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:

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.