Burning Bad: Cash burn, cash runway and valuation
Before we jump in, if you’re in the midst of navigating the murky waters of venture debt post-SVB, join me, Daniel, and Lalit on Wednesday, April 19, at 11am PT for a conversation. We’ll address the state of venture debt today, options for securing funding, terms to look out for, and more.
Now let’s roll the windows down, crank the Nickelback, and get into today’s topic: cash burn🔥…
TL;DR:
With the markets returning to focus on profitability, valuations are no longer linked to growth at all costs.
If the past recipe for a premium valuation was three parts growth, one part profitability, the recipe seems to have shifted to at least two parts growth, two parts profitability.
Cash burn has become a “dirty word”… But perhaps we were just overdue in reassessing what “good” cash burn looks like…
I. The Art of Burning Cash
Startups usually need a financial product of some amount to get going. Ten years ago, it used to be, say, a $3M Series A for 25% of the company. Over the last decade there have been more rounds added to the mix (e.g., “pre-seed”). And at the same time, valuations have grown, as VCs formerly focused on later stages have shifted left, driving up round sizes.
Nonetheless, the point of raising money is to use it as a backstop to delay the pursuit of free cash flows and concentrate on a fleeting market opportunity.
Cash burn is simply the amount of money a company is using from their bank account to subsidize the shortfall from current operations.
Burn = What you bill your customers - What you spendII. Cash Runway: Fuel for Takeoff
Cash Runway is the number of months you have until cash runs out. If you’re driving a car and look at the gas tank, how many miles do you have until you hit empty? This, of course, is dependent on how fast you’re driving. The harder you push the engine, the sooner you’ll sputter out on the side of I-95.
Managing your cash runway is also dependent on your future capital strategy. Are you running the business with plans of raising again? Or do you want to become self-sustaining?
If you’re on the venture path, post-fundraise you typically want a cash runway of at least 18 months. This gives you 12 months to go out and make magic before coming back to the table with your coffers, plus another 6 month buffer in case the markets aren’t in great shape.
# of Months @ Current Burn = Ending Cash Balance for period / Most recent monthly burn
# of Months at Forecasted Burn = A count of the number of months until you go negative if you spend to forecastAssumptions for the exhibit above:
You raised $500K in Month 1 and it’s sitting in the bank
You’re growing Revenues 6% M / M and Expenses 20% M / M
Ending Cash becomes your Starting Cash balance for the next period
This forecast tells us we either need a cash infusion going into month 8 (fundraise time!) or we need to scale back expenses to get to a healthier run rate (snip snip).
III. Burning Up Valuations
Investors know that you can’t trade a dollar for seventy-five cents forever (unless you’re Uber… still not sure how they are making that all work). That’s why VCs look at a number of different metrics to validate a company is not burning cash in vein.
For businesses losing money, my top five leading indicators when attempting to triangulate future business success are:
CAC Payback Period: How many months does it take to get back the cash you spent to get a customer?
Generally anything under 12 months is great for startups and under 18 months is great for larger, more mature (or publicly traded) companies
LTV to CAC: What’s the multiple of value you get from a customer compared to what you spent to get them?
Anything under 1x means you are literally destroying value
Anything over 3x is good
Anything over 5x is awesome
Net Retention: How much does a customer grow after you acquire them?
Generally, anything over 110% is good and anything over 130% is great
This varies by the sales segment you are selling into
Gross Margin: After servicing your existing customer base, how much money do you have left to invest in the business?
Top tier software companies tend to hover around 80%
Burn Multiple: How much cash are you burning for each incremental unit of growth? Unlike the metrics above, this focuses on the efficiency of the whole business, not just the go to market engine
Under 1x is amazing, 1.5x to 2x is good, anything over 3x is bad
IV. Getting Comfortable with Cash Burn
Valuation is, at the end of the day, as much art as it is science. When you’re painting a picture, it’s hard to work with just one color. The same can be said when assessing a business - you need to know more than just a growth rate. Growth is a byproduct of a company’s monetization model, not a driver of it. And growth can have both healthy and unhealthy aspects.
Yes, we are in a market correction, and maybe we have over-rotated towards prioritizing free cash flow in the short term. But burning cash is NOT suddenly a definitively bad thing. It should just come with more sanity checks.
Actually, one of the biggest beneficiaries of this change will be employees. Raising cash usually signals a company is on to something. Startups use their fundraising events as recruiting tactics all the time. But if mediocre businesses are receiving premium valuations, there’s a disconnect. When cash is better gated, fewer potential employees will receive false signals and get wrapped up in ultimately bad bets.
For employees, joining a startup is the most important “investing” decision they make. So they should ask some of the same questions a traditional investor would ask when assessing long term business viability. Use the metrics above as discussion points to form a personal investment thesis.
And pack sunblock when you choose which company to burn with - it’s never a straight line to profitability.
This week’s newsletter was written with our friends over at SecFi, a company that specializes in equity planning for startup employees. It originally appeared in their newsletter, where you can get insights on public and private markets, what to do with your stock options, and startup trends straight to your inbox.
What I’ve Been Reading
At this stage of my life, reading texts from Stoics like Seneca and Marcus Aurelius is the equivalent of listening to Young Jeezy to get pumped up before high school football games. I could run through a wall after. YouTopian Journey draws on ancient texts and the writings of prolific authors to provide motivation and wisdom to help you become mentally stronger and realize your potential. The imagery is cool, too.
Quote I’ve Been Pondering
“If there’s a book that you want to read, but it hasn’t been written yet, then you must write it.”
-Toni Morrison
Great article.
Thanks CJ, great article. Curious why NRR wins out over GRR?