Tuesday, February 21, 2012

Startup Runway Length Depends on Your Burn Rate

Cash is the fuel of every startup. Your burn rate is the rate at which that money is being spent, and allows an estimate of how long you can go before refueling (runway). That refueling is when you will need more investment, or when you will break even and begin that steep profitable growth curve.

Investors also look at your burn rate to see how efficient and effective you are at running the business. It continually amazes me how two startups, seemingly comparable in stage and objective, can be so far apart in their burn rate. One can build a new website application for $10,000 per month, while another is burning $50,000 per month. Which would you bet on?

For obvious reasons, you need to keep your burn rate low. As a rule of thumb, investors expect each investment round you get to last at least a year to 18 months. Here are some recommendations on how to keep the rate low, and help your startup to prosper at the same time:

  • Measure it and manage it. As a rule, you need to review your burn rate every month, and manage it every day. The components are simple - expenses and income. If you don’t have any income, the job is even simpler, be ruthless about controlling expenses. Think twice, at least, before committing to any big outlays, and add up small ones.
  • Include buffer when you raise money. The cost of giving up more equity early is often more than offset by the increased flexibility to recover from mistakes. Your startup will require more money than you expect, and the cost of going back to the well is very high. It takes time, the well may be dry, and you look bad for not getting it right the first time.
  • Pay people with equity or future revenue. When I was interviewed for my first startup CEO job, I was expecting a $150,000 salary, but instead was offered an opportunity to contribute $50,000 to the business, and work for equity only. Great strategy. Another one to avoid cash burn for software development is a contract for percent of future revenue.
  • Do it yourself and barter for services. Do you really need that full-time assistant, regular bookkeeper, and big-name attorney? There’s tremendous leverage in learning to use Microsoft Office, QuickBooks, and how to Google for sample contracts and the latest tax changes. Be humble and offer to clean all the offices, if you can use one for free.

A good rule of thumb for most startups is a burn rate of less than $50,000 per month. For example, a web-based startup should be able to operate for a year if they raise $500,000 from the founders or angels. This will equate to 2 working founders (taking no salary), hiring a 5-person development team for a year.

The cash will be burned on the team salaries and operating expenses of the startup, and should provide enough runway to build an initial product, get a few customers, and an initial revenue stream. That will position the startup to raise a venture round at a favorable valuation.

Always make sure you’re putting the money in the right place. That may mean waiting till you have a product before you add salespeople. Or manufacturing some product inventory to sell, before acquiring office furniture that makes you feel good. Focus precious cash only on producing revenue for your startup business.

Of course, a projected burn rate can’t account for expensive mistakes and unusual challenges along the way. For these, you need a little reserve and a lot of luck. Be forewarned that taking out loans and accumulating debt is not a long-term solution to the cashflow challenge. It’s too easy, and it bites you in the end.

Controlling your burn rate is the only way to get the confidence and resources to ramp up your startup business the way you want. If you forget to check and manage this compass within your new business, you could run out of cash before you reach breakeven – and find yourself managing the ashes.

Marty Zwilling


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4 comments:

  1. These are great points, but definitely consider what positions are best to take on yourself instead of paying an employee, and what positions are best to just outsource. For example, you need a lawyer. Do you need one on hand at all times, just working on your company? No. But thinking you can take everything on yourself can blind you to the fact that sometimes, a professional is going to save you money in the long run by avoiding costly compliance mistakes or an IRS audit.

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  2. When you talked about hiring a 5-person development team, it reminded me of something Paul Kenjora said in his interview with me. After receiving 1.5 million in funding for his Arizona tech startup, he hired a team of developers, just like you said, and went to work on creating a product. After a year, he realized they weren't making any money and had to pivot, which mostly went South. He said if he had it to do all over again, he'd spend less money on development and more money on marketing from the very beginning, before the first developer ever started work.

    Any entrepreneur could pick up a few nuggets from his experience. Read the interview here:
    http://flatterline.com/blog/2012/01/12/entrepreneurship-series-interview-with-paul-kenjora

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  3. Nothing more stressful than raising start up capital and managing it with a start up, eh? I've always found that having a solid business plan and running metrics on a small scale helped convince investors to perhaps give a little *more* than what I asked for. I've also found that Angel investors (http://www.connexx.com/angels.html) are always a little more amiable to flexible budgets and time constraints. But I agree, at some point cash needs to come in or the ideas are futile.

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  4. These are great points, but definitely consider what positions are best to take on yourself instead of paying an employee, and what positions are best to just outsource. For example, you need a lawyer. Do you need one on hand at all times, just working on your company? No. But thinking you can take everything on yourself can blind you to the fact that sometimes, a professional is going to save you money in the long run by avoiding costly compliance mistakes or an IRS audit.
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