August 2, 2021 Last updated August 2nd, 2021 286 Reads share

The Cash Burn Paradox in the Startup World

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Every startup is obsessed with hyper-growth for which they have to burn cash. But is cash burn sustainable? Speak to founders and investors. Both will enthusiastically tell you cash burn is an investment. But let’s see how to test the waters when you think you’ve got a likely shot. As a startup founder myself, I’ve been keeping to acquire this skill. Slowly, but surely. 

What is cash burn?

Cash burn is the dragon that slumbers with a jewel mine under it. Get past the dragon successfully, you get big wins. If you don’t, you better go find another tower on a hill. It is the rate at which you use up capital to run daily operations with or without contribution from the revenue and margins. It’s a dicey affair. You don’t want to botch it up if you’re startup is vulnerable. Even at Series B or C.

In business speak, cash burn is the actual amount of cash that has decreased in your account every month. A simple rule of unit economics: unit revenue minus unit cost is your gross margin. If your overheads and don’t match your revenues squarely, you’re burning cash at a faster rate than you can make up for it. Also, your volume influences business performance. Inadequate volume in proportion to the size of your fixed overheads, you need to break even.

Cash burn as an investment

In a board room today, you’ll find cross-generational teams. The legacy leaders and investors are often in favor of a more conservative approach to spends and efforts. Younger executives will content that cash burn should be seen as an investment. While this sounds innovative and proper, the question remains. Why should investment only include physical assets? Is cash burn only an investment that we measure an ROI on? No, not always.

No one can operate ceaselessly on a negative margin. Money lost cannot be recovered. And yet three things are clear:

  1. It could take years before a company makes revenues.
  2. Both you and the people who funded you can breathe if you broke even.
  3. More people will want to fund you if arrived at that faster.

Maybe companies with financial muscle can afford it. Shareholders and investors fund this plan of action. But there are multiple options today. It’s not all “high burn rate, shrinking balance sheet, and narrowing set of options.” You can course-correct even if you’ve already invested for too long. 

The founder’s perspective

Before we go further, let’s take a few steps back. Here are a few things that preoccupy the founder’s mind:

  • Value proposition: 

Is the value proposition distinguishable to the customer? Why should the customer jump brands? Here’s where businesses fail: the conversion. A good way to do this is to highlight a need and present your offering. 

Make sure you define your value proposition with quantifiable audience data. Segment your market based on core tools used, tech attitudes, geographical factors, pain points, purchasing process, the main channel of acquisition, and preferences for your features.

  • Fixed costs: 

Are all fixed and overhead costs well dimensioned? You don’t need a large office space or full-time employees if you can hop onto the future of the work wagon. Your marketing costs are exorbitantly high because you’re paying high-value brand ambassadors when your service can be bought for $ 50 from a freelancer anywhere.

An environment that gives fulfillment is great, but that fancy office can be burning cash faster than you can afford. Today, your headquarters can be Slack or Figma files. Think big picture. 

  • Employees and contractors: 

Are the profiles of your teammates aligned with the costs, market size, and complexity? Do you need positions that exist in large companies but are redundant in a startup? Outsourcing is an option for a fraction of the cost. 

The workforce today consists of “complementaries and interdependencies.”  They include service providers, gig workers, contractors, and software bots. The majority consensus is that independent workers are doing more and more significant work. 

  • Policies & procedures: 

Are all the policies and operating procedures in tune with the costs appropriate to the nature of your business? You also don’t need a sophisticated ERP software system if you can spend a few hours on a simple piece of paper with the right stakeholders.

Quick math in unit economics will lead you to attach a unit of measurement to the value you created. If it’s too much cost for too little value in exchange, it can go out the window.

  • Prices: 

Can you raise prices enough to an acceptable level and play with discounting strategies? Pricing is a subset of dynamic smart decisions with long-term profitability. Many companies don’t touch it again when it is figured out. But recent data shows that the most successful companies optimize monetization in some way every quarter. 

Change the price every three months? No, pricing design is more than the price itself. It depends on range, discounting, value metric preference, indifference price point, and other such elements. Re-evaluate often and optimize quickly.

The investor’s perspective

Investors are fond of scalable options. So, the advice you get for the most part is aggressive growth. The consequence is that they tolerate cash burn. But there are more nuanced workings in the mind of the investor. 

  • External variables: 

People decide to go aggressive or conservative is based on volatile valuations and even more volatile newsflows. Do you want to make decisions that hang on a he-said-she-said game? And are we in a position to make these decisions after attempted IPOs that didn’t go well? Every investor likes to do their homework. They do independent research.

  • The company’s progress: 

Are you able to demonstrate the model, ability to scale, prove unit economics, show consistent growth month on month and year on year? It’s not just about selling a good story. It never is.

  • Other slices of the pie

Your startup is a small fraction of diverse portfolios. If your ability to accept a high cash burn is proven well, the size of the slice might just increase. It’s a numbers game at every level.

  • Change in investor teams

Any change of people from the investors’ side is going to matter. Investors also have investors and bosses. When the going gets tough, they’ll take a call. You may or may not have them in your corner endlessly.

The promoter’s perspective

Any change in the world has been directly related to game-changers. Often these game-changers envision a dream which is larger than life, bold, and audacious. This largeness comes with a risk. When an idea takes on a life of its own, it becomes larger than a promoter. And often this is not reflective of the promoter’s worldview. 

Think of the mentors who encouraged startup founders while failure was inevitable. Think of the mergers & acquisitions that went awry. For any vision to survive, the idea has to be tested and tried in the furnace of the capital markets. 

First-time entrepreneurs might fail to recognize this dynamic. Even first-time investors may miss it. Well-intentioned people can often fail to see the pragmatics of cash burn. This can lead to a lot of unnecessarily expensive mistakes. So, watch out for all the right facts. Beware of being grounded by your dreams, it is often safer to dream up your grounding.

What to do in different contexts?

Take a cold, hard look at the above factors, you can find faultlines that tremble underneath your company. After that, it’s a matter of a renewed budget and a plan to make your financials healthy.

If your unit economics continues to be negative, the business is going to fail. If the targeted costs are not achieved and a price rise is not possible, your balance sheet will make for an interestingly sad story.

As a founder, here’s what I’ve learned.

    • Product-market fit. If you can establish the relevance and acceptability of the product, it’s half the job done.
    • Positive unit economics. How fast can your balance sheet reflect positive values? A startup founder needs to be obsessed with this.
  • Niche down. Establish your brand in one or two market segments before you expand. It helps burn cashless and makes mistakes more manageable.
  • Re-evaluate spends periodically. This may simply mean looking at the elements that are highlighted under the founder’s perspective of this article. Simplicity, low costs, and reliability can go hand-in-hand. No need to trade off one for the other.
    • Volume. If the pricing strategy is higher for the market share, make sure you increase the volume so you can create revenues faster. Target the key income variables with more focus and effort. Eliminate smaller shares if you can.
  • Data-proof. A strategy, no matter how good it looks on a deck, will not work unless there is sustained evidence that it is working. 
  • Fixed-costs optimization. The agenda is to utilize the optimal amount of things. “The optimal amount depends on your goals. It is also almost always less than you think.” This is easier to correct in the early stages of a startup.

Burning cash is neither a virtue nor a vice. It is sometimes a strategic business necessity. Oftentimes, that money belongs to institutional investors who trust your business model and invest in good faith. It is important to be sensitive and act responsibly with every collateral in mind.

Of course, aggressive investors encourage cash burn for rapid work. But if the grounding isn’t ready, that money can be like the gunpowder to your fuse. While it may be both necessary and unavoidable to burn cash, every decision needs to be regarded with the consequences in mind. Scale and sustainability are not trade-offs.

Sharekh Shaikh

Sharekh Shaikh

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