Burn Rates: A Scary Balance

Tell me what your burn rate is, and I’ll tell you who you are.

It was 31st of October, also known as Halloween. Serial entrepreneurs, opinion leading investors and keynote speakers were eager to attend a popular costume party. Everything was running smoothly.

John, the Venture Capitalist, was dressed up as one of the scariest creatures in the startup ecosystem, a malfunctioning Theranos Blood Testing Device. As he got into the party, he saw a lot of friendly faces. He also met a couple new ones; founders looking for investment, mainly.

He started talking to this young man, whose invention was planning to disrupt the agro-industry. It sounded quite interesting, however, as John started asking questions…you know the basic ones: unit economics, profit margins, runway, etc., his face turned completely pale, and his heart stopped beating; he couldn’t believe the amount of cash this company was burning with nothing but a couple employees, and the shock paralyzed him. After that night nobody has heard from John again…

Don’t blame me if you didn’t like the story. I’m not a fiction writer.

Anyways, the moral of the story is true (if there’s even one): Do not approach an investor with a suboptimal cash burn rate, otherwise they will disappear. At least from your sight.

According to CB Insights, running out of cash is the second most common reason why startups fail; therefore, Private Equity investors — with fewer liquidity opportunities than Public Equity investors — run away when they see companies with unattractive characteristics.

Let’s back up a bit, for the newbie readers.

What’s even burn rate in the first place? Basically, how much money you’re spending on a monthly basis.

There are two types: Gross (Spending) and Net (Losing). Gross Burn Rate is the sum of all your fixed costs on a monthly basis, while Net Burn Rate adds up your revenue, to calculate how much money you need to put into the company to cover the losses.

One of my life maxims, along with “Get rich or die tryin‘” is: “Tell me what your burn rate is and I’ll tell you who you are”. Let me be clear first, a high burn rate isn’t necessarily a bad thing; if you’re able to execute and achieve the proposed milestones. It’s all about justification and proof.

Is your burn rate high? Yes. Are you achieving results because you’re investing heavily, and therefore it’s justifiable? No? Then you do have an issue.

Now, is a Low Cash Burn Rate always good? Short answer: No. But it relies on the same dilemma: profit vs. growth. The convenience store down the street is in black numbers already. But profitability at a low scale does not mean a thing to most VC investors. Red numbers do not scare VC’s, it’s part of the job, it’s actually necessary to achieve high-growth companies.

However, there are also red flags, when the expenses stop making sense and those red numbers portray only over-the-top salaries, office luxuries and worldwide trips without real strategic purposes, something more-or-less like this:

As a founder, you risk your autonomy as a manager when VC’s start watching you spend a lot on “unimportant” things. They might choose to become a lot more hands-on in the company, creating agency issues.

Here are a few ways to know if you’re burn rate is too high or too low, and how to adjust it:

Essentials

Before subscribing to any type of service, purchasing any asset or hiring any person, ask yourself: Would my operation be compromised if I don’t do this? If the answer is yes, then by all means, do it! Some expenses just are not necessary, and you can’t afford luxuries when your company has not achieved its milestones yet.

Rule of Thumb

Fred Wilson’s basic formula for identifying if your burn rate is optimal is as follows: each employee should “burn” a total of USD 10k every month. And when I say total, I mean it; including rent, marketing, operation costs, etc.

Make sure this makes sense in your case; USD 10k might make sense for a SaaS operating in Silicon Valley during 2011, but if your startup is operating in 2018, located in Bali, Indonesia; then no, USD 10k is not a justifiable burn rate.

Moderate Hiring

Many entrepreneurs get the hiring frenzy after they received funding. This just means you’ll have to lay off people when money runs out.

Please, do not rely on this strategy and start properly, by hiring moderately, instead. Bad hires is one of the costs that could make or break a company, so be very careful when hiring people. If you need a one-time task done, you could either hire temporary employees or freelancers to help you relieve that workload.

Remote teams

Consider hiring abroad. This could help you cut costs in 1) Office space, and 2) actual salaries, when hiring from less expensive countries.

Equity, not cash, is king

Can’t afford the payroll? Include early employees as first time investors by granting them equity. This will improve their motivation, since it is directly correlated to their performance.

Runway

Runway is the amount of time (months) you have left, until you’re bank account goes empty.

Here’s an easy way to calculate it:

  1. Identify how much liquid assets you have (AKA Cash in the bank),
  2. Calculate your average monthly expenditure (gross) and your average monthly losses (net).
  3. Divide the cash over the other two.

This will tell you how many months you still have left. Runway is something you have to keep in mind on a daily basis, since it will let you know when you should start fundraising again. Keep your timing on your mind at all times, to decide when it is best to cut costs and/or raise capital.

Optimize working capital

This is something that doesn’t come on top of mind, when thinking about cutting costs, but it’s one of the most useful strategies.

How to optimize working capital? Pay bills as late as possible and collect payments from your clients sooner. Of course this is easier said than done; being a startup and having little leverage over clients and suppliers is a real struggle, but there are cases where this is possible, and others where it might just be unfeasible (i.e., SaaS companies). Analyze your specific case thoroughly.

The PR Myth

For gods sake, this one might seem like a no-brainer, yet so many people actually do it. You don’t need a PR agency to launch your company. You don’t need a tequila sponsored pool-party to launch your B2B web platform. You don’t need Michael Bublé to compose a Christmas song about your product. I recommend reading Rework for this specific concept.

Keep in mind that this is just a general overview. As I said, burn rates and runways depend on many variables, and it might be completely different for most startups. Keep these in mind as a general guideline, but always adapt it to your specific case.

If I had to emphasize some ideas from this post, they would be the following:

  1. Burn rates depend on your startup (market, stage, product, location, etc.), so try to consider as many variables as possible before actually jumping into conclusions.
  2. Burn rates and runways should be calculated on a regular basis (they’re not stagnant, they should not be). Keep them in mind at all times.
  3. Find a balance. Low burn rates could slow exponential growth, but high rates could mean the company is not being managed properly.

Burn rates provide a quick insight about the company’s general management, make sure it’s not a scary one.

– VC.

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Publicada 31 octubre, 2018


Originally published at cortesvictorh.com on October 31, 2018.

This story is published in The Startup, Medium’s largest entrepreneurship publication followed by +384,072 people.

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