In this period of over-supply of cash for technology startups globally, the fact remains that justifying high cash burn has become a lot easier. I fundamentally believe that we are lucky to be living in times wherein access to capital for innovation is plenty, having said that, over capitalization is having its side effects ranging from entrepreneurs losing focus (as they suddenly believe that capital is a strong enough moat), lowering the bar with regards to capital allocation decisions to the more recent echo of justifying cash burn through loosely held assertions like ‘Leading consumer internet companies are also losing cash’ – this last statement got me thinking. While the statement is absolutely correct, it misses two key points which I hope to detail using this blog (1) Not all cash burn incurred is equal – ‘Good Cash Burn’ helps the company drive rapid growth which is sustainable at scale and there is a solid path to profitability which is then justifiably accompanied by high valuations. While ‘Bad Cash Burn’ drives top line growth and more often than not, at high revenue scale, pushes the company to a point of no return with entrepreneurs fighting the five key battles of growing, controlling burn, proving unit profitability, fighting competition and raising capital TOGETHER! (read ‘Herculean task’) (2) At the cost of stating the obvious Companies with ‘Bad Cash Burn’ can only sustain high valuations for a short period of time
The Good Cash Burn
Consider the following scenario – your startup spends a $1 to acquire a customer, you recover this acquisition cost, from contribution profits (revenue less all direct variable costs), in 6 months. Customer lifetime value is large and the company continues to grow at a healthy clip. Your marketing team has cracked at least one acquisition channel which is working well (consumer acquisition cost is stable as you spend more acquisition dollars on the channel). I am inclined to add one more layer to this situation which is more probable in B2B or software startups rather than B2C startups – let’s say with the above-mentioned metrics the company is fast approaching profitability and hence, the company is in no real hurry to raise capital. Let’s examine the following two possible scenarios –
Scenario I – entrepreneur remains conservative in increasing acquisition spend as the lure of profitability and/or the pain of dilution and fundraise holds her back. She increases customer acquisition spend conservatively by 2x.
Peak Cash burn = $5
Scenario II – entrepreneur raises a large round of capital and pumps money into customer acquisition. She increases the customer acquisition spend by 10x.
Peak Cash burn = $25
The following graph does justice to the point I am trying to make –
CUMULATIVE CASH FLOW COMPARISON – Scenario I & II
Following are some of the key highlights from the graphs above –
1. While total cash burn in Scenario II ($25) is way higher than in Scenario I ($5) but the scale and hence, eventual profitability is much higher for the aggressive entrepreneur. And hence, this burn is absolutely justified given the long term return on this invested capital.
2. If you end up in Scenario I, the opportunity loss (and heartburn) of a missed opportunity can be quite crazy. I have been in a real situation wherein the board decided to be conservative in a situation like this which resulted in an outcome which was well below potential!
3. This is a case of ‘Good Burn’ – if your company is experiencing ‘Good Burn’ please reach out to me (and mention the same in the subject line and I will come back as fast as I can)
The Bad Cash Burn
‘Bad Cash Burn’ can have multiple situations. I capture some of them below –
1. Situation I – characterized by long customer acquisition cost payback period and short customer lifetime values – let’s say a business with 36 months payback but 9 months of customer lifetime value (read ‘high churn’). The business never recoups invested capital forget making a return. At this point, the company needs to re-think it’s ‘product-market fit’(more on this here)
2. Situation II – Customer retention is high (customer loves the service) but the company fails to make contribution profits at the transaction level (and hence, there is no payback in sight) and the company scales losses with more transactions! I believe there are two reasons why companies don’t make contribution profits (1) Heavy competition (2) Rapidly scaling behind a flawed ‘product-market fit’ or loss of ‘product-market’ fit. I believe the first reason is a relatively better position to be (vis a vis the flawed ‘product-market fit’ situation) in as competitive madness can hope to settle sooner than later for the pursuit of real profits (topic for a separate blog). Having said that, you need to strictly guard against scaling up if you are in the second bucket – my strong suggestion is that you need to go back to the drawing table to prove strong product-market fit and prove a line of sight of unit economics before putting more capital to scale.
3. If you push for scale in a ‘Bad Cash Burn’ scenario, there will be a point in the evolution of the company wherein you will be fighting the five key battles of growing, controlling burn, proving unit profitability, fighting competition and raising capital TOGETHER! (read ‘Herculean task’).
4. Solve to avoid a ‘Bad Cash Burn’ scenario under any circumstances. More on how a public company lost 90% of its value due to ‘Bad Cash Burn’ scenario
To Summarize –
1. The statement that ‘Leading consumer internet companies are losing money’ and hence, a high burn is justified is an irresponsible statement to make. The burn needs qualification between ‘Good’ and ‘Bad’. If there is one thing that is true it is that companies with ‘Bad Cash Burn’ scenarios can only sustain high valuations only in the short term.
2. If you are experiencing ‘Good Burn’ and you DO NOT accelerate investing behind the same – you run the risk of losing a big opportunity. Essentially, doing a disservice to yourself, your team and existing investors.
3. If you are experiencing ‘Bad Burn’ and you DO accelerate investing behind the same – there will be a point in the evolution of the company wherein you will be fighting the five key battles of growing, controlling burn, proving unit profitability, fighting competition and raising capital TOGETHER! (read ‘Herculean task’). You run the risk of putting the company to a point of no return as your existing investors might help for some time but will sooner than later want outside investors to price the round and invest – essentially, doing a disservice to yourself, your team and existing investors.
4. At the cost of repetition, solving for unit economics is far easier at a small scale than that at a large revenue scale
5. Everything starts from Nothing!!