate x 3] x 91 days)

For Example:

  • Zero cash date = Thursday September 7 2017 + ($500,000 ÷ [$25,000 x 3] x 91)
  • Zero cash date = Thursday September 7 2017 + ($500,000 ÷ $75,000 x 91)
  • Zero cash date = Thursday September 7 2017 + 607 days
  • Zero cash date = Tuesday May 7 2019 (sources: 1, 2).

It’s important to note that this formula does not take into consideration the revenue your company generates or the real possibility that your startup will experience significant contraction and expansion throughout its lifecycle.

With this caveat in mind, calculating your zero cash date is particularly useful when you’re trying to raise external capital (a process that sometimes requires 4–6 months’ time).

Continuously and accurately calculating your burn rate and runway figure is vital for at least 3 reasons:

  1. These numbers explicitly remind you that your startup will run out of money at some point in the future if you don’t eventually start generating sufficient revenue (i.e., achieving a positive cash flow state).
  2. These figures influence investors’ assessments of, and decisions regarding, your company.
“Investors look at a start-up company’s burn rate and measure it against future revenues of the company to decide if the company is a worthwhile investment. If the burn rate is greater than forecast or if the company’s revenues are not growing as rapidly as they are forecast to grow, then investors may think the company is not a good investment. It may be too risky [and so they might not invest their money.” — source

3. If these data indicate out-of-control spending then your investors are likely to experience anxiety, prompting them to interfere with your startup’s operations.

Fred Wilson, co-founder of Union Square Ventures, explains why this is so:

“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.”

In other words, because venture capitalists usually can’t hold you personally financially liable for founding a failed (or failing) startup, i.e., they typically cannot seize your personal assets, scary burn rate and runway numbers are likely to prompt them to take action to prevent the (further) loss of their investments.

Growth Versus Profit

As I’ve recently discussed, tech startups tend to have high upfront costs, which they attempt to recuperate at a later date by capitalizing on growth:

“Startups differ from SMBs small- and medium-sized businesses in the sense that small businesses usually need to generate profits as soon as possible in order to stay afloat whereas it’s basically taken for granted within the startup world that new companies must sacrifice profits in order to produce growth. Successful startups typically drop far down ‘into the red’ for quite some time before they then sharply turn ‘into the black’ and start generating significant revenues.”

In 2014, Bill Gurley, Partner at Benchmark, gave an interview to the Wall Street Journal in which he warned readers that Silicon Valley startups were taking on excessive risk by spending dangerously high amounts of cash.

Other influential leaders and investors, including Fred Wilson, Marc Andreessen, and Mark Suster, weighed in on the growing public discussion about startup burn rates.

Most seemed to agree with Gurley’s view that venture-funded startups are spending too much money — or at least much more than the amounts they’re earning as revenue from customers (sources: 1, 2, 3, 4).

Fast-Forward a few years later and the startup world is still actively debating ideal burn rates and the more general contest between growth and profits (examples: 1, 2, 3, 4, 5).

Today, the software sector in particular is witnessing a deep-seated trade-off between growth and profitability.

As a quick reminder:

  • Growth” refers to a state in which a company “adds resources or infrastructure to handle increased demand, at a cost that is more or less equivalent to the level of increased revenue coming in it’s strictly a measure of greater volume”; and
  • Profit” refers to “a financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity”.

Software-as-a-Service (SaaS) companies face the unique challenge of having to spend large amounts (perhaps all of their) money on acquiring customers before they can re-claim that cost in the form of revenues and thereby generate profits.

As such, a SaaS company’s initial burn rate might appear alarming to outside eyes (including those of investors).

Scott Kupor and Preethi Kasireddy, partners at Andreessen Horowitz, explain the dynamics behind these high burn rates quite well:

“Under a service-based model 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 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 is misaligned.”

As an example, a SaaS company with 7 full-time employees, a gross burn of $100,000 per month, and $5 million in the bank from a recent Series A fundraising round would have a runway of 4 years and 2 months at its current burn rate ($100,000 x 50 months = $5 million).

Hypothetically, this is quite an impressive runway: the company has more than 4 years to achieve growth and ultimately become profitable.

Realistically, however, it’s very unlikely that any given startup can maintain a consistent burn rate for 4+ years.

Why?

Because over the course of the next 50 months the company will almost certainly invest in additional resources and possibly even pivot in order to encourage, manage, and accelerate growth.

The burn rate, thus, might increase causing the runway to decrease (especially if there’s no incoming cash from paying customers).

Continuously calculating, re-calculating, and re-strategizing in terms of assessing burn rates and runways is virtually always necessary for any given startup.

Ash Maurya, creator of the Lean Canvas, contends that building a low-burn startup requires taking the right actions 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” (source).

Burn rates and runways are crucial for both venture-funded and bootstrapped startups.

Founders of self-funded companies must be especially resourceful and efficient: working with limited resources (time, money, connections, etc.), they should seek to minimize their burn rates whilst simultaneously committing to spending money on the right investments (in terms of marketing, employees, etc.).

For more information on running a lean startup, see here: 1, 2, 3, 4.

Ryan Holmes’ popular growth vs. profit infographic for startups:

If you’re looking for a more detailed examination of profit vs. growth then consider giving this article a read, which describes the increasingly popular “40% rule”.

What Is the “Right” Burn Rate?

In 2011, Fred Wilson suggested a basic formula for calculating (what he believes should be) the maximum burn rate for a startup:

“A good rule of thumb is to 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.”

Thus, if a startup has 5 full-time employees and is spending $100,000 per month then, by Wilson’s formula, the company is spending 2x as much as it should be (i.e., $50,000 vs. $100,000).

Another commonly accepted rule of thumb is to spend less than 10 percent of your most recent capital raise per month.

As an example, if you raised $1.5 million during your latest fundraising round then you should spend less than $150,000 per month on expenses.

In this scenario, it’s important to realize that such an amount would give your company only 10 months of runway before you’d need to raise another round of funding.

A slightly small figure, then, such as 5 to 9 percent, might be more appropriate (depending on how much money has been raised).

Indeed, angel investor Martin Zwilling stresses this very point:

“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.”

Insofar as not all burn is created equal, it’s impossible to follow an exact formula that can easily and universally identify the ‘right’ burn rates for all startups.

Two companies with identical burn rates can be “worlds apart” in terms of each of their statuses in the market.

Opportunity costs, the speed of growth, differing approaches towards taking on investments, and many other factors affect the suitability (and sustainability) of a particular burn rate for a specific company.

Some, such as Scott Nolan, Partner at Founders Fund, go so far as to suggest that founders ought to focus less on burn rate as such and more on the impact that company spending has on execution:

“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. 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.”

Offering similar sentiments, Mark Suster insists that it’s impossible to determine an acceptable burn rate without first factoring in the founder’s (difficult-to-measure) risk tolerance, i.e., willingness to make decisions that expose the company to potential collapse for a shot at achieving rapid growth.

Self-funded startups should grow only as fast as they can reasonably manage and sustain.

Indeed, we’ve written lots about the dangers associated with premature scaling (i.e., “biting off more than you can chew” by trying to scale too big too quickly).

As with many other aspects of trying to build a high growth startup, you must achieve a balancing act between spending wildly and running out of cash on the one and being too cautious and missing opportunities for genuine growth on the other.

As I previously mentioned, many startups dip into the red before eventually, and then quite rapidly, transitioning into the black.

It’s important to keep in mind that your company, if it is to be successful, will likely follow the hockey stick pattern of growth:

Ultimately, figuring out your optimal burn rate and runway requires that you perform holistic (i.e., comprehensive) analyses of all the major economic and strategic aspects of your company, from solving a real customer pain, creating and testing a minimum viable product, and securing product/market fit to applying and testing different monetization strategies, working with advisors and mentors, and expanding internationally.

6 Ways to Optimize Your Burn Rate

To bring this article to a close, let’s now briefly discuss 6 different strategies for optimizing your burn rate.

In addition to thoroughly exploring and testing the unique needs and abilities of your particular startup, you can optimize your burn rate by taking guidance from the following principles:

  1. Spend no more than 5–10 % of your budget on extra-salary expenses

You should avoid spending more than 10 % of your budget on resources or investments outside of salaries, tax, equipment/technology, and rent.

2. Test marketing channels before investing heavily in specific marketing approaches

The most attractive marketing channels for your startup are those that bring the lowest customer acquisition costs, attract the highest volume of users, and perform the best in terms of delivering the highest conversion rates.

As we’ve previously discussed here at Appster, your goal should be to utilize marketing tactics that produce a 3:1 ratio concerning your customer lifetime value and customer acquisition cost.

3. Invest in people only when necessary

Paying staff members is virtually always a startup’s most costly expense.

Therefore, you need to ensure that your hiring practices are based on the true needs of your company and the anticipated value that new hires will bring to your operations.

Ask yourself: What skills are we currently missing? Which areas of the business are we overlooking or inadequately attending to because of a skills shortage? Should we consider outsourcing, hiring internally, and/or various other hiring methods?

4. Shorten your cash conversion cycle

A “well-oiled”, consistently growing startup with solid execution is one with short cash conversion cycles.

The goal is to re-claim as revenue every dollar you spend as an expense as quickly as possible without harming your business.

To put it tersely, don’t sacrifice the long game (i.e., earning significant revenue months or even years down the road) merely so as to optimize the short game (i.e., gaining back a few dollars here and there every day).

The goal is to re-claim the money you’ve spent so that you can re-invest that money and spend more to grow your startup even bigger.

5. Form strategic partnerships

The Appster blog contains plenty of detailed content on the importance of, and methods for securing, strategic partnerships.

Be sure to check out the following links for some in-depth discussions of various ways to grow your business by partnering with other companies rather than furiously spending every last dollar in your bank account: 1, 2.

6. Engage in break-even analysis and work towards your break-even point as soon as possible

The U.S. Small Business Association describes “breakeven analysis” as:

“A process used to determine when your business will be able to cover all its expenses and begin to make a profit. It is important to identify your startup costs in order to determine your sales revenue needed to pay ongoing business expenses”.

Your company’s “breakeven point” is the point at which your revenues (i.e., the amount of money you’re bringing in from sales) exactly match your expenses (i.e., the amounts of your fixed and variable costs).

The point beyond your breakeven point is where you begin to accumulate profits.

Calculating your breakeven point can allow you to make your burn rate more efficient by uncovering and documenting crucial economic data about your company.

As discussed here, analyzing your breakeven point makes it possible to determine:

  • “How profitable your present product line is;
  • How far sales can decline before you start to incur losses;
  • How many units you need to sell before you make a profit;
  • How reducing price or volume of sales will impact on your profits; and
  • How much of an increase in price or volume of sales you will need to make up for an increase in fixed costs”.

To be blunt, reaching your break-even point can mean the difference between the survival and death of your startup.

Pursuing your break-even point requires assessing essential vs. optional expenses and making a variety of difficult decisions.

When, if ever, would you be willing to:

  • Clamp down or ramp up investment in product development or marketing?
  • Reduce your personal salary and/or that of your employees?
  • Terminate staff members?
  • Move to a cheaper city?
  • Work even harder to improve gross margins?

On the upside, achieving profitability will make it possible to invest in initiatives with big potential to produce high growth.

Practically, you might be able to reach your break-even point faster by:

  • Eliminating as many one-off expenses as possible;
  • Making your fixed costs more efficient by utilizing new technologies — such as Google Docs, Quora, Skype, and Slack — to communicate with your customers and co-workers/partners, to collect data, and/or to conduct research in cheaper ways as compared to more traditional forms of market research, advertising, and communication; and
  • Negotiating flexible software licenses.

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Originally published at http://www.appsterhq.com
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