Calibrating Cash Burn
Leadership teams across the startup ecosystem are rightly focused on cash burn. On-demand access to venture capital can no longer be assumed in an environment where venture firms are thinking far more carefully about where to allocate capital. Startups that are spending to grow but have yet to reach cash independence are being forced to protect the money that they have and reduce unnecessary overhead. Burn must now be more deliberate, as cash is one of the non-negotiable items that is crucial for survival.
In this context, we thought it would be helpful to follow our refresher on the SaaS P&L with a detailed look at cash burn. What, precisely, is “cash burn” and why is there more to it than just what a company spends? For such an important concept, cash burn is often loosely defined or confused with other terms such as operating loss or cash from operations.
What Is Cash Burn?
Cash burn refers to the change in a company’s cash position from the beginning to end of a period. It can be calculated by looking at a company’s cash flow statement, which outlines how a Company’s cash position changes during a period of reference. Cash flows are typically broken down into three distinct buckets:
Cash from operations: how a company’s cash inflows from customer collections less general business expenses (e.g. salaries, technology spend, hosting costs) increase (or decrease) one’s cash position. This number is close to a Company’s net income (or loss) - with which “cash burn” is often confused - but with non-cash expenses (such as stock-based comp, depreciation, or amortization) added back.
Cash from investing: shows how a Company’s cash is affected by internal investment activities, such as the purchase or sale of stocks, bonds, or physical assets. Because most early stage SaaS startups tend to be asset-light businesses (e.g. do not purchase heavy equipment or real estate and have relatively small amounts of investible cash on the balance sheet, activities in this bucket tend to have a minimal impact on cash changes from period to period.
Cash from financing: this bucket outlines how external financings affect a Company’s cash balance, that is an equity financing from an outside investor like a venture fund that purchases company stock in exchange for cash. At more mature stages, startups may also conduct debt financings, whereby an outside investor loans money to a company that is repaid at a specified schedule along with interest payments. These types of payments would fall into this bucket.
Factors Impacting Cash Burn
Outside of external events - which we’ll get into below - the most important factors that directly affect a startup’s burn rate are a company’s cash collections (from invoices), gross margin profile, and the operating costs used to grow the business.
In the world of early-stage SaaS, growth and burn are often closely related, as it’s unusual (but not unheard of) for startups to find growth levers that translate into disproportionate levels of efficiency gains. Churn is also the enemy of growth and, if severe, can have material effects on a startup’s cash burn (see for details Scale's three-part series on customer retention metrics).
Some investors encourage startups to make the distinction between “gross” and “net” cash burn to delineate how much cash a company is consuming independent of cash collections. The two measure related aspects of your cost structure and operations:
“Gross” cash burn equals the amount of cash that the company spends on operations before cash collections from revenue are added back.
“Net” cash burn is measured by a company’s cash consumption during a period after accounting for any cash inflows resulting from invoices.
We often advise tracking both measures to understand how cash (and total runway) differ across various planning scenarios.
The Less Obvious Factors Affecting Cash Burn
There are a few other factors that affect a startup’s cash burn that may be less obvious. At first glance, some of these areas may feel like they’re on the margin, but as startups begin to scale, they can start to have a material impact on a company’s burn profile. Let’s jump into a few of these areas below:
Customer prepayments. Part of the beauty of most SaaS businesses is that customers agree to pay for services on a subscription basis. Most SaaS customer agreements have monthly or annual terms where the customer has the choice to renew their contract at the end of each period.
Occasionally, a customer may elect to prepay for services, opting to pay in advance for the entire year instead of, say, four quarterly installments. Not surprisingly, this has a positive impact on a startup’s cash position. In accounting terms, a prepayment is recognized as a liability (deferred/unearned revenue) on the company’s balance sheet.
In cases where customers agree to prepay for multi-year contracts, the positive effect on a startup’s cash position will be even more pronounced -- which is why sales compensation is often structured to incentivize prepayment terms.
Interest and other payments associated with external financing. We discussed the two major types of external financings above, which are equity and debt offerings. Equity financings involve the exchange of cash for company stock, which dilutes founders and other earlier investors. A debt financing is effectively a loan to the business that the startup agrees to repay at a future point in time. For the startup, debt’s advantage is that it is non-dilutive. From an investor’s perspective, one advantage is that it will be senior to any equity in the event of a sale.
Debt offerings can become complex, but for simplicity’s sake, debt usually consists of two forms of payments: principal, the amount of the loan, and interest, the cost of the loan. Interest payments are often amortized over the life of the loan, but in some cases (take balloon payments, for example), can happen all at once. Not surprisingly, debt repayment can have a material effect on a startup’s cash position and should be carefully planned for.
Days Sales Outstanding (DSO). This is the average number of days a startup takes to collect payment from a customer. If a company, for example, requires two months from the date of an invoice to collect payment, their DSO would be 60 days. Moving this number up or down can affect a company’s cash position, as receivables convert into cash earlier or later depending on which direction DSO fluctuates. As an aside, this is often a point of contention during vendor procurement as startups tend to have opposite motivations from their customers with respect to cash collections.
Clawbacks and other adjustments. Occasionally service agreements don’t work out and startups are forced to adjust a contract’s terms of or terminate it all together. In cases where a customer has prepaid for their service, this situation could result in a clawback, whereby the startup is required to repay some amount of cash back to the customer.
Tying It All Together
Cash burn is one of the Four Vital Signs of SaaS and ultimately the one asset without which a startup cannot survive. Run out of money? The party’s over.
We have entered a period in which cash burn has become a focal point, especially for early-stage startups where growth has traditionally been prioritized over spend and cash independence is usually not achieved until later stages. In this environment, it’s critical to understand and measure the many factors that go into burn rate. Doing so is a key to ensuring access to your next round of venture investment.
The next piece in our Burn Rate series will present Scale’s research into just how much cash SaaS startups use to scale their businesses and benchmarks on operating expenses at various revenue levels.
Originally published July 9, 2020.