Medium Craft Ventures | David Sacks | Apr 23, 2020
As the economic crisis deepens, capital efficiency becomes a more pressing issue for startups. Not only is it necessary to maximize runway, it also plays a larger role in how investors evaluate companies. While growth is always prized during good times or bad, investors increasingly scrutinize burn and margins during downturns. Startups whose burn is too high relative to their growth will find it hard to fundraise. Founders should be prepared for this shift in emphasis. This post provides a framework for how to think about capital efficiency.
How to Measure Capital Efficiency
Two simple ways to measure capital efficiency are the Hype Ratio and Bessemer’s Efficiency Score:
- Hype Ratio = Capital Raised (or Burned) / ARR
- Efficiency Score = Net New ARR / Net Burn
I think Bessemer has the right idea but I prefer to flip the numerator and denominator, so the ratio is an annualized version of the Hype Ratio. I call this the Burn Multiple:
Burn Multiple = Net Burn / Net New ARR
This puts the focus squarely on burn by evaluating it as a multiple of revenue growth. In other words, how much is the startup burning in order to generate each incremental dollar of ARR?
The higher the Burn Multiple, the more the startup is burning to achieve each unit of growth. The lower the Burn Multiple, the more efficient the growth is.
See: Bank On It Podcast: Turning a Funding Failure Into a Win
For venture-stage startups, these are reasonably good rules of thumb:
I like this ratio because it’s an easy way to judge whether burn is too high in any given month, quarter, or year.
For example, Q1 just ended and it’s time for a board meeting. The startup reports that it burned $2M in the quarter while adding $1M to its ARR. That’s a 2x Burn Multiple — reasonable for an early-stage startup. On the other hand, if the company burned $5M in Q1 to add $1M of net new ARR, that’s a terrible Burn Multiple (5x). It should probably cut costs immediately. That company is spending like a later-stage company without delivering later-stage growth.
Too many startups report their growth without contextualizing it as a function of investment. If extraordinary investment (3x burn or more) is required to deliver that growth, it’s an indicator that product-market fit isn’t quite what it appears to be or there’s some other problem in the business.
A Measure of Product-Market Fit
One can understand why VCs might want to use the Burn Multiple to help assess the quality of product-market fit. The startup that generates $1M million in ARR by burning $2M is more impressive than one that does it by burning $5M. In the former case, it appears that the market is pulling product out of the startup, whereas in the latter case, the startup is pushing its product onto the market. VCs will make inferences about product-market fit accordingly.
A Proxy for Everything Else
The beauty of the Burn Multiple is that it’s a catch-all metric. Any serious problem will eventually impact the Burn Multiple by either increasing burn, decreasing net new ARR, or (most tricky) increasing both but at disproportionate rates.
See: Getting In Early: SEC Sees Growth In Equity Crowdfunding
For example:
- A gross margin problem — If the company spends too much on COGS in order to deliver the product or service, its burn will increase rapidly as it scales. If there’s not operating leverage in the business, the Burn Multiple will not improve with scale.
- A sales efficiency problem — If CAC is prohibitive or sales productivity is diminishing, burn will increase relative to new ARR, causing the Burn Multiple to worsen even though growth continues.
- A churn problem — Churn will net against the denominator of the Burn Multiple, causing the multiple to increase. A leaky bucket makes it hard to grow efficiently.
- A growth challenge — If growth is stalling, the company may seek to compensate by spending more on marketing, give-aways, discounts, or promotions. That will be picked up in a higher Burn Multiple, as burn rises faster than new sales.
- A founder leadership problem — If the founder lacks the skill or will to control burn, that will show through in the Burn Multiple.
Continue to the full article –> here
The National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada’s Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org
Related Posts
