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.

Living in a Bubble? Demystifying Startup Valuations

Just when it seemed as though start-up valuations had peaked in 2013, the year 2014 has started with an opening shot in the form of the reported $3.2 billion acquisition of Nest Labs by Google, followed with Facebook’s $19 billion acquisition of WhatsApp. It now looks as if this year continues the perfect-storm conditions, which will sustain the trend of high valuations for exits (M&A and IPOs) and transactions in coveted markets such as the Internet of Things, where Nest has a strong foothold.

From my vantage point in Silicon Valley, I am frequently asked whether we are in the midst of a ‘valuation bubble’. The answer to that goes back to the definition of a ‘bubble‘, which inherently involves some irrational behavior driving otherwise rational participants in the marketplace to stray from reasonable prices that could have been anticipated under similar circumstances. Understanding the factors driving business valuations hinges on understanding the valuation framework, access to capital, liquidity conditions and the overall technology landscape. With that in mind, let’s look at some of the major trends that are shaping startup valuations in order to establish whether current valuation levels actually represent irrational, bubble-like conditions.

1. Demise of Financial Fundamentals: Rise of KPI-Driven Valuations

Valuations in certain high-growth industries are undergoing a paradigm shift, with financial fundamentals making room for valuations based on key performance indicators (KPIs) such as user stickiness, churn and conversion rates. A common pitfall involves trying to benchmark valuations of pre-revenue companies against traditional financial valuation fundamentals, such as revenues and profit multiples. This might give people a false sense of irrationality when they try to justify the valuation. This may sound like a radical idea, but it is the only way to explain the price parity between Instagram and Ducati, two companies purchased on the same week in April 2012 for around $1 billon. Instagram, a high-flying social media start-up with no revenues and 50 million users, commanded the same price as Ducati, a century-old Italian motorcycle manufacturer with €500 million in revenues. Last year saw a proliferation of KPI-driven valuations, with pre-revenue start-ups such as SnapChat and Pinterest valued at billions of dollars.

2. JOBS Act and Crowdfunding: New Platforms for Funding Innovation

Reward-based and equity-based crowdfunding platforms are emerging as prominent means for funding innovation, with over $2.7 billion raised in more than 1 million campaigns across all types of crowdfunding platform in 2012. Equity-based crowdfunding was made possible by the Jumpstart Our Business Startups (JOBS) Act, which lifted the 80-year ban on public solicitation in the United States. The long-awaited equity crowdfunding Title III Securities and Exchange Commission regulations are expected to be released later this year, marking the full launch of equity crowdfunding in the United States (which is currently limited to accredited investors only). At the same time, reward-based crowdfunding is becoming increasingly popular, with major platforms such as Indiegogo and Kickstarter helping start-ups to raise millions of dollars and bring new products to market.

3. Supply and Demand: Cash is Abundant

The consensus in US investment circles is that there is a lot of cash on the sidelines waiting to be deployed. Several factors are at play here: corporate cash levels are at an all-time high, creating shareholder pressure; high liquidity is fueling private equity investors, which are moving into growth equity; and venture capital investors are increasing their funds, resulting in higher investment rounds. The abundance of cash for investment is pushing up valuations to higher levels across the board – a trend that is expected to continue in the near future.

4. Multiple Paths to Liquidity: Intense M&A and IPO activity

In 2013 the NYSE reported a total of 230 IPOs with a combined value of over US$55 billion across all major US stock exchanges. Companies going public in the United States are generally more mature and are staying private longer. Subsequently, pre-IPO liquidity in secondary markets is very important, especially to early shareholders and investors. M&A activity saw some decline in 2013, with slightly over 10,000 deals reported overall, including about 2,200 technology deals with a combined value in excess of $100 billion. IPOs and M&A deals represent alternative paths to liquidity, which drive valuations up as companies have several options. These pricing pressures are expected to continue through 2014.

5. Hot Technology Sectors: Major Disruption Ahead

Some technology sectors represent particularly high-growth opportunities, and are expected to rise above the tide and generate M&A activity and higher valuations in 2014. One such sector is the Internet of Things (IoT). The IoT represents the vision of a connected universe where objects, devices and people will all share a common network of communication. IDC estimates that the number of connected devices will grow to 212 billion by 2020, with about 30 billion devices smart enough to operate without human control. A study by GE concluded that the IoT market over the next 20 years could add as much as $15 trillion to global gross domestic product, which is roughly the size of the current US economy. The Internet of Things is gaining momentum with industry leaders such as GE and Cisco, which adopted it as a key element of their corporate vision in 2014 and beyond.

So, are we living in a valuation bubble? The answer is probably somewhere in the middle, and perhaps we could characterize current valuation levels as “somewhat inflated, but mostly expected” under existing market conditions. These are exciting times, when disruptive technologies finally meet the right market conditions and capital infrastructure that allow for the kind of unprecedented valuations witnessed in recent years.

Business Model Innovation: Why Building a Better Mousetrap is Not Enough

mousetrap2What do solar energy and personal communications have in common? While energy and communications seem unrelated industries, they have significant similarities if one considers the role of business model innovation as a precursor to success in bringing new intellectual property to market. Take, for example, two companies:

  • SolarCity Corporation (Nasdaq: SCTY), a solar panel installation company, which is publicly traded with a market cap of over $7 billion; and
  • WhatsApp, the text messaging company which was purchased in February 2014 by Facebook for $19 billion.

In a playing field littered with the corpses of failed ventures, these two companies point not necessarily to cutting-edge technology, but rather to filling the gap in a business model as the key enabler of their success. SolarCity had one of the only initial public offerings (IPOs) in the solar industry, an industry known for high failure rates, due primarily to its successful solar system financing program which allows it to distribute a product with a negative return on investment to millions of households. And the recent WhatsApp acquisition is largely attributed to the lack of revenue model agility on the part of incumbent carriers, which created an opportunity for WhatsApp to tap into its user base – and grow to 450 million subscribers worldwide.

SolarCity: making solar systems affordable
In late 2007 I was on the founding team of a residential energy efficiency start-up in Silicon Valley, engaged in developing a data-driven analytical platform for homeowners to understand their energy consumption and savings opportunities. The residential sector has always been a tough nut to crack when it comes to energy efficiency: homeowners are motivated by a complex set of incentives (saving energy, saving cost and reducing their carbon footprint) that often seem at odds with their actual energy consumption behavior. Utilities have been experimenting for years with all types of initiative, ranging from handing out free energy-efficient light bulbs to installing smart meters that would balance off the load during peak hours. Successful IPOs are the exception to the rule in an industry that has grown accustomed to a steady stream of bankruptcies, poor earnings reports and dwindling funding resources.

SolarCity was founded in 2006 and was originally backed by Elon Musk, the maverick Silicon Valley entrepreneur, who is also the founder of successful electric vehicle company Tesla Motors. The company designs, installs and maintains photovoltaic (PV) solar systems on residential rooftops. Solar panel installation is a lucrative business. Most of the money being made in the solar industry does not come from making and selling solar panels, where the market is flooded with cheap PV panels from Asia. A recent Massachusetts Institute of Technology study found that in residential systems, solar panels typically account for only 20% of the overall cost of the system. The rest includes the cost of electricians to install the panels and hardware to connect the systems to the grid. Most of that money goes to companies like SolarCity.

From an economic standpoint, residential solar systems are expensive to install and do not actually pay back in energy savings over the duration of typical home ownership, which creates a major hurdle to adoption. The key difference between SolarCity and many other solar companies is that its strategy is not based on innovative new PV panel technology; rather, its competitive edge lies in utilizing existing solar technology with an innovative approach to financing the panel installation. Instead of asking for a big upfront payment, the company created a financing program whereby it leases the systems to homeowners. The lease payments are offset by power savings from reduced electric bills and the surplus electricity that can be sold back to the local utility. By doing that, SolarCity has managed to convert a product with a negative return on investment to an affordable energy-efficiency solution.

WhatsApp: picking up the slack in messaging services
Telecom research company Ovum Ltd estimated that service providers worldwide lost about $32.5 billion in 2013 in text messaging revenues to free social messaging applications like WhatsApp, a loss that is projected to reach $54 billion by 2016. Internet-based messaging services have particularly increased outside the United States, where carriers charge high fees for texting on top of the regular voice and data plans. In order to protect their text-messaging subscribers, US carriers began to offer flat-rate, unlimited text messaging in many of their plans. However, carriers in other parts of the world are largely affected by the proliferation of free social messaging apps: in Mexico, for example, it is estimated that about 90% of all instant messaging goes through WhatsApp.

For much of the past three decades, voice has dominated the revenue streams for almost all telecoms operators. The changing face of the mobile industry affected the business models and revenue structure of service providers. In 2013 voice revenues were expected to fall below the 60% threshold globally for the first time. The drop in voice revenues has been compensated by the rise of messaging and data revenues, as service providers try to keep the overall average revenue per user (ARPU) at stable levels. A ‘perfect storm’ set of circumstances created the fertile ground for WhatsApp to take over the market: the ubiquitous broadband internet access, the proliferation of mobile devices and the gap in business model on the part of the service providers. These circumstances pushed subscribers to adopt free personal communication applications at increasing rates.

One might argue with the price paid by Facebook for WhatsApp’s massive user base, but this acquisition was definitely triggered by the global accelerated growth of WhatsApp, which would not have been possible but for the gap in revenue model that caused telecoms companies to lose users that they already own, due to the wrong billing model. It remains to be seen how WhatsApp’s 450 million users will be monetized by Facebook, but this represents a missed opportunity for the service providers whose focus on maintaining their ARPU metrics and existing billing structure is causing them to lose sight of some of the new revenue opportunities in telecoms services today.

In some industries it is not enough to build a better mousetrap. Often, the key to product or service success in the marketplace hinges on coupling intellectual property with the right business and revenue model.

Proudly powered by WordPress | Foresight theme designed by thingsym