Do The Right Thing: Burning Cash Without Burning Out

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.
  1. 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.
  1. 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.
  1. 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.
  1. 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.

FIRRMA and its Impact on That Which it Seeks to Protect

The Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) was signed into law by the current Administration on August 13, 2018, to protect US technological superiority and address national security risks associated with the ability of foreign parties to obtain equity interests in domestic businesses and influence decisions or obtain information related to critical US technologies. However, FIRRMA poses a threat to a wide range of innovative industries, including Biotech, Aerospace, and Nanotechnology, by adding increased governmental scrutiny that may restrict the funding needed by entrepreneurs seeking to build the next-gen technologies. Without the funding necessary to take the risks necessary to develop these next-gen technologies, FIRRMA may erode the technological superiority it seeks to protect. Moreover, the pace of innovation in other parts of the world may increase as corporations are free to accept the investments that US companies are denied because of FIRRMA.

FIRRMA is designed to reform and modernize the review process of the Committee on Foreign Investment in the United States (CFIUS) and gives CFIUS authority over technology transfers. FIRRMA modified and broadened the power of the president and CFIUS by expanding the scope of foreign investments in the US subject to national security review. CFIUS’ authority applies to the technology transfers of US businesses to foreign organizations as well as domestic organizations that are controlled by a non-US person. While FIRRMA will not be fully implemented until February 2020, the US Department of the Treasury issued temporary regulations in October 2018 through a pilot program to address what it considers to be critical American technology and intellectual property from potentially harmful foreign acquisitions.

The pilot program implements two sections of FIRRMA that did not take effect upon FIRRMA’s enactment. The first section expands the scope of transactions subject to review by CFIUS to include certain investments involving foreign persons and critical technologies. The second section makes effective FIRRMA’s mandatory declarations provision for all transactions that fall within the specified scope of the pilot program. The regulations state that the pilot program establishes mandatory declarations for certain transactions involving investments by foreign persons in certain US business that “produce, design, test, manufacture, fabricate, or develop one or more critical technologies.” The language of the temporary regulations may be concerning to businesses seeking investment due to the broad language it contains and without these investments, there will be a negative impact on the types of R&D efforts that facilitate the creation of innovative technologies that generate intellectual property portfolios that can be licensed.

The regulations also state that the purpose of the pilot program is to assess and address ongoing risks to the national security of the US resulting from two urgent and compelling circumstances: (1) the ability and willingness of some foreign parties to obtain equity interests in US business in order to affect certain decisions regarding, or to obtain certain information relating to, critical technologies; and (2) the rapid pace of technological change in certain US industries. While the regulations state that the current Administration “supports protecting our national security from emerging risks while maintaining an open investment policy,” it is unclear how this Administration will utilize this program and how it may impact funding in the US and the downstream impact that this lack of funding may have on IP licensing. In the first quarter of 2018, net foreign direct investment into the US has declined from $146.5 billion in the first quarter of 2016 to $89.7 billion for the same quarter in 2017 to $51.3 billion for the first quarter of 2018.  While most of the decline is attributed to general economic factors, many believe that it also reflects fears of what the administration is going to do given their stance on China and the threat of trade wars and tariffs.

The expansion of CFIUS authority over investments through FIRRMA may lead to decreased interests from foreign individuals, business, and funds that, in part, created an environment for US businesses to secure the technological superiority this Act now seeks to protect. If that is the case, we may see significantly less investment in the industries covered by the pilot program which includes many industries at the forefront on IP licensing activity such as: Computer Storage, Semiconductor, Battery, Aerospace (Aircraft manufacturing, Space Vehicles and Propulsion), BioTech, Wireless Communication Equipment and Nanotechnology.

It is too soon to know the impact FIRRMA will have on US businesses that seek investment to fund the type of research and development necessary to maintain the pace of innovation that led to the US holding a strong position in technological advancement; however, given the current decline in funding, there is a real possibility that these new regulations that are being imposed on US innovation companies may further restrict the funding necessary to drive the US technological superiority that FIRRMA was created to protect.

Lessons learned from 2 years of startup surveys: Key observations about founders and the companies that they build

In 2016, we launched a startup assessment survey, aimed at analyzing startups that approach us for services and scoring them on the Product/Execution Quadrant map.  This analytical tool provides a useful framework for early stage startup assessment (Pre-Series-A) and for identifying areas of weakness on either the Product or Execution side that should be addressed in order to take the company to the next level.

More on the Product/Execution Quadrant map can be found in this article.

 With over 2 years of data, we have seen some interesting trends in the responses we get to our 20-Question assessment survey.  Below are a few observations that can shed light on early stage founders’ motivations, products, competitive advantages and other factors critical to success:

  1. Founders who are experts in their industries are often targeting problems based on personal pain

There is strong evidence in the market that in instances where entrepreneurs are addressing a personal pain in an industry they know well, they are more likely to succeed.  Our survey results show a high concentration of founders who fit this profile, and we believe that the two are actually correlated: the more experience you have in an industry, the more likely you are to stumble upon a problem that is rampant in that industry.  When asked about the problem they are trying to solve, 50% of respondents indicated that the ‘Idea came from personal frustration’, and 53% further responded that it is a ‘Problem in an industry where I know the customer needs’.  These answers bode well with the responses to another question about relevant industry experience, where 58% of respondents indicated that they have ‘Significant experience (over 5 years)’, and another 18% indicated ‘Some experience (under 5 years)’.

  1. Most founders in the software industry have self-funded a product to minimum viable product (MVP) and beyond

Software products are easier to self-fund to a relatively advanced stage of product development, as opposed to products in hardware, materials or life sciences which require large amounts of R&D and depend on grants or other type of early stage funding. This correlation is clearly supported by our survey results:

  • 76% of the respondents identified their product as ‘Software’ related, while close to 50% specifically identified a Software-related industry (Mobile, Social media, Enterprise software or FinTech).
  • 65% of the respondents characterized their stage of product development as MVP and beyond (31% at the ‘MVP/Proof of Concept built’ stage, 24% at the ‘Initial Release’ stage, and 10% have already released a product to the market).
  • Finally, 88% of respondents have self-funded their venture to-date (29% each also indicated Friends & Family or Angel Funding), and only 2% took in VC funding.
  1. While many founders have some form of patent protection, an overwhelming majority mention ‘Superior product features’ as their competitive advantage

While approaches to patent protection vary in our survey, there is almost a unanimous consensus about ‘Superior product features’ being the most important competitive advantage. This finding makes sense in light of the large concentration of software companies in our survey.  Software companies grow in valuation by gaining user traction, and user metrics are often the most important metrics analyzed by investors.  It is therefore no surprise that 92% of respondents indicated a user-facing metric such as ‘Superior product features’ as their competitive advantage (some of these may be overlapping since there was more than one possible answer to this question).  The next popular answer, at 50% of respondents, was ‘Intellectual property’.  When specifically asked about methods of protecting their idea, founders’ answers seem to be all over the place: about a third of respondents (34%) indicated having a pending patent, 27% of respondents indicated they have not protected their idea at all, 15% had a granted patent and 12% had a portfolio (more than one) patent (some of these may be overlapping since there was more than one possible answer to this question).

  1. First time entrepreneurs seem to overestimate their addressable market and/or underestimate the competition

As we have learned throughout our work with hundreds of startups around the world, many founders (especially if it is their first venture) are overly optimistic in that they overestimate the addressable market, and/or underestimate the competition.  Both of these biases are present in our survey results: when asked about the size of their addressable market, 67% of respondents indicated the market was larger than $2 billion, and another 17% indicated the market was between $500 million – $2 billion.  When asked about the state of competition, 68% responded that there was only ‘a handful of competing products’, and only 12% felt like they were entering a ‘crowded market’.  We expect these biases to be correlated with lack of experience, and indeed, when looking at the makeup of our survey respondents: 38% of respondents are first time entrepreneurs, only 19% have raised money before, and only 10% have had a previous exit.

  1. While most founders operate as a team, the definition of a ‘team’ is subject to interpretation

A strong team is a critical factor in our Execution score, and we collect a lot of information about the startup’s team and its makeup.  59% of our respondents reported having a full-time team working on this project, and 35% of them also reported that they have worked with key members of the team before.  This combination is highly sought after by investors, as past work experience is a factor likely to reduce personal frictions in the team, a problem that is considered one of the top growing pains of early stage ventures.  Having said that, perceptions of what constitutes a team varies among founders, and could be subject to interpretation: while 7% of our survey respondents reported that they have no team, 29% of them indicated in a different question that they are ‘Sole entrepreneurs’.  This seemingly conflicting answer is actually typical of startup founders, especially those with little experience, who sometimes include in the team people who are contractors (17% indicated their team is comprised of independent service providers) or advisors (38% reported that they have an advisory board).  While these two groups can fill in the gap in the early stage, they are often only a temporary substitute to a real, dedicated team.  Finally, while 43% of respondents indicated that they were looking to build their team, only 19% indicated ‘Access to talent’ as a major challenge to scaling the business in a different question.  We attribute this pattern to lack of experience, as seasoned entrepreneurs fully understand the challenges involved in putting a team together.

Conclusion

We will keep monitoring the trends as more startups take our survey.  As previously mentioned, our sample of survey respondents over the last 2 years constitutes primarily of early stage ventures developing software products.  We use this survey to map each company on a Product/Execution quadrant map to figure out their readiness for Series A funding. Founders in our survey often fall into the ‘Rookie’ quadrant (scoring low on both Product and Execution) or ‘Visionary’ quadrant (scoring high on Product and low on Execution). This seems consistent with both the industry they are in (Software) and their stage of funding (seed, pre-Series A).  Our goal is to move them to the ‘All Star’ quadrant (high on both Product and Execution) and get them ready for Series A funding.

Proudly powered by WordPress | Foresight theme designed by thingsym