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When it Makes Sense to INCREASE the Burn Rate

January 7, 2010

vcmike

I was in a board meeting earlier this week of a portfolio company that appears to be in the early phases of a very encouraging ramp, both in terms of users and in terms of revenue. Our CEO is torn between investing in growth, and burning some more of the precious capital we have in the bank, versus focusing on getting to profitability and then investing in growth. So, the question came up, should we manage expenses to make sure we are closing the gap toward profitability?

The answer the board gave was “it depends.” And, in my opinion, this was the right answer.

The now famous Sequioa “RIP” powerpoint was the most public of a widespread movement amongst VCs to get entrepreneurs focused on capital preservation. As a general matter, this was a very positive movement for the startup ecosystem, especially since there was little prospect of raising outside capital during much of 2009.  Running out of cash, in most cases, meant running out of business.

However, a general frugality and focus on profitability does not mean that startups should, in all instances, focus on burning less and less capital each successive month. In fact, sometimes, as in the case of the company whose board meeting I just mentioned, it is just the opposite: the wise thing to do is to increase burn at a certain point.

No, the rationale is not so that the VCs can own more of the company! Let me explain.

Right now, the company has some very positive indications in terms of user growth. But, it’s ability to monetize, while certainly showing promising signs, is still fairly unproven.  So long as we remain unclear on our ability to monetize our users and service, it makes sense to be very, very careful with our capital, and preserve the longest possible runway to iterate and experiment in the hope of  cracking the monetization nut.  BUT, once we hit the point where, on a unit basis, we know we can monetize enough so that on average we make a profit off each user we acquire, it then makes sense to invest in growth and increase the burn rate to do so.  The reason is simple: once we reach this point, the value creation equation become fairly straightforward, and the ability to raise capital at an increasing valuation become much more certain.

Assume we burn through, say, $2 million dollars to build a business with 4m users,  with positive unit economics (in other words, imagine it costs us $.50 to acquire a new user but we bring in $1.00 of revenue over the life of that user).  A new investor should, therefore believe they could invest growth capital at a healthy valuation and, at the other end of that capital, have a company worth much more than it was when they invested.

What this should mean for the team is that the cost of capital is less than the increase in value they have created.  Say the company raised $3m on a $6m premoney valuation in their last round.  The founders own 66%. Remaining very frugal at first, the company takes a while but only consumes $1m of that $3m to crack the monetization nut and demonstrate growth with the unit economics above.  By then spending their remaining $2m to grow their business to 4m users, the company can now attract new capital at, say, an $18m valuation. What this means is that the cost of replacing that $2m is 10% of the business. So while spending the capital effectively dilutes the founders by 10%, they own a little less of a bigger pie; specifically, whereas originally they owned 66% of 9m, now they own 59.4% of 20m.  And, the company is well positioned for further growth in size and value.

Of course, the tricky part here is guesstimating in advance of what usage and financial metrics will translate into what valuation at any point in time. Which is always an art not a science, but also illustrates why it makes sense for entrepreneurs and VCs alike to have a solid sense of the market for raising venture capital.

One Comment

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  1. Ido #
    January 12, 2010

    Profit will never be maximized on the internet until the tools are in place to do so. While people realize that volume – hits – traffic – views are the basis of an internet economy, no one has figured out how to maximize their value. Nothing in place, a credit card actually works against making money on line, fits the present needs of a digital world. We are at a tipping point in the free internet world, and a straw, or an idea will push it over the edge. It’s appallingly simple, all you need is —-

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