Fundraising and Financials, Part I of II

For my first true post I’d like to address a financial topic that a lot of seed stage founders struggle with: burn rate and the timing and size of seed stage fund raising.  I’ll be splitting this into two posts, the first dealing with some of the key terms and why this problem is not so easily solved as simply “constantly raising money”, the 2nd part covers what I believe to be the best timing along with an SAAS example with financials and timing requirements.

First, some definitions:

Monthly Burn Rate: this is effectively your monthly cash flow from operations.  However, since there is typically not a lot of revenue (again, cash basis) coming into a company in the seed stage, VCs will think of this figure as how much of their investment is being “burned” in efforts to get the company successful.  While technically Cash Flow from Investments (reminder: that is different from Cash Flow from Financing) also burns cash, these tend not to be reoccurring.  A monthly Burn Rate can spike if there are outlays for equipment or Intellectual Property and then level off again back to the operational average.  A typical Burn Rate is 35T€ for seed stage, though that can vary widely depending on the business model and sector  (hardware start ups will almost certainly have huge burns towards the beginning as they acquire the necessary equipment, software start ups can begin with almost no burn if it’s a guy coding in his garage, for example).

The only way to decrease the burn rate is less cash out (cut expenses) or more cash in (increase revenues, on a cash basis).

Runway: This is how much time is left before the company dies from running out of cash (“liquidity crisis”).  The calculation is easy: average burn rate divided from remaining cash on hand (i.e., the seed investment).  A 35T€ burn rate divided into a 500T€ Investment gives the company a 15 month runway.

The only way to increase the runway is to decrease the burn rate (see above) or increase the “remaining cash on hand” (fundraising).  Cash Flow positive essentially means you have an unlimited runway.

Cash:  It’s essential for founders to understand intuitively the difference between cash-in and revenue.  This is not easy for some first time entrepreneurs, since we are used to thinking of our own personal monthly budgets as cash based, but most of the business world deals in revenue.  In the US, according to GAAP, cash-recognition is simply when the money is in your bank account, while revenue recognition is when the benefit of the good or service is realized (that’s an over simplified version).  I tend think of the cash flow as how healthy the business is and P&L statements as how successful the business is.  There is a strong correlation over the long term, but if we look at a specific period, like a month or a few months, these two numbers can be widely divergent.  I’ve seen companies, who hold contracts with large customers worth hundreds of thousands of Euros in revenue, but the customers were given good credit terms (90 days to pay, for example), so while the start-up has a successful and market-validated product, it becomes nearly insolvent since it doesn’t receive for a while the cash to pay its bills.

So let’s say you’ve just started a company.  You are putting together your pro forma financials, making assumptions on revenues and costs, and you’re beginning to think about talking to investors.  What kind of investment do you ask for?   I’ll address the typical amounts for various profiles elsewhere (and has been done exhaustively by others for the US market in other blogs), but let’s just say you’re talking to a seed stage or angel investor.  You may calculate that in order to reach long term profitability you need 5 Mio. €.  The odds of finding an investor for that are low (although as I am writing this in August 2011 the start up market is certainly hot), and especially low in Germany.   You would need to find probably more than one VC, since in the seed or early stage a 5 Mio.  € Investment would be an exception for an unfinished product or not-yet market-validated business.  Building a syndicate is possible, but very time and effort consuming.  So a better strategy is to calculate what you need right now, and go back to the VCs later for the rest.  Going back later has several advantages, namely you will have more credibility so it will be easier to raise money, and since the business will be validated in the meantime, you can command a higher valuation.

The question of what you need to raise to get started is also a bit tricky.  On the one hand, you don’t want to constantly be doing fundraising – you want to be running your business.  So raising 100T€ every three months is a losing strategy long term.  On the other hand, the larger the amount, the longer it will take to raise and the harder it is to convince investors.

A good compromise is “sufficient capital to reach a convincing milestone plus at least 6 months buffer”.  We’ll be looking at that closer in part II of this series on the timing and volume of seed stage financing.