February 2019 - Foresight Valuation Group

Do The Right Thing: Burning Cash Without Burning Out

Posted on February 27, 2019 9:34 pmModified on February 27, 2019 10:51 pmby Efrat Kasznik

If you follow the headlines from Silicon Valley you might have encountered the stories reciting the chronic shortage in CFOs, particularly for late-stage VC backed startups who are looking to get ready for exit (IPO or acquisition). I find these stories particularly troublesome, as one of the key assignments of a CFO in a startup is manage cash flow, which is one of the most daunting tasks of any startup at any stage in its lifecycle. In the early stage there’s pressure to find product market fit, following that stage there’s pressure to scale, and in the later stage there’s pressure to sprint to the exit. All throughout that cycle, cash is generally a scarce resource that needs to be managed efficiently, as any new cash influx usually means the current shareholders lose some of their share in company to the new investors (a process known as “dilution”).

I was reminded of the cash flow management issue when a journalist recently contacted me for an interview for a story about cash flow management tips for startups. The questions that were posed to me highlighted some of the common misconceptions and myths surrounding the cash utilization in a startup (post-funding). What I set to do in this blog is try to dispel some of the myths around cash flow management and create a set of practical guidelines for early stage founders, most of whom are not people with any financial background, who find themselves in the enviable position of having to spend millions of investors’ dollars in the most prudent and efficient manner.

So what is a startup to do to manage its “burn rate”, a term referring to the monthly cash burned through expenses? More often than not, startups think they are doing the right thing while inadvertently burning cash the wrong way. Moreover, founders and investors can have different incentives when it comes to funding for growth; so when framing the question about what is the right pace or what is the optimal cash burn rate, it’s really a question of what is the business model, what is the exit strategy and how quickly you plan to grow the company. Higher growth usually means higher burn rate, which in turn could lead to more funding; investors may like the accelerated growth since it gets them to a point of liquidity (exit through a sale or an IPO) more quickly, but you as a founder may find yourself with a smaller piece of the pie due to excessive dilution.

With that in mind, below are the 5 things every early stage startup founder needs to know about burning cash without burning out:

There’s a fine line between burning too quickly and burning too slowly, and neither of them is desirable – a startup should generally raise enough cash for 12-18 months. The challenge then becomes managing the burn rate carefully, to ensure that the company grows to the next “inflection point” (a point when certain milestones are achieved, and the valuation increases enough for the company to go for its next round of funding). Burning too quickly means that you underestimate the cost of growth and will be back on the road raising funding much too soon (a time consuming activity that distracts the CEO and other senior management form running the company). Burning too slowly, on the other hand, is not appreciated by investors, despite the common belief, shared by many founders, that stretching their funding longer should always be the goal. If you are not spending enough then you are not growing the company fast enough to get to the next inflection point, which in turn would slow down the path to an exit point in time for your investors to have the right return on their investment.

An increasing burn rate is not necessarily a bad sign – this is another common misconception, which ignores the fact that the pace of cash burn is largely a function of your business model. Take, for example, the ubiquitous software-as a service (SaaS) business model, where an increasing cash burn is a strong indication of growth. A SaaS company generally invests heavily in marketing, which it then recouped over a long period of time with monthly subscription fees, so in that industry there is a cash “trough” that is expected to present itself when the company is in hypergrowth mode. If a SaaS company raises funding for growth but cash flow is going down, it is generally considered to not be spending its investment money wisely. In this example, managing burn rate is not to be confused with necessarily reducing it, because it may signal to investors that growth is slowing down. On the other hand, if your startup is in the hardware manufacturing business, your cash flow might indicate the efficiency of your supply chain, where managing payment terms with suppliers is key to executing your business model. In this type of environment, increasing negative cash flows might indicate inefficiencies in managing your supply chain that are getting worse, instead of getting better.

Spend on the right things at the right phase in your company’s lifecycle – the burn rate should not only be evaluated based on its absolute size or direction, but also on its composition. To that effect, spending should be aligned with the business model and also with the phase in the startup’s lifecycle. If you run a SaaS company that raised Series A funding, which is a round of funding that is largely raised when the company is ready for scaling, and your post-funding spending is mostly on R&D and not on sales & marketing, then even though your burn rate is increasing (which, as previously mentioned, is to be expected of a growing SaaS company), you are burning cash in the wrong place. The unintended consequence of that is you will run out of cash before you can hit your next inflection point. Conversely, if you run a medical device startup and you are in the pre-clinical phase of your product development, any cash that you raise should be invested in R&D, and not in unnecessary administrative overhead, as an example. This rule may sound straightforward, but it’s easy for companies, when showered with millions of dollars and lacking the right financial acumen, to lose sight of the important things and throw money in the wrong places.

Breaking-even is not always the right goal for your startup – a common mistake that I see in startup financial models is the obsessive focus on “breaking-even”. The break-even point is loosely defined as the year when cash inflows exceed cash outflows. Startup founders are usually very eager to show investors that they are planning to reach break-even in year 2 or year 3, or sometime in the horizon of the 5-7 years leading to the exit event. The problem with this approach is that breaking-even is not a one-size-fits-all goal of every startup. On the contrary: in some business models, breaking even is not necessary, nor expected to occur pre-exit. Take Amazon as an example: a company showing unprecedented revenue growth that is rewarded nicely in the stock market, while barely breaking even (as measured by accounting net profits). Amazon’s valuation is driven by revenue growth, not by net profits. This is the business model and this is what investors expect it to keep doing. Going back to the world of startups: if you are in the business-to-consumer (B2C) software business, say: you develop a social networking mobile app. The classic B2C business model is offering the service for free, growing to a critical mass of users, and then monetizing through advertising or other ways; the larger the user base, the higher the valuation (see Facebook’s business model as the best example of this strategy). As a founder of the B2C company, you are expected to drive towards user growth; that is your #1 objective, and the best use of investor’s money as it drives your valuation and will ultimately improve the return in an exit event. Your investors are not expecting you to break even, it’s not a desirable outcome as by definition it means that you are focusing on the wrong objective.

Focus less on your cash burn and more on your unit economics – finally, even if you incorporate all the foregoing lessons when managing your startup’s cash flow, the burn rate alone may not reveal some red flags that could jeopardize the survival of your company. In addition to managing their monthly burn rate, startups should always also focus on their unit economics. More specifically: what founders should worry about is not the increasing burn rate, but rather the worsening unit economics. Your cash burn rate can increase due to investment in sales & marketing, for example, which may be fine for a growing SaaS company; however, if the economics of the customer operations (as measure by a set of SaaS metrics) are getting worse, as opposed to getting better, that should serve as a red flag. Let’s take as an example one of the key SaaS metrics: Customer Acquisition Cost (CAC) which is measured as the overall sales & marketing cost over the year divided by the number of new customers added that year. So if the CAC is $1,000, and you spend $1 million in marketing every month, it will get you 1,000 new customers every month. Now say that you raised funding to grow your customer base, but your customer acquisition cost now increased to $2,000, i.e.: the efficiency of your sales people is decreasing. You may now spend double in marketing, $2 million every month, but this spending will get you to the same 1,000 customers per month. This is an example of why it is so important to focus not only on the burn rate, but first and foremost on your unit economics.

The best practices laid out in this blog were learned through working and interacting with hundreds of startups from Silicon Valley and around the world. These are universal lessons that should help improve cash flow management and lead to better outcomes for founders and investors alike: burning at the right pace, focusing on the right expenses at the right time, and not losing sight of your business models and the factors driving valuation.

The Annual Intellectual Property Report to Congress: Risking 40% of GDP to Recoup 3%

Posted on February 27, 2019 1:33 amModified on April 19, 2021 8:30 pmby Lynn Dudinsky

The Office of the U.S. Intellectual Property Enforcement Coordinator (IPEC) issued its Annual Intellectual Property Report to Congress this month (“Annual IP Report”). The Annual IP Report details the coordinated efforts of the White House, the Departments of Commerce, Justice, Homeland Security, State, Treasury, Health and Human Services, and Agriculture, the Office of the U.S. Trade Representative, and the U.S. Copyright Office to promote strong intellectual property rights protection and enforcement, both domestically and abroad. Included in the Annual IP Report is the Administration’s four-part strategic approach to promote and protect intellectual property which is quoted below:

Engagement with our trading partners;
Effective use of all our legal authorities, including our trade tools;
Expanded law enforcement action and cooperation; and
Engagement and partnership with the private sector and other stakeholders.

While the Annual IP Report goes into great detail about the above referenced strategic approach, as well as other actions taken by the Administration to enforce intellectual property rights over the 197-page report, one interesting section that occupies only 2 pages of the report describes the impact of intellectual property on the U.S. economy as well as the economic costs related to theft of U.S. intellectual property (pages 32-34 of the report). The one-page summary titled “Intellectual Property and the Economy” highlights the significant role intellectual property plays in the U.S. economy. Below are a few highlights from this section of the report that are worth mentioning:

Intellectual Property Intensive Industries Accounted for 30% of U.S. Employment in 2014: The Annual IP Report references a 2016 report published by the USPTO in conjunction with the Economics & Statistics Administration that details the impact of intellectual property on the U.S. economy. In this report, IP-intensive industries directly accounted for 27.9 million jobs in 2014. Interestingly, Patent-intensive industries rank last in the IP-intensive employment with 3.9 million jobs in 2014 compared to 5.6 million for Copyright-intensive industries and 23.7 million jobs in Trademark-intensive industries. The downstream impact of IP-intensive employment includes nearly 18 million additional supply chain jobs resulting in the share of employment directly and indirectly supported by IP-intensive industries totaling approximately 30 percent of all U.S. employment.
Intellectual Property Intensive Industries Accounted for $6.6 trillion in value added in 2014: This figure represents an increase of more than 30% since 2010. This also represents 38.2 percent of the U.S. GDP which is attributable to IP-intensive industries, an increase over the 34.8 percent of GDP in 2010. IP-intensive industries also provide a 46% wage premium over non-IP-intensive industries. Patent and Copyright-intensive industries see an even larger wage premium of 74% and 90%, respectively.
Innovation-Driven Growth is Linked to Roughly 75% of U.S. Growth Since the Mid-1940s: Referenced in this section of the Annual IP Report is a study from the Department of Commerce that investigated the impact of technological innovation on U.S. growth.

It is unfortunate that the Annual IP Report does not include more recent statistics regarding the impact of Intellectual Property on the economy in the past 5 years. However, the report does include some recent statistics on the economic cost of IP theft, which may explain the focus of this Administration on imposing sanctions and tariffs in an effort to protect U.S. IP rights internationally, rather than engaging in efforts directed at promoting the role of U.S. IP in domestic and foreign markets. The Economic Cost of IP Theft section of the Annual IP Report largely focuses on the role China plays in the misuse and misappropriation of U.S. intellectual property. The focus on China is not limited to this section of the report and can be found throughout the report, and China is specifically the target of the Administration’s four-part strategic approach to promote and protect intellectual property. The focus on China’s role in IP theft and the impact on the U.S. economy relies on the following statistics:

The U.S. Customs and Border Protection Bureau (CBP) reports that approximately 88% of seized goods were sourced to China and Hong Kong in 2016.
It is estimated that the total value of seized counterfeit goods from China and Hong Kong was between $52.9-$101.4 billion in 2016, roughly 0.5% of 2016 GDP.

Given that an estimated 1.2-2.3 percent of counterfeit goods are actually seized by CBP, it is difficult to see how the approaches outlined in this report will make a meaningful impact on preventing IP theft, and in turn on the U.S. economy. Time will tell whether this approach will further the Administration’s stated goal of advancing American economic interests overseas and enabling American innovators and creations to operate in foreign markets with clear paths to secure and use their intellectual property. However, given the profound impact of IP-intensive industries on the U.S. economy, any approach to promoting and protecting U.S. intellectual property must balance the economic value add of the status quo which accounts for roughly 40% of the U.S. GDP against the risk of disrupting IP-intensive industries to address the 1%-3% cost to the U.S. GDP from IP theft in the form of counterfeit goods, pirated software and theft of trade secrets.

The “Secret Formula” for Choosing a Brand Name

Posted on February 21, 2019 6:17 pmModified on April 19, 2021 8:27 pmby Sebastian Custodia

Unarguably, one of the most important branding decisions to be made by an entrepreneur is the name of the venture. Some of the world’s most iconic brands not only have catchy names, but also names with a great story behind them. These stories often offer a glimpse at the company’s history, whether or not the name actually has anything to do with the product or service itself. The origin of the Apple name, for example, is tied to a story told by Steve Wozniak in his autobiography, in which Steve Jobs suggested the name after returning home from a stint in a commune which he referred to as an “apple orchard.” The name Google was the result of a misspelled search in the domain name registry, and a welcomed change to the company’s original name, “BackRub.” And who can forget Justin Timberlake (as Sean Parker) advising Mark Zuckerberg to “drop the ‘The’” from TheFacebook.

From these examples, and many more, we learn that the origin of the name is arguably equally important as the actual name itself. From a sheer branding perspective, having these stories to tell about your company history can greatly aid in the building of a community around your brand – fostering loyalty and contributing to sustained success. In fact, some suggest that brand names that are directly related to a product or service are less likely to succeed than an extraneous name. Scrolling down any list of top brands reveals that this notion seems to be accurate. Perhaps the reason is that the disconnect between the name of a company and its offerings provides for much stronger and sustainable Brand Awareness, Brand Association, Brand Positioning, etc. when consumers are tasked with connecting a name to a product or service themselves rather than being told exactly what to expect. In my own mind, for example, I was tasked with creating the associations between the Disney name (which at its origin is simply a surname with no relation to animation) with family-oriented, funny, and wholesome cartoons. Because I have learned to associate the name with the product and accompanying emotions on my own, that bond is far stronger. Conversely, another animation brand that I have grown up with is Cartoon Network. The company offers a brand name that is immediately reconcilable with their offering. Over the years, it is possible that by allowing me to skip the step of creating this brand association on my own, the brand has fostered a less meaningful and sustainable relationship. Among many other factors, the difference in brand power in my mind is conceivably attributable to the mechanics of the brand name itself.

Given that the brand name is so important, entrepreneurs spend countless hours mulling over their options to find the perfect fit. Sometimes, however, there are roadblocks. In a recent U.S. circuit court case, an entrepreneur was denied the right to use “The Krusty Krab” as the name for his new restaurant venture. The Krusty Krab, a Bikini Bottom staple, is of course the name used by the fictitious restauranteur Mr. Krabs in the SpongeBob SquarePants cartoon show and movies. The case is an example of an interesting rule around trademark protection for things that are not officially registered with the Trademark Office and that originate from fictional sources. Having appeared in over 80% of SpongeBob episodes, in addition to 2 feature films, the court ruled that Viacom (the rights holder to SpongeBob) should retain the rights to The Krusty Krab. In court, Viacom successfully proved that diners at the proposed Krusty Krab restaurant would likely confuse the establishment with SpongeBob’s fictional employer. The courts have taken a similar stance in the past on trademark related cases, granting trademark protection to the Daily Planet (from the Superman universe), as well as the General Lee (from The Dukes of Hazzard).

When developing a brand strategy, brand name is a pivotal decision. The various components of Brand Equity can be bolstered by a solid name with an interesting origin story. Unsurprisingly, entrepreneurs tap in to any and all available resources while attempting to derive the perfect name. It is important, however, to remember that trademark protection can be awarded for things outside of the official registry. But just because a name may be protected, does not necessarily rule out the possibility of its use for your venture. Interestingly enough, Viacom itself has a history of lending its marks in the food business. A license of the Bubba Gump Shrimp Co. name from the hit movie Forrest Gump is responsible for the turnaround and massive success of a once declining seafood provider. In this case, Mr. Krabs was not quite ready to grant access to his infamous secret formula.