Burn, Baby, Burn
What is “burn rate”? How should start-ups think about it?
“Spend each day trying to be a little wiser than you were when you woke up.” Charlie Munger
“Burn Rate”: An Important, Often Overlooked Metric
Two important metrics to private company investors in growth companies are:
(i) The monthly “burn rate” (historical and projected), and;
(ii) How many “months of runway” (months of cash in the bank) does the business have.
In my experience, “burn rate” is not something most CEOs/founders track as a metric in their week-to-week business cadence or discuss regularly at the Leadership Team meetings.
In most start-ups the founding team does not have a deep background in finance. As builders and optimists, they are more focused (and rightly so) on the big market opportunity ahead of them. Their top priority is to invest in (hire) the right people to build and sell their product or service.
My work, as a fractional CFO and business coach, is predominantly with early-stage businesses that are growing but not yet profitable. One of my roles is to alert CEOs and co-founders on a regular basis, at least monthly, on changes in the burn rate and its implications for the business trajectory. I regularly evaluate recent performance and reforecast future performance (based on the sales funnel and investment priorities) to estimate the likely remaining months of runway.
I have had a number of recent discussions with clients on this topic. And these conversations have helped me realize this topic merits a short article.
Common Questions I Encounter
How is “burn rate” defined? How is it different from total expenses, EBITDA or net income?
Why was the actual monthly burn rate different (more or less) than we had forecast?
What is an appropriate or defensible monthly burn rate? Obviously less is always better than more.
How do I balance growth and burn rate? What matters more to investors?
Definitions
Total expenses: All the “accrued” expenses for the month as recorded in the income statement. This includes (i) cost of goods sold, (ii) sales and marketing, (iii) product and engineering, and (iv) general & administrative. The word “accrued” is highly important. It means incurred expenses in the period, whether invoiced or not. All accrued expenses (not just those invoice or those paid) need to be recorded as they will come due at some point in the future.
EBITDA Loss: The acronym EBITDA stands for “Earnings before Interest, Taxes, Depreciation and Amortization”. The EBITDA loss in an early stage business is total revenue recognized less total expenses incurred excluding interest, income taxes, depreciation and amortization.
Net Income Loss: Net income loss is defined as the revenue recognized less total expenses incurred.
“Burn Rate”: When investors say “burn rate” they usually mean free cash flow before financing. This calculation includes all the cash (earned and spent) related to operations, working capital and capital expenditures. However, it excludes any cash raised from the issuance of equity, debt and option exercises, or any cash spent to pay down debt.
Interpreting Variances in the Burn Rate between Actual and Budget
One certainty is that every budget will be wrong. The actual burn will always be different (higher or lower) than the budget. An important skill is to correctly interpret the meaning of these variances.
When analyzing variances, categorize them in four distinct buckets.
Timing Changes. Most commonly related to changes in working capital. Examples would include deferring bill payment to a later period than budgeted. Another timing change would be collecting cash either sooner than forecast or expecting payment in a later period than had been budgeted. The important takeaway - all timing differences are temporary. These differences will reverse in the future. So they are neither found money nor a huge drain on the business.
Temporary or Short-Term Changes. These are variances due to an expense being deferred (i.e. a budgeted new hire is delayed for a month or two) or the incurrence of a one-off expense (e.g. holiday gifts for all employees in a COVID year). These variances are temporary in that they will have a short-term and non-recurring impact on the burn rate. Yes they impact cash flow for a period (or two), but not permanently.
Permanent Changes. These are the most important variances when it comes to forecasting the normalized future monthly burn rate. Permanent changes means a cost will no longer be incurred (e.g. office rent is going away altogether, if the new plan is for everyone to work from home) or forecast revenue that will no longer be realized (e.g. a customer with a 5-year contract surprisingly went out of business during COVID and will never pay). Permanent changes in cash flow have the largest impact (positive or negative) on business value.
Budget Errors. The budgeting process is stressful with lots of changes made in a compressed period. Because we are all human, errors happen. A budget error is when the team forgets to include something in the budget or makes an error in the starting point balance sheet off which working capital changes are forecast (e.g. missing accruals.) These will be permanent changes (and are usually negative though can be positive).
Only permanent changes should be viewed as long-term “good” or “bad” events. Budget errors happen and hopefully the magnitude is not huge. Timing events (whether positive or negative to operating free cash flow in the current period) should reverse at some point in the year. Temporary changes (in hiring timing) may be actual savings for those periods. Or, department leaders may choose to ask to spend that money saved in this period on another expense in a future period.
How Much Is it “Ok” to Burn?
This is the most important and hardest question to answer. At the risk of sounding glib, the simplest answer is do not run out of cash. Adjust the burn rate to prevent that fatal outcome from coming true.
A more nuanced answer differentiates between later stage and earlier stage companies.
Later Stage Companies. The “Rule of 40” metric, introduced by Brad Feld in 2015, works best for asset light companies (esp. software) to help understand how much burn is acceptable given the pace of revenue growth.
Some weaknesses of applying the Rule of 40 to later stage companies include:
Stage Definition. There is no accepted definition of a “later stage” company. Most private company investors would agree that over $50 million in annual revenue definitely qualifies. It may be applicable to companies at have that level of revenue. For these companies, the rule of 40% is a good benchmark to rely on in judging “burn rate” relative to growth rate.
Profit % Metric. Profit % is an unclear metric. It has no single definition. Profit % could be interpreted as EBITDA, Operating Income or Free Cash Flow. I personally prefer free cash flow as it speaks to the total cash efficiency of the business (i.e. not just actual operations but also including payment terms, billing frequency, inventory build-up etc.) Amazon, in their retail operations, was able to negotiate amazing payment terms and thus was free cash flow positive in many years that operating income and net income were negative.
Earlier Stage Companies. The Rule of 40 is not very informative as a burn rate benchmark for early stage companies, especially those experiencing hyper growth in revenue (> 100%) starting from small actual revenue levels. So what to use instead? I have no perfect answer. Here are some thoughts on ways to benchmark if the burn rate is reasonable.
Based on # of Employees (or equivalent if heavily reliant on outsourced labor.) In 2011, Fred Wilson wrote a post about burn rates referencing that a spend of $10,000 per month per employee (fully loaded for all business costs) was an acceptable burn rate. Costs (especially salaries) have risen since then, so an update figure of $12,500 would be my reference point for 2021.
Funded for the number of months necessary to achieve the next key milestone(s) plus a cushion. Early stage companies will typically raise additional money. Successful fundraising is usually determined by demonstrating attainment of key milestones (whether product related or customer traction related). Achievement of these key milestones “de-risks'' the future investment and supports a higher valuation.
Carefully monitor the monthly burn rate and make adjustments to allow the business the time to achieve these milestones. Remember to plan for a few months of cushion. Execution is rarely perfect.
What Matters More, Growth or Profitability?
This is one of the perennial questions in investing. The companies up frequently in Board meetings of early stage companies where the founding team believes they are attacking a substantial market opportunity.
As a former CFO, I have always argued for efficiency to be included (alongside growth) in all incentive compensation plans and bonus schemes, particularly for the Leadership Team.
That being said, most of the data suggests that growth matters more, especially at the early stage. Put another way, in more traditional finance speak, all organizations (even those who are cash flow negative) should invest in projects when they are confident that the present value of the return on these investments will substantially exceed their risk-adjusted cost of funds. The hard part is ensuring the projections are done reasonably and not simply created to solve for a positive net present value.
Here are some other reasons to favor growth.
Scale matters in assigning value to a business. Buyers of companies (or stocks) have shown a preference for growth over profitability (particularly in the last decade.) That preference shows up in the data where multiples assigned to a business increase as a business gains scale. A business that reaches $5 million in revenue and is profitable is valued at a lower multiple than a similar $100 million revenue business that is losing a little money. Larger scale proves the market opportunity and suggests greater potential for future cash flows through increasing efficiencies.
This reality leads to the suggestion to reweight the Rule of 40. The revised formula is as follows:
Weighted Rule of 40 = 1.33x Revenue Growth % + 0.67x Profit Margin %
An analysis on public companies based on the weighted rule of 40 by the Software Equity Group shows the following result.
Minimum Growth Rate Needed to Raise Venture Funding. Since early stage investors are seeking outsized returns, there is a minimum growth rate and potential revenue scale over time necessary to get these investors to pay attention.
The Mendoza Line. Rory O’Driscoll (a partner at Scale Venture Partners) has written a thoughtful piece about how there is a minimum growth rate needed to raise additional venture funding. He calls it the Mendoza line for SaaS growth, in homage to baseball and needing to maintain a batting average about 0.200 to stay in the major leagues.
Growth Persistence. The most interesting part of the Scale Venture Partners analysis is that “past performance is indicative or future performance.” Or that growth rates tend to decay over time in a predictable fashion, so the starting point for growth rate is telling of likely future results. This pattern is called growth persistence, the data for which is here. (It would be great to see this updated to include more recent results.)
This leads to the Mendoza line graph below showing the minimum future growth required (with the decay curve shown) to reach $100MM revenue.
Conclusion
As with most things in life (sadly), there is no “right single answer” on the appropriate burn rate. I would counsel all entrepreneurs, founders and CEOs to:
Pay attention to the burn rate. Don’t leave it only to finance or accounting to worry about.
Run business model sensitivities with lower growth rates and longer collection times.
Prioritize the investments you want to make, knowing you can’t make them all (usually). Defer less critical investments to future periods.
Really understand the order of operations. The activities that are upstream of others need to be invested in first. A simple example would be investing in marketing and creating qualified leads before hiring additional sales people.
Capital efficiency is your friend. This is true even in market environments as we have today where valuation multiples are at or near all time highs and capital availability seems high. Capital efficiency will mean that you (the founders and employees) will own more of the business over time.