Mark Suster, Fred Wilson, Tomasz Tunguz and Danielle Morrill have written blog posts on burn rates. These posts and others are linked to in the Notes to this blog post as is usual.
This post will focus on the optimal burn rate after product/market fit has been proven by a business. In other words, the assumption in the discussion that follows is that the value hypothesis has been proven and work on the growth hypothesis has at least started.
Before jumping into the cash flow discussion it is important to describe how business has changed in recent years. One of the most under-appreciated changes in the business world in the past ten years is that companies are more often selling a subscription or trying to create an annuity-like business rather than trying to generate a single sale to a customer. This change is happening as quickly as it is because customers are now connected to the suppliers via the Internet. A business with a connected customer relationship now has telemetry on its customers that allows it to create greater lifetime value for the customer and higher return on investment for itself. Why is all this relevant to burn rate? A business which values a customer on a on a a lifetime value basis will pay more to acquire that customer and that cash goes out the door in month one (i.e., up front).
A lot of this change in the way businesses are run is the influence of people like Jeff Bezos. Amazon investors have been willing to invest in a business that is generating annuity-like value even if price earning are low because the DCF value is very high as is absolute dollar free cash flow. Investors can best see this value by doing a discounted cash flow analysis (DCF) and watching free cash flow. This change baffles some people who want use to use a price to earnings ratio to value a company because the new approach requires that they actually understand the business. Doing a DCF on a business is hard. But it always has been the best way to value a business. In other words, doing a DCF is a simple do to in theory but hard to do in reality since it requires a forecast. In doing a DCF you take the cash flows that you expect to generate over the life of the asset and you discount them back to their present value. Using a P/E ratio is easy, but increasingly misleading. Some investors have been slow to adjust. This shift to a DCF methodology does not mean that some companies are not highly overvalued, but rather that the right way to do a valuation has changed. Some companies are also undervalued. It depends.
Tomasz Tunguz called out just one major implication of this shift to subscriptions and annuity like business models in a recent blog post entitled: “How Much Should A SaaS Startup Invest in Sales & Marketing?” In that post he writes:
The box marked revenue range 10 indicates the median publicly traded company at between $5M and $10M of revenue spent about 90% of revenue on sales and marketing. Looking in the outer revenue ranges at $25M, $50M and $100M, that figure asymptotes to about 50%. However there are some notable outliers to continue to spend close to 150% or 250% of revenue even at the $100M mark.
In case it isn’t obvious: SPENDING THIS MUCH OF TOP LINE REVENUE ON SALES AND MARKETING IS NEW. This is not business as usual. The higher gross margins generated by software and SaaS are enabling unprecedented spending on sales and marketing below the gross margin line. I read a study recently in which two economists tried to advance their preferred narrative by citing high gross margins that can exist in business today. Yes they are high in SaaS. No, that is not the whole story. Spending below the gross margin line on sales and marketing is far higher.
No business can sit on the sidelines during this “connected customer” transformation or it will be crushed. Business after business is finding that the “game on the field” is to have ongoing connected customer relationship (i.e., not just disconnected transactions). A business that does not have connected telemetry on its customers is at risk of its competitors doing so and providing a vastly superior product. The race is on to connect every product from cars to tractors to refrigerators and to create a service relationship with customers.
It is worth repeating that this approach to generating growth is not possible if the cash is not there to make the business model work. Harold Geneen is famous for saying “the only unforgivable sin in business is to run out of cash.” Liberty’s John Malone also was talking about the value of cash when he said that business must make sure it has “enough juice to survive.” Some business that are generating lots of cash and have very healthy unit economics have little or no current GAAP quarterly income because they are growing their business. These are often highly valued because markets are doing the discounted cash flow (DCF) analysis of the business rather than looking at P/E ratios in Yahoo Finance on Saturday mornings in their pajamas.
OK. Now it is time to focus more on burn rate rather than the changed environment that has greatly impacted them. Jason Lemkin wrote a tweet recently that advises his followers: “Burn rate is situationally dependent. But pick it, don’t let it pick you.” He seems to be saying that you can’t be neutral on burn rate. Choices must be made and those choices will impact the growth of key financial metrics like recurring revenue and cash flow. Making the choices harder is the reality that optimal burn rate will vary over time based on many factors. Wilson points out:
Assuming a constant burn rate can be very dangerous. Always know if your burn rate is going up or down and include that fact in your analysis. Most startups burn money for a time. Some for only a very short time. But many for a longer period of time. During that period of cash consumption, it is critical to keep a close eye on cash balance and burn rate and cash out date. It will tell you when you need to raise money again (at least six months before you run out of cash please!).
Among the factors that impact the optimal burn rate are the answers to questions like:
- How many months of runway exist for the business given the current burn rate?
• How strong is product/market fit (which is never just binary)?
• How long is the payback period on customer acquisition cost?
• How much of spending is for expenses other than payroll, payroll tax, benefits, and rent?
• Does use of the product or service generate strong network effects and is the market likely to “tip” to a small number of winners?
• How big is the targeted market?
• How sustainable is growth?
• How much of growth is organic vs paid?
• What is the current ability of the business to raise additional funds?
• How proven is the sales process and how many leads per account representative can be given to the sales team?
- “To grow faster businesses need resources in today’s financial period to fund growth that may not come for 6 months to a year. The most obvious way to explain this is with sales people. If you hire 6 sales reps in January at $120,000 / year salary then you’ve taken on an extra $60,000 per month in costs yet these sales people might not close new business for 4–6 months. So your Q1 results will be $180,000 less profitable than if you hadn’t hired them.” Mark Suster https://bothsidesofthetable.com/should-startups-focus-on-profitability-or-not-ae54fc95790e
This quote from Suster is in part about the tradeoff between growth and earnings, which is a very complex multidimensional topic. That set of decisions impacts the impacts of entrepreneurs on raising funds or bootstrapping.
One way to understand what it will take to scale a business is to do growth experiments to determine how much growth must be paid versus organic. It is always better to have organic growth since that results in a lower customer acquisition costs and higher customer quality but that is not always possible.
In his book The Lean Startup https://www.amazon.com/eric-ries-lean-startup/s?ie=UTF8&page=3&rh=i%3Aaps%2Ck%3Aeric%20ries%20lean%20startup (which I wrote about previously https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/ on this blog), Eric Ries describes “engines of growth” as follows: “An engine of growth is the mechanism that startups use to achieve sustainable growth. Sustainable growth is characterized by one simple rule: new customers come from the actions of pasts customers…. A poor growth model has trapped many companies, leaving them with a small profitable business when a pivot might lead to more significant growth.”
Ries believes that the optimal method of demonstrating to investors that shareholder value is being created is to benchmark progress via an “Innovation Accounting” system. He suggests that operational be simple so the team can focus on clear and understandable goals. Too many North Star goals can confuse the product teams, so may people believe that simple but powerful key performance indicators (KPI) or even one should be chosen. These operational metrics can then be translated by a other specialized teams with finance expertise into customer lifetime value (CLV) and return on investment (ROI) metrics that investors can understand.
Ries argues that are three engines of growth:
The Sticky Engine of Growth- Word of mouth customer referral is higher than the customer retention rate; “Companies using the sticky engine of growth track their attrition rate or churn rate very carefully. The churn rate is defined as the fraction of customers in any period who fail to remain engaged with the company’s product. The rules that govern the sticky engine of growth are pretty simple: if the rate of new customer acquisition exceeds the churn rate, the product will grow.”
The Viral Engine of Growth- New customers are recruited to use the service as a natural side effect of normal usage (e.g., Facebook and PayPal); “Like the other engines of growth, the viral engine is powered by a feedback loop that can be quantified. It is called the viral loop, and its speed is determined by a single mathematical term called the viral coefficient. The higher this coefficient is, the faster the product will spread. The viral coefficient measures how many new customers will use a product as a consequence of each new customer who signs up.”
The Paid Engine of Growth- Revenue generated from existing customers is reinvested in the acquisition of new customers. This is the part of growth that is not organic. Customers most often acquired by direct sales, by paying cash for advertising or via other paid channels.
One reason why so much cash can be consumed by “paid” growth engines is illustrated by an example created by Tom Tunguz:
A business at $100M in revenue looking to grow 100% annually with a blended customer acquisition cost of $400 and a payback period of 9 months, and an average annual revenue per customer of $533, must spend $75M dollars per year – we’re ignoring churn. That’s a massive amount of capital even if after a year, all the users start generating cash for the business. The startup must have a a balance sheet of more than $100M to shoulder that type of annual marketing spend. And would might happen if the company didn’t spend all this capital? Market fragmentation.
The strategy to deal with what Tunguz is talking about above was pioneered by John Malone. It turns some common ideas about business on their head. Four snippets from articles about John Malone make the points
In its early days, TCI struggled to stay in the cable television business and managed not to be bought out by such large competitors as Westinghouse, General Electric and Warner Communications, among others, said Malone. “Little by little we were able to grow the company through investments and acquisitions,” said Malone. He added, however, that even as late as 1986, the company’s success could not be measured in terms of its earnings, and sometimes, explaining his unconventional philosophy about investing was a challenge. Malone recalled that if a shareholder asked the question “What are your earnings going to be next quarter?” the Yale alumnus would have to reply, “You’re in the wrong meeting. We don’t have earnings, we don’t intend to have earnings, we may never have earnings. Why don’t you ask me how much we’re going to be worth next quarter?” http://archives.news.yale.edu/v28.n9/story2.html
TCI and others were expanding by leverage; we were buying assets for cash, basically. It made our earnings look awful, but it meant were sheltered from income tax and we weren’t diluting that common equity. Over those years, we were shrinking our equity fairly dramatically and growing our company fairly aggressively. There’s a study, a Harvard Business School study I believe, that shows TCI had the highest return on equity of any public company through that 20-year period. We had to do it by completely ignoring what they teach you in business school about earnings and all that. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric. http://www.manualofideas.com/files/content/20090429malone.pdf
Through that period into the ’80s, those who were in cable and got measured by earnings because they were part of some industrial company — whether it Warner Amex, whether it was Westinghouse or it was GE — they all bailed out of the industry. They could sell these (cable) businesses and boost their earnings per share dramatically, and they were all induced to do so. In the ’80s into the ’90s, the industry really became a cash-flow growth story. … It gave us great freedom to grow the business. The public companies that were earnings oriented were issuing equity to grow. They could avoid depreciation and amortization and so on, but they were diluting the value of their equity in the long term. TCI and others were expanding by leverage; we were buying assets for cash, basically. It made our earnings look awful, but it meant were sheltered from income tax and we weren’t diluting that common equity. http://stuff.maxolson.com/2009-04-27-John-Malone.html
The first thing you do is make sure you have enough juice to survive and you don’t have any credit issues that are going to bite you in the near term, and that you’ve thought about how you manage your way through those issues. And once you’re comfortable in that regard, you start looking for what opportunities exist that you can take advantage of in what is essentially a very tight credit environment. https://www.bizjournals.com/denver/stories/2009/04/27/daily45.html
- “The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.” Brad Feld https://feld.com/archives/2015/02/rule-40-healthy-saas-company.html
This 40% “rule” is not binary and somewhat arbitrary. How close a given business should adhere to the 40% rule will depend on many factors like the presence and importance of network effects, the startup’s stage of development, the amount of cash on hand, the current fund raising environment and whether the business is generating cash or consuming cash. Making these decisions in an intelligent in a uncertain environment is why having a great CFO is important. Dave Kellogg writes on his blog: https://kellblog.com/2017/07/25/the-saas-rule-of-40/
It’s important to understand that such “rules” are not black and white. As we’ll see in a minute, lots of companies deviate from the rule of 40. The right way to think about these rules of thumb is as predictors. Back in the day, what best predicted the value of a SaaS company? Revenue growth — without regard for margin. (In fact, often inversely correlated to margin.) When that started to break down, people started looking for a better independent variable. The answer to that search was the rule of 40 score. Let’s examine a few charts courtesy of the folks at Pacific Crest and as presented at the recent, stellar Zuora CFO Forum.
This scatter chart plots the two drivers of the rule of 40 score against each other, colors each dot with the company’s rule of 40 score, and adds a line that indicates the rule of 40 boundary. 42% of public SaaS companies, and 77% of public SaaS market cap, is above the rule of 40 line.
- “The Rule establishes a relationship between the growth rate and burn rate of a business and defines a healthy operating zone for a growth stage business. Consequently, the Rule of 40% metric may be a solid first pass filter for a growth equity investor to determine whether a business might be a good investment candidate. But for early stage companies, …. founders should focus more on the unit economics (average revenue per customer, cost of customer acquisition, churn rates, contribution margin), which drive the business’s top line and bottom line. Everything else will take care of itself.” Tomasz Tunguz http://tomtunguz.com/rule-of-40/
I am more or less a broken record (sorry) on the importance of unit economics (my post on that are numerous but they key ones are here https://25iq.com/2016/12/31/a-half-dozen-ways-to-look-at-the-unit-economics-of-a-business/ and here https://25iq.com/2017/07/15/amazon-prime-and-other-subscription-businesses-how-do-you-value-a-subscriber/ ), but in my obsession exists for good reason. If a business gets its unit economics right very good things happen. If it doesn’t get unit economics right nothing can save the business.
If you have unit economics like Sirius XM, https://25iq.com/2017/08/19/what-would-a-healthy-music-streaming-business-e-g-spotify-soundcloud-pandora-look-like/ then it makes sense to take up the burn rate
Subscriber Acquisition Cost (SAC) $31
Gross margin 62%
Churn: 1.7% a month
Assuming a 10% discount rate in this LTV calculation, the Sirius XM unit economics look like this:
If you have unit economics like my fictional meal delivery company Green Oven, https://25iq.com/2017/07/15/amazon-prime-and-other-subscription-businesses-how-do-you-value-a-subscriber/ you have work to do on product/market fit and the burn rate should be reduced:
Fred Wilson is a very recent post created a new rule for value creation that that has a very macro viewpoint:
“Your company’s annual value creation (valuation at the end of the year minus valuation at the start of the year) should be a multiple of the cash your company has consumed during the year. …annual value creation should produce a 3-5x return on annual burn.” $10mm annual revenue company in 2017 growing to $18mm in 2018… public comps and companies similar to your business are trading at 6x revenues. So you can estimate that your business is worth $60mm this year and $110mm next year. So there will be $50mm of value creation in 2018. If you want a 5x return on your burn, you should not burn more than $10mm in 2018. http://avc.com/2017/09/some-thoughts-on-burn-rates/
I like Wilson’s macro burn rate test as long as the underlying economics are positive. A business with terrible unit economics will eventually crash and burn no matter what the top line revenue (unless they are bought by a greater fool).
- Achieving profitability is the most liberating action a startup can accomplish. Now you make your own decisions. It will also minimize future dilution. Gavin Baker, a high-profile portfolio manager at Fidelity has a message for Unicorn CEOs: ‘Generate $1 of free cash flow, and then you can invest everything else in growth and stay at $1 in free cash flow for years. I get that you want to grow and I want you to grow, but let’s internally finance that growth by spending gross margin dollars rather than new dilutive dollars of equity. Ultimately, internally financing growth is the only way to control your own destiny rather than being at the mercy of the capital markets.’” Bill Gurley http://abovethecrowd.com/2016/04/21/on-the-road-to-recap/
I have already written a post on what Gurley meant and intended when he wrote this essay on the lifetime value model. In my blog post https://25iq.com/2016/10/14/a-half-dozen-more-things-ive-learned-from-bill-gurley-about-investing/ I discuss issues like the game on the field problem. A “growth at virtually any cost” mentality can be dangerous and deadly for a startup. There is no hard and fast formula that determines the right level of paid spending on growth. High customer acquisition cost can quickly become uneconomic. The benefits of hyper growth eventually start to reflect an S curve most notably when the benefits of a network effects start to decline. At a point an additional user of a system no longer generates the same benefit it did when the company was smaller and had fewer users. For example, an incremental new user when you have only thousands of customers is worth far more than when you have millions of customers. Growth is still important but hyper growth driven by an outsize paid customer acquisition cost is no longer financially supportable. The goal of a business at that point should be greater organic growth driven by the sticky and viral growth engines.
- “There’s a reason venture capitalists and entrepreneurs are so focused on growth. To generate venture returns, VCs need companies to consistently grow north of 100% year over year.” Jeff Bussgang. https://seeingbothsides.com/2016/05/16/growth-vs-profitability-and-venture-returns/
The venture capitalist must hunt for very big opportunities to achieve their goals. This desire can create some tension since the entrepreneurs may be satisfied with a financial outcome which is not consistent with the goals of the venture capitalists. Entrepreneurs can benefit from understanding he goals of their financiers since it can help prevent conflict. The other reason for entrepreneurs to understand the needs of venture capitalist is so that they realize that most businesses do not raise venture capital. There were only 800 to 1,200 Series A financing round in the united States in 2016 depending on who you talk to. That means that an entrepreneur raising more than a seed round is a relatively rare event. That is OK since there are many great businesses that do not require venture capital and do not need it.
The financial goal of a venture capitalist is to produce an investment return of more than 20 percent for their limited partners over the lifetime of the fund, which we will assume to be six years for purposes of this blog post. We will also assume that the venture capitalist and her partners have raised $400 million for this fund. In order to produce this more than 20% financial return after the fees and carried interest the venture capital firm must return at least $1.5 billion to investors. If the fund owns 20% of the business in which it invest on average, those businesses must collectively create at least $7.5 billion of market value and the venture capitalists must be able to extract the $1.5 billion in value in some sort of a financial exit that procures distributable cash or stock that can be turned into cash. This last point is why obsessing about “unicorns” is not helpful, since limited partners can’t buy things like groceries with a financial return until it is actually distributed to them in cash or cash equivalents the venture capitalists. Rather than seeking unicorns as an end result the venture capitalist seeks grand slams which, unlike a unicorn (often with a dirty terms sheet), are more than just a valuation.
What creates the financial opportunity for venture capitalists is convexity. They make an investment which has limited downside (only the amount they invest is at risk) but create a massive potential financial upside. In other words, the venture capitalist is essentially buying long–dated, deeply–out-of-the-money call options in a portfolio of startups.
One factor that complicates the life of a venture capitalist is that the distribution of returns from that portfolio of businesses will be higher skewed. About 6% of investments representing 4.5% of dollars invested by the venture capitalists from the fun will generate about 60% of the total financial returns. This skew is what creates one of the power law distributions in venture capital that you may sometimes hear people talk about.
Since a very small number of startups must generate more than $7.5 billion in market value it is essential that the business generate massive amounts of revenue and profit growth. Jeff Bussgang explains this point with a few examples:
For a company to achieve a 10x or 20x or better return on invested capital, it needs to grow very, very fast. To bring this to life, take a look at the table below. It represents a profile of three startup company examples that start at $1 million in revenue at “year 1” (note – to achieve its first in revenue often takes 2-3 years from inception). If you model out three different growth rates – 100%, 50% and 25% – for the subsequent six years, then the fast growing company has a shot at achieving venture returns. It will grow to $64 million in revenue and, assuming a 6x revenue multiple (reasonable assumption for a company growing that quickly at that scale), it would be worth nearly $400 million. Assuming the company required something like $20-30 million in capital over the life of its growth – perhaps accumulated across two to three rounds of financing – and assuming the position of early investors is a post money valuation of $40M (again, reasonable assumptions based on my experience), then a 10x outcome is achieved.
Lastly, if the third company is growing at only 25% YoY, your firm will lose money – a lot of money. These companies, because they’re slow growers, maybe only be worth 2x invested capital and so worth $7.6M, only 20 cents in return on each invested dollar in capital. Think about that for a minute – six years in a row of 100% growth, executed perfectly, and you get to 10x. But if you achieve “only” 50% growth over six years, which is still outstanding performance by almost any other metric, and have a revenue multiple of 4x (lower than the 100% growing company for obvious reasons), you have a company worth only $45 million in value and investors basically get their money back.
P.s., This burn rate question is related to several other questions I have written about like:
- Unit economics https://25iq.com/2016/12/31/a-half-dozen-ways-to-look-at-the-unit-economics-of-a-business/
- Scalability https://25iq.com/2017/08/25/a-dozen-attributes-of-a-scalable-business/
- Subscriptions: https://25iq.com/2017/07/15/amazon-prime-and-other-subscription-businesses-how-do-you-value-a-subscriber/