Refocusing the Burn Rate Debate

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Nice fire keeping us warm

It seems like everyone is talking about burn rates this week. Several high-profile VCs have sounded the alarm (starting with Bill Gurley in the WSJ and then with Marc Andreessen going on one of his now patented “tweet storms”). While all of those guys have addressed some very real concerns (namely, that when the market turns, it could expose high burn rate companies and the investors backing them), I don’t think burn is as black and white as it’s being made out to be.

Yes, high cash burn rates can be destructive. And, yes, high burn rates followed by higher valuations can be indicative of startup investment largesse.

But that isn’t always the case. And it’s certainly not just the entrepreneur’s responsibility to decide when burn is (or isn’t) acceptable.

The Importance of “Why”and Product-Market Fit

Ultimately, you can’t really have a conversation about burn rate without proper context. After all, assessing a company’s health just by its burn rate is like judging it purely based on revenue, profitability, or capital resources. Those things are indicators of health, growth, and sustainability. But on their own, they fail to paint the full picture.

To acquire context, it’s important to consider a few questions when we’re talking about burn rates:

  • How is that money being spent?
  • What will it accomplish?
  • Is cash burn supported by a sound economic model?
  • What kind of value or competitive advantage is that burn creating?

Mark Suster did an excellent job of diving into this issue, pointing out that one of the most important questions founders (and VCs) need to ask when they fund a company is: Why?

Why do you want to raise capital? Why will it help your business grow? Why do you need it now, instead of six months or a year down the road? Typically, founders will answer those questions by suggesting the money is to build a team, grow sales and marketing, or invest in product development. And those are all perfectly fine reasons to raise money — in context.

For instance, if your company is operating in a fast-moving, competitive vertical and you need to quickly accelerate to establish market dominance, then cash burn becomes a bit more digestible —particularly if the business has already achieved product-market fit. In that scenario, a company can (and probably should) raise and spend as much money as it can manage, because doing so will increase the likelihood of capturing market share and achieving market dominance before competitors have a chance to. In that scenario, the theoretical ends (rapid growth/market dominance/IP/etc.) justify the means (cash burn).

However, if you’re raising and spending capital just because some investor is willing to throw it at you, or because that’s what this frothy VC market has programmed you to think is good business strategy, then the narrative of cash burn change dramatically.

Knowing When and Why to Raise (and Invest) Capital

Again, it’s all about context.

A good example of a business that waited to raise capital until it had the economics and need to do so is ExactTarget — a marketing platform I first invested in back in 2004 as part of Insight Venture Partners.

In its first few years in business, ExactTarget grew from no revenue to $100 million in ARR on less than $10 million in outside funding. That’s phenomenal efficiency, and the business may have been able to self-fund its growth if it so chose. At some point, however, ExactTarget’s leadership recognized that in order to completely separate from its market, it needed to aggressively step on the accelerator.

And to do that, the business needed to raise and spend a lot of cash.

So, starting in 2009, ExactTarget began aggressively raising outside funding —to the tune of more than $150 million over two years. That might sound like an absurd amount of money, but the cash was systematically raised and deployed to scale its teams, product, domestic and international presence, and sales/marketing investment.

I don’t remember exactly what ExactTarget’s burn rate was during that period, but it wasn’t a small sum. That being said, burn made sense in that context. The cash was being spent to achieve a very specific set of goals —and that razor sharp focus paid off. By 2013, the business had grown to a $400 million run rate and, in July of that year, was acquired by Salesforce for $2.5 billion.

How a Company’s Economic Model Changes the Burn Rate Debate

Another good reason to raise (and burn) capital rapidly is if your company’s economics support that resource growth and expenditure. Most entrepreneurs work hard to build great product-market fit, grow their user/customer base, and, in the process, establish a competitive advantage over their competitors. In fact, the most valuable companies are built this way.

But they are also built with great economic model performance in mind. Put another way, the best companies find a way to figure out:

  • How to become large without a lot of capital being consumed (this is the key to owning a greater amount of your business)
  • How to engineer investment ratios to most efficiently fuel revenue growth and profitability (this is the basis for your financially-based valuation, which is often based on top or bottom line revenue, or gross profit)
  • How to structure economic results to create value over a long period of time (see above)
  • How to convince others that they’ve built a great company and will have great economic results far into the future (this is the key to ultimately getting a great valuation multiple)

Great economic models come in many forms, but they’re often driven by two distinct operating points: High growth or high cash flow.

With the first, a company might boast high growth potential and high gross margins, but not-so-great bottom line results. In this scenario, the bottom line (and high cash burn) are acceptable because entrepreneurs and investors can at least envision a scenario in which the company will grow into a big, profitable business. With the second, a company might boast strong cash flow and capital reserves, but low growth rates. In this scenario, high cash burn is more digestible because doing so can stimulate growth without the risk of wiping out cash flow.

Every once in a while, a company will have high growth and high cash flow, and there isn’t an investor on the planet who doesn’t love those types of businesses.

The Risk in Tying Cash Burn Rate to Valuation

One of the biggest problems with burn rates today is the sky-high valuations being placed on businesses that might not have the economics or product-market fit to justify them.

In fact, valuations are so high these days that a lot of entrepreneurs and investors are thinking: If I put more cash against sales and marketing, it might mean I can get more revenue. And, because my valuation goes up by a multiple of revenue, then the valuation for my next round/IPO/acquisition will be that much higher!

Here’s the problem with that way of thinking. If you’re putting $2 against sales and marketing to generate $1 in revenue and (hopefully) $10 in additional company value, then you’re making a risky assumption.

Why? Because market dynamics effect the valuation equation. And you can’t really control those market dynamics.So, while your valuation might be high right now, what happens if/when the market takes a turn for the worse in two or three years? If you’ve been engineering that valuation via cash burn, then you may very well get caught with your pants down.

The reality is that a lot of growth investors (and even some in the IPO market) have come around to the cash-in, cash-out economic model. If you drift away from that and instead operate with a cash burn strategy that’s directly tied to valuation, then you may be disappointed with the results when you go to raise your next round or facilitate an exit. If your economic model sucks, people won’t be as enticed to buy. And that could put you on the wrong side of the negotiating table.

That’s not to say, of course, that a cash-in, cash-out economic model is a low burn strategy. In fact, if your growth rate is high, then your cash burn rate will likely be high, as well. But here’s the key difference: if your economic modeling is rock solid and in-line with previous cash-in, cash-out customer growth, then there’s really no compelling reason not to invest more capital into the company. The bigger issue at that point centers on the maximum growth rate you can sustain before you start bloating the business with bad hires, unnecessary processes, or useless management layers.

Start with a Strategy, then Worry About Cash Burn

To summarize: Great growth strategies typically result in a high burn rate — they don’t start with one.

So, before you start spending, it’s more important to consider what you’re trying to achieve and why you’re trying to achieve it, and then answer this question: Will raising and spending more money allow us to deliver on the value we’re trying to create?

If a larger investment is going to provide you a much larger value increase in your business (relative to the dilution you’re taking), then by all means raise capital and invest it appropriately. But if you can’t confidently and predictably declare that your value (however you quantify it) is going to increase by a multiple of the dilution, then why the heck would you do it?

At that point, cash burn rate isn’t the issue — fundraising strategy, business focus, and investment motivations are the three things I’d question.