Growing Your Business: It’s not the cash you burn, it’s how you prepare to burn it
As a venture capitalist, I commit funds I manage to companies that project a certain sales growth. As my focus is on early-stage ventures, all companies I back with growth capital are losing money at the time I invest and, generally, expect to lose money for a year or more beyond my initial investment.
Given that sales and expense projections are just that, I spend meaningful time assessing how long our investment dollars in a given financing will last, under various assumptions set out by management.
The term of art we use to describe our cash remaining is “months of cash burn” — the amount of cash a business spends compared to the amount it generates from sales and profits in a given period. To many, the notion of growing a business with planned negative cash flow seems, at minimum, ill-advised and, at worst, psychotic. But for early-stage venture capitalists, this is the game we play — fund a worthy but risky high-growth venture in hopes that, likely through multiple financings over a three-to-six-year period, the company achieves a level of self-sufficiency without more infusions of capital.
In a startup, entrepreneurs seek to build a business by committing investment and energy to feed a variety of critical uses — product development, staffing, facilities and overhead, marketing and working capital needs.
While many entrepreneurs are reluctant to consider outside investment (fearing dilution of ownership/economics and some loss of control), others understand that they can grow faster than possible with internally generated funds and they can mitigate the risk that a competitor with greater capital resources will take their market opportunity away. So an entrepreneur trades ownership interest for outside investment (and the relationship, obligation and risks that come with it) and begins to burn cash, investing in people and infrastructure ahead of the hoped for tidal wave of sales to come.
Experienced venture capital investors understand that it takes money to make money and plan for losses on the path to profits. Investors also understand that precious few business plan projections ever realize their targets, the result of which is typically over-spending, resulting in accelerated cash burn.
Money to burn
To illustrate: Let’s say you built a new gizmo with a view to generating $1 million in sales the first year. Your gross margin gives you the cash you generate from sales to pay for your operating overhead. Let’s assume you project your gross margin at 60 percent of sales and that you’ve got a $250,000 annual operating overhead, meaning if you reach $1 million in sales, you generate $600,000 in cash to cover your $250,000 of operating expenses. That leaves you with a healthy pre-tax profit of $350,000. Sound good so far?
But then reality sets in. At the end of the year, you find that you’ve only managed to bring in $400,000 in sales. And your gross margin wasn’t 60 percent, but 50 percent, generating only $200,000 against an operating infrastructure of $250,000.
You’ve just burned $50,000 where you’d expected profits of $350,000. I won’t add insult to injury by noting that operating costs are almost always underestimated, meaning that $250,000 actually ends up at $300,000. Oh — and there are those other pesky non-operating uses of cash, such as product development and working capital, which are common to most startups.
Venture capitalists see this pattern so frequently that they come to be skeptical, if not downright cynical, about aggressive sales plans that generate early profits. Most business owners who come to us for capital (and are first-time entrepreneurs) present a plan that shows need for only one round of finance that will result in break-even/profitability by the second year of operations, with no additional cash required to achieve the balance of their five-year business plan. This rarely happens.
More commonly, a company loses money for the first two to three years and needs multiple rounds of finance (typically, every 12 to 18 months) to get to the promised land of self-sufficiency.
Burning cash is not the problem. The real problem is one of realism in planning, born of inexperience on the part of the first-time entrepreneur — those who have been there before understand too well the cash dynamics of an early-stage growth venture.
You can avoid the biggest pitfalls by finding advisers in your target industry who have done something similar to your venture. Work with venture investors and small-business consultants early in your planning process and see if they’ll help you vet your plan for realism. Bring on team members who’ve had experiences that will help you avoid common pitfalls in business planning as relates to cash consumption.
Do all of these things and you’ll probably still run out of cash before you’d planned. Even experienced entrepreneurs miss sales plans and overspend against that illusory target. However, they know how to recognize the risk and to make adjustments accordingly. They also know how to work and communicate with their investors to help make them part of the solution.
Michael Gurau is managing general partner of Clear Venture Partners, an early-stage New England fund-in-formation. He can be contacted at firstname.lastname@example.org.