Understanding “The Burn”

I walked into a swanky hotel lobby for a meeting with an ‘aspirant’ VC. I had no idea what to expect because when I got a call from him (Lets just call him New Boy) I had never heard of the guy. Turns out New Boy did not even have a decent Linkedin Profile, which was surprising because in the VC world, you either have a kickass profile or you just don’t create one (Their network is already too good for that).

A few calls before my meeting and I get to know that he is the moneyed scion of a construction company. That gave me enough reason to be sceptical. Construction is exactly the kind of old world, bad money, low-innovation and unethical industry which lies on the other side of the spectrum from Venture Capital and Startups.

The New Boy was going around asking for help to set up his VC firm. I guess I must have been next on his call list.

Anyway, I decided to meet him because he sounded like a good guy on the phone. And that perception got further reinforced on meeting him. Nice, affable, well educated and easy going, this guy would have been nice to work with. All was well until he said something that made me almost choke on my salad.

“Startups MUST make profits from Day 1”

I thought it was like one of those moments of aberration, like when a Supermodel farts in the middle of a Photoshoot. You act as if you never noticed and move on. It’s just too hard to break that mental model of perfection in your head.

But this guy just kept at it. The New Boy went as far as to state that most VCs just had it wrong, Startups must not be allowed to languish in the red… ever. 

I disagreed and he kept pushing his point of view, proselytizing like a new convert.

By the end of our meal, I was full. Half with food and the other half with his point of view.

We shook hands knowing very well that we may never work together. Yet, I asked him to look over the concept of “Burn Rate” of startups used by the best Venture Capital firms in the world. 

I hope he did.

 

What is a ‘Burn Rate’?

To understand “The Burn” or as it is better known, the “Burn Rate”, one has to get hold of the below fact.

Startups don’t make profits or revenues for a long time.

 

Why?

Startups need to develop a differentiated product or service. That takes time, people and resources. All of this costs money.

More importantly, startups need to scale up rapidly, gain customers, build a brand, be known, tweak their product, R&D stuff, come out with new versions, promote sales, scale up their head count, get into new offices, build assets etc

All this takes even more money.

And if you can’t do the above a VC will never ever invest in you.

 

Why?

Because if you can’t scale up you can’t increase valuation and hence won’t be able to increase the value of his stake in your startup.

VCs don’t want you to just grow, they want your startup to exhibit explosive growth which will get future investors all tickled up and bring in great valuations.

It will also help you capture market share and eyeballs before the next guy can blink.

 

So what does that mean?

VCs wants you to make profits & money… but they really really want you to scale up and grow like hell. And the fact that they have invested in your business means they know that someday, with the right tweaks and critical mass, you will turn profitable.

 

Ok…

The VC knows you won’t make money and exhibit negative cash flows (means you are using more cash than your startup can generate). That’s where the VC money comes into play.

In fact, VCs are happy with a ‘healthy’ negative cash flow. Because what it means is that you are using their invested cash to fuel your growth. 

Something like a Sports Car using more petrol when speeding up the race track.

 

Therefore 

Negative Cash Flow (under certain conditions) is a byproduct of the High growth of a Startup.

Or

The amount of Cash per month/week/day utilized or projected by a Startup to finance its growth is called “Burn Rate“. This Cash is usually the money invested in by the VC, investors and lenders.

 

Formula

(Cash requirement to run your startup over and above the revenues) / 12

Note – You can calculate it for days and weeks by substituting the denominator. The above formula is for Burn Rate per month for a year.

 

A few Things to know about “Burn Rate”

1. Venture Capital firms may ask you to give “Projected Burn Rate” figures. Don’t shit in your pants yet. All they want to know is the monthly requirement of cash to finance the growth of your Startup.

2. Many Indian Startups like Snapdeal, Myntra, Flipkart which show great topline, are still unprofitable, but are chasing growth and hence will have a certain Burn Rate figure which is looked at every day. Hence this is a natural phenomena for every Startup. Growth over short term profitability.

3. The Burn Rate will also be used to measure how effective you are in customer acquisition, awareness and sales. So if you are able to acquire 2000 customers for every $ 1 Million spent and in a year’s time you see 1800 customers acquired for the same money, then maybe, your efficiency in real terms has dropped.

4. Burn rate is calculated using ‘Total Cash’ spent for those startups, like Biotech firms, which may not make sales for many years due to a high gestation period. However, if you are an operational eCommerce Startup, then Burn rate will be calculated using Negative Cash flows since revenues will hopefully start coming in by then.

5. When things get really bad for the Burn Rate, like high spikes due to sudden drops in revenues or other non-growth reasons, it may be important to look at Burn Rate on a weekly and Daily basis.

6. Due to great spikes and falls in the Burn Rate over a period, it is important to average it out over that period.

7. An important metric to note with the Burn Rate is “Zero Cash day“. That’s the projected day when you have no cash from investments and other sources left to support your Startup.

8. When your Zero Cash Day is about 2-4 months away, it’s time to start sweating. When its 1 year away, it’s time to breathe.

9. The Burn Rate and Zero Cash day will help you understand the time frame in which the next round of funding is required. LetsBuy was acquired, in part, because it could not raise funds anymore and Zero Cash Day was looming large.

10. The Burn Rate can increase due to a number of Negative and Positive reasons. A Positive one may be that you suddenly spend a lot of money in acquiring assets, infrastructure and hiring people in anticipation of sales for the future. Negative reasons may be drop in revenues, inefficiency of processes, unutilized assets, spike in overheads etc.