Runway and Burn Rate for Startups06.01.11
If there's one area that I'm usually most concerned with with respect to startups -- it's how they manage their runway. Very simplistically, there are 3 ways to control your runway:
1. Raise money
2. Burn rate (how much cash you're using)
3. Bring in money (via the business)
Let's look at them one by one -- #1 raise money. When I was in college, we had a class at Princeton called "High Tech Entrepreneurship" which was taught by Ed Zschau [link]. Ed's been really great to me over the years (among many other things, he arranged for a summer internship at Reader's Digest which I believe played a critical role in my getting a job at amazon.com) -- but one thing that he said repeatedly in that class which really stuck with me was the as a startup, always raise more money than you think you'll need -- because you'll need it.
As an observer, raising money has always struck me as really strange -- because it's almost as if it's really difficult to raise money, until it isn't. One day, the doors just open up. However, when that day comes, I feel like startups can easily be a little too clever. They're usually trying to preserve equity and essentially say, "We'll take this much now and then raise more at a later date when we can raise at a higher valuation." The problem arises when you can't raise at that later date -- you didn't hit your milestones or the market turned south or who knows what happened. To borrow a phrase that my friend Wesley sometimes tells entrepreneurs, "Don't overestimate your ability to execute." Running out of money is binary. You either run out of money or you don't. When you have the ability to raise money -- unless you're going to get crushed on terms or you're raising money for things that aren't critical or you're really raising too much money too quickly (e.g. giving up 40+% of your company in your Series A) -- I'm usually of the mind... take the money.
2. Burn rate. I've seen startups that one day have X employees, they raise their seed round, and the next time I see them, they have 2x the # of employees. Not the best. Here's what I think is the problem with that approach -- odds are high that the economics of your business haven't fundamentally changed to support those additional employees.
I think psychology plays into the hiring of additional people and here's why. When you work in a company, almost invariably, no matter you do, there's always this sense of, "There's so much to do." or "No one can do the job I'm doing." or "What are they going to do when I'm not here?" I'll tell you what they're going to do. Absolutely the same thing. Your job will get subsumed into someone else's job or they'll stop doing whatever it was that you guys were doing or things will break and that'll probably be fine too. The opposite is true too. When you start thinking about hiring people -- there are all these people and functions that you can hire for -- all these untapped opportunities if we only had the people! I think it's really difficult, psychologically, not to hire these people in a startup / as an entrepreneur. Almost by definition, an entrepreneur is someone who is willing to take risk and seizes opportunity when they appear. So, they have money, they deploy that money, and they worry about tomorrow... tomorrow. That 1 person will almost never invariably make or break your company. But not managing personnel costs can break your company. And don't kid yourself. The biggest factor in burn rate is personnel. Just break out your P&L and calculate as a percentage of total expense where the money is going -- inevitably it is dominated by people-related costs.
Here's the other thing too. When you're not profitable, your startup is factually going out of business. It may be going out of business really slowly -- your burn rate is low and you have a lot of money in the bank -- but eventually you will run out of money if the economics of your business don't change. So each new hire pretty much has to be looked at as an investment -- will this person actually get me that much closer to profitability / self-sustainability? They shouldn't be looked on purely from a, "Do I have enough work for this person / will they free up work / will I get sufficient value from them?" It can get a little tricky when you use this thinking around something like customer service, but even then -- if you think about it, at its core, bad customer service basically shows up in low customer retention. That can get costed out. What's the lifetime value of a customer? How much of their lifetime did you lose? What's your cost per acquisition? It's not the simplest of calculations -- but even in that case, you can conceivably do that and figure out where that point lies -- where the incremental cost of extra customer services costs equals the incremental profit of keeping that customer satisfied.
The short of it is -- be really disciplined about each of your hires. They're expensive, they're hard to adjust (you have to fire / lay off people which is tough and does all sorts of bad things to morale), and they're often not really necessary. Wait until your business model supports it. There's likely going to be a time for that hire -- it just might not be now.
3. Bring in money (profits not just straight revenue). Startups, especially if they raise institutional money, can be under enormous pressure to grow. Investors (especially those investors) are looking for home runs and grand slams -- not walks and singles. They want you to have millions of customers. I understand this on a logical level but it's a little hard for me to wrap my mind around just wildly unprofitable businesses. Take XBox for example -- to this day, I don't believe it's net positive for Microsoft. XBox! Bing is supposedly billions in the hole for them. When you're not fundamentally accountable for the economics of your business -- are you really running a business?
I was walking down the Santa Monica Promenade last night and noticed that 3-4 stores were new -- the old ones probably went out of business and new ones took their place. There was an interesting deli / wine bar / restaurant (I'm serious) that went out of business and in its place was a clothing store and a for lease sign for the other half of the store. Think about this business. Month to month, they probably have crushing rent. They're bringing in X dollars. Maybe they were profitable for a while or maybe they weren't. Or maybe they were fundamentally unprofitable but they could wait it out because they started with several hundred thousand dollars in the bank. Eventually that either runs out or the owners basically say, "Why am I shoveling money into a pit?" They're fundamentally accountable to the business. Maybe it's a bad idea to have a deli / wine bar / restaurant at the location. Maybe they're running it really poorly. Maybe the margins for that type of business can't support the location. The stores on Rodeo Drive are going to be different than the stores on any street in Omaha, Nebraska. This is the same situation -- you're investing money into a money losing business. So you have to constantly ask yourself -- is how I'm running this business going to turn it around? Is this a good investment?
I understand that sometimes you will make a strategic decision to do something unprofitable to grow revenue -- we did this at amazon.com when the Electronics store was starting out. The Electronics industry has really tight margins so in order to have a chance at long-term profitability, you have to go direct (i.e. be able to source products directly from manufacturers like Sony or Toshiba and not buy through middlemen like Ingram-Micro.) But Sony or Toshiba won't talk to you unless you're sufficiently big -- hence the need to grow revenue at the expense of profitability. Totally understand and obviously that decision has paid off big for amazon. But keep in mind, amazon had massive resources to be able to invest this way. Does your startup?
I bring this point up because I feel like most startups I know are often all too willing to leave $ on the table with almost the implicit sense of, "We don't need to worry about profitability -- we're so young." What I would say here is just run it smart. You can leave money on the table but just be thoughtful about when you leave money and how much you leave. You want to take calculated risks -- not fundamental risks. It also hones your ability to make decisions -- because then the lens is around having a sustainable business -- you're actively trying to run this as a business that doesn't need an external factor (money raised) to keep it alive. In that scenario, trading off for when you're leaving $ off the table is the same as doing any investment -- is the expected return for this decision worth it?
So all this is a factor in how much runway you have -- total $ in the bank / (burn rate - revenue brought in). So let's say you raised $600K, your burn rate is $70K/month, and you're bringing in $10K -- you have 10 months worth of runway. What type of situation is this? Or better yet -- what type of situation was this when you had major decisions to make -- like how much money to raise? 10 months is not a lot of time -- it's not bad, but it's not a ton. In this scenario, let's say you raised $900K instead of $600K -- then you have 15 months instead of 10 -- now that's a lot of time. Or maybe your burn rate was $40K instead of $70K/month -- then you have 20 months instead of 10. Or maybe your revenue is growing quickly -- so much so that you think in 3 months, you could be at $60K/month -- well, that completely changes everything.
But it's these types of decisions where you want to give yourself more breathing room. More money raised up front, less cash going out the door, and perhaps growing revenue / profitability more aggressively that you were planning. These are the levers you can pull with respect to runway.
Here's an example situation that sometimes happens. Burn rate is relatively static -- it's a good team and everyone is performing well. Revenue is low or non-existent and it's not really growing. If you're running out of runway, what does that mean? It means you have to raise. Is that a viable option? If so, then you can leave the other two alone. But let's say it's not -- maybe people aren't as excited about your startup anymore or liquidity is tight. Then you only have two levers. If you can't move revenue, you gotta move people. If you don't want to move people, then you have to improve the economics of your business. I raise this up because the levers you can pull are fundamentally limited.
I'll end this post reiterating something I said earlier -- if you're a startup founder, you're probably willing to take more risk than the average person. But when you're running out of money -- you exist in two states, in business and out of business. Generally, startups are not a short horizon game -- they take time to nurture and develop. Give yourself the time to figure out your business and succeed.