The startup and venture capital businesses are based on a general idea that you can and should invest heavily into your business in order to increase value creation, amplify it, and accelerate it.
These investments mostly take the form of operating losses, driven by headcount, where the monthly expenses are larger, often much larger, than revenues.
These losses are known in the industry vernacular as “burn rates” – how much cash you burn on a monthly basis.
But how much burn is reasonable?
I have been thinking a lot about this in recent years.
Instinctively I feel that many of our portfolio companies, and the startup sector as a whole, operate on burn rates that are too high and are unsustainable.
But it is hard to talk to a founder, a management team, or a Board about burn rates objectively.
There are no hard and fast rules on burn rate so you end up getting into an emotional discussion “it feels right vs it feels wrong.”
That’s no way to have a conversation as important as this one.
So I’ve been looking for some rule of thumbs.
One that I like and have blogged about is the Rule of 40.
The rule of 40 makes an explicit relationship between revenue growth rates and annual operating losses. Below 40 is bad. Above 40 is good.
But the issue with the Rule of 40 is that it is oriented toward businesses (like SAAS) where there is a well-understood relationship between value and revenues and ones that are reasonably developed.
So I’ve been deconstructing the Rule of 40 in hopes of trying to get to a more fundamental truth about burn rates.
And what I have come up with is this:
Your company’s annual value creation (valuation at the end of the year minus valuation at the start of the year) should be a multiple of the cash your company has consumed during the year.
That seems simple and obvious and that is a good thing.
But in order to make this work you need to lock down two things;
- how are you going to objectively measure valuation absent a financing event?
- what is the multiple?
The latter one is easier I think. The multiple should be large. 1x is clearly not enough. I don’t think 2x is either. 3x is borderline. I like 5x. I would want a 5x return on my annual burn.
I think annual value creation should produce a 3-5x return on annual burn. That feels like a good solid range to me.
The first question is trickier. If you have revenues, then using a revenue multiple to establish value is a good way to do this. You can look at comparable company financings and acquisitions and also public company valuations to figure out what revenue multiple to use. But you should be careful to understand that revenue multiples are a function of revenue growth rates. The faster your revenue is growing the higher they are.
So let’s do an exercise here to flesh all of this out.
Let’s say you are a $10mm annual revenue company in 2017 growing to $18mm in 2018.
And let’s say that you look around at public comps and companies similar to your are trading at 6x revenues.
So you can estimate that your business is worth $60mm this year and $110mm next year.
So there will be $50mm of value creation in 2018.
If you want a 5x return on your burn, you should not burn more than $10mm in 2018.
If you are willing to accept as little as 3x, you should not burn more than $16mm in 2018.
That’s how this rule works.
I like it because it is objective and will lead to rational discussions about burn rates vs emotional ones.
It does break down in pre-revenue companies where it is harder to objectively measure value creation. You can use financing valuations as a proxy in pre-revenue companies but then you quickly get back into emotional territory as the end of year valuation will be an aspirational number and unreasonable aspirations/expectations are what lead to unsustainable burn rates in the first place.