Cash Burn: When Does It Make Sense? – By David Gens
Those of us that follow business news get constantly bombarded with stories of companies raising large amounts of money. Whether it’s Uber raising $8 billion in an IPO or a local start-up raising a few million dollars, we see these headlines non-stop, and it’s creating a culture of “celebrating the fundraise”. The numbers are impressive and they serve as a form of entrepreneurial validation, plus they make good headlines.
What we don’t see, particularly for private companies which make up most of these headlines, is what is happening behind the scenes. What does the full financial picture look like for these companies?
Having started my own business, co-founded others, and invested in more than a dozen early-stage companies, I’ve been a first-hand witness to the debate of whether to raise money to fund operational growth. The question of whether to raise money goes hand-in-hand with whether it makes sense to lose money for several years in order to build something bigger in the future.
There are plenty of companies who never raise money and stay out of the headlines, and they’re able to do so because they run in the black (or get to profitability fairly quickly without the need for much outside investment). In my years of experience, I’ve seen some companies run at a loss that really didn’t have to. They did so because they thought they could get bigger faster that way. They probably also did it because it’s an accepted path – the culture of celebrating the fundraise and the acceptance of cash burn has swayed corporate decision making towards running in the red. By seeing these scenarios play out, I’ve come up with a few scenarios where it makes sense to run at a loss – and in my view, it’s important to be honest with yourself and if you don’t fit into one of these scenarios, then it’s best to take it slow and boot-strap your growth.
Scenario #1 – Large Market, Potential for Large Share
If the market you’re after is relatively large and you have the potential to grab a large share of it, then losing money now to get big quickly makes sense. However, in order to ensure that grabbing a large share is possible, it is important that you’re in a high barrier to entry business and that you have a unique & highly differentiated competitive advantage. There needs to be a real reason why you might end up being the winner (or at least a very large player) with high margins / returns on capital when you get there.
If you look at today’s technology giants such as Facebook or Amazon, they clearly fit this bill. In the case of Facebook the advantage was their epic network effect (people flock to the most popular platforms since their appeal is tied to the number of people using them) that allowed them to cement their position as market leader. Amazon similarly benefited from a network effect of both sellers and buyers on their platform, as well as the other benefits that come with massive scale in their business model.
Both companies lost considerable amounts of money for years as they scaled. And it clearly paid off.
Scenario #2 – Recurring Revenue Model, Up-Front Customer Acquisition Costs
Sometimes it makes sense to run at a loss, simply because you recognize customer acquisition expenses up-front, while you earn revenues off those customers over longer periods. The best example of this is subscription-based businesses. It costs you $X per customer to acquire your customers. The customers pay you $Y per month for their subscription, and you have churn rate of Z% (the % of customers that cancel their subscriptions in a given period). From there you can calculate your life-time customer value, and as long as the customer life-time value exceeds what it costs you to acquire that customer, then it makes sense to put the pedal to the metal. The result of doing that is your P&L will show large losses when the business is growing – since accounting rules don’t let you recognize the newly-acquired customer life-time value as revenue in the current period. All you get to recognize as revenue is the monthly subscription payments, so inevitably this puts the business in a loss position, since one month’s worth of subscription payments is just a small fraction of that customer’s lifetime value, and you likely spent a lot more than that to acquire them.
But in effect, despite the losses on the P&L, in the above example the business is actually increasing its value in a given time period. At any point in time (assuming you’ve done a good job on your forecasting) if you theoretically stopped acquiring new customers and just let the subscriptions run their course, you would end up with more money in the end than if you did that same calculation in the prior period. Therefore, your business is now more valuable than it was before, despite what your accounting books are showing. Common examples of these business types would be streaming services like Netflix and software-as-a-service (“SAAS”) companies, to name a few.
Scenario #3 – Losses Required before Minimum Viable Product (“MVP”)
There are some business types where operating losses in the early stages are simply unavoidable. That’s because a certain amount of money needs to be spent / lost before the business has anything to sell. Whenever possible, I’ve always held the view that it’s best to simplify the MVP, get to market fast, and test to make sure there is uptake, without having to raise much capital. Then iterate from that point forward and steadily grow.
But, in some cases, it just takes a lot of money to get to an MVP – some obvious examples that come to mind are biotechnology companies (that need to spend on research & development to come up with a drug, and then spend potentially a decade or more in various testing phases before they can earn revenue off that drug) and junior resource companies (who have to survey lands and drill holes before having a product to sell). These tend to be high risk businesses that have large upside along with large downside. Failures where investors lose everything are common.
That’s It – No More Scenarios!
In my opinion, if you don’t fit into one of the above three scenarios, then it’s best to take it slow. Business is a long-term game of hard work, patience, risk management, and ultimately, it’s about profit – that’s why it’s called the “for-profit” sector. We should celebrate the scrappy, bootstrap stories of businesses that steadily put one foot in front of the other, spending only what they could afford, and are financially healthy.
As I mentioned earlier, I’ve seen some companies run at a loss that didn’t have to. I’ve seen this end in financial ruin. Companies that were once celebrated for their successful fundraises ending up in the corporate graveyard – and it could have been avoided. If those businesses took it slow, they would have stayed out of the headlines, grown slower, but ultimately been successful in the end. At the risk of using an over-used cliché, there is a lot of wisdom behind the phrase “slow and steady wins the race”.
If you decide it makes sense to run at a loss and raise money to achieve your goals, then go for it – but be prudent in the way you do it. I would urge you to always have back-up fundraising options, and if your back-up fundraising options fall through, you should have a plan B ready to go – cutting expenses and getting in the black, before it’s too late.
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