Understanding Investor Focus on Burn Rate

Burn rate is a metric that is specific to the start-up world. On the one hand, most of the financial world is obsessed with frugality but at the same time, investors in start-up companies often pressurize the management to spend as much money as possible within a short span of time. The excess of spending over revenue is called “burn” in start-up terminology. Start-up founders who do not have experience dealing with investors may be shocked to find out that these investors actually encourage them to “burn” more money.

In this article, we will have a look at the rationale behind this excessive focus on burn rate and why it harms start-up companies.

Understanding Investor Focus on Burn Rates

It is important to understand that even though investors and founders are on the same side, they may not have the exact same objectives. Investors are in it for the short run. Most venture capital firms raise their money by borrowing funds from high-net-worth individuals. These funds are borrowed for a specific period of time. The funds have an expiration date when the original capital plus profit has to be returned to the high-net-worth individuals.

Now, it is important to realize that venture capital management does assume that about 50% of their investments will fail. For them, it is important to realize which of their investment is likely to earn money for them. For a venture capitalist, one of their companies going bankrupt is not the worse outcome. This is something they have already accounted for and hence it does not surprise them.

On the other hand, if a company takes too much time, it cannot figure out whether it is a winner or a loser. This can be very painful for venture capitalists. Their entire business model is based upon identifying the winners as soon as possible. They then proceed to cut the losses and inject more capital towards the winners.

Hence, investors are on a completely different time schedule as compared to the actual start-up founders. They want the business to scale up as soon as possible. They carefully monitor the results of the scaling-up exercise. If they find the results favorable, they will continue to invest in the company. Otherwise, they will simply desert the company making it more difficult for them to survive. There are several start-up organizations that have failed since they have not been able to keep up with the pace of venture capitalists’ expectations.

Why Founders Should Avoid Accelerating Their Expenses?

  • In some cases, a higher burn rate can be used to quickly validate the business model of the company. However, in a lot of other cases, it tends to simply empty the bank accounts of the start-up firm.

    It is important to realize that even though investors can pressurize the firm to spend money at a faster speed, they cannot force the company to do so. The ultimate decision lies in the hands of the founders as well as the chief executive. It is important for them to be receptive to the needs of the investors. However, it is also important for them to ensure that they are not completely driven by the whims and fancies of investors.

  • The importance of having sufficient cash in the bank cannot be overstated when it comes to the success of a start-up firm. The data provided indisputable evidence in this regard. It is a known fact that companies which have a comfortable cash position are able to obtain funds on better terms. Hence, it is important to not react under pressure since it will lead to double the loss.

    On the one hand, there is a chance that the current venture capital investors might classify the company as a loss-making bet and hence stop making further investments. On the other hand, the company may run out of funds and hence may not be able to raise funds from the market since it has a weak bargaining position.

  • It is also possible that sometimes investors deliberately encourage start-up founders to have a higher “burn” rate. This is because once start-up founders run out of funds, they will not be able to raise money from the market on favorable terms. In such cases, they will have to offer a larger chunk of equity to the investors at a lower rate. Many times, it has been observed that investors have ended up owning the majority share in the company as a result of overspending in the earlier phases of the start-up.

  • The worst outcome of a higher-than-required burn rate can be quite catastrophic for the start-up firm. It is possible that the firm may run out of funds completely and may have to shut down operations due to the bankruptcy of the firm.

The bottom line is that the concept of “cash burn” and “burn rate” is quite new. Many start-up founders do not know how to effectively manage this metric. They also don’t realize that their failure to manage this metric could lead to catastrophic outcomes for the firm.

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