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.

Fundraising and Financials, Part II of II

In the previous post, I looked at how problematic it is to decide on the size and timing of fund raising, in particular for the seed stage.  A company can’t typically raise all the money it needs at the very beginning (nor should it), and it also can’t be constantly engaged in “the next round” for in some perpetual fund raising cycle.

A good compromise is “sufficient capital to reach a convincing milestone plus at least 6 months buffer”.  Let’s break that down:

         “A convincing milestone” can be anything which interests additional investors to come on board.  For A-Round investors, it could be a finished product (if the technology was hard to develop), existing and growing revenue (if market validation was hard to develop), a growing user base (if there’s a lot of competition for the users’ time), etc.  Really anything that proves that your company is special (as opposed simply to how you claim it is special).  This varies widely, for a dot-com a finished and live website probably isn’t impressive, for example.

         “A 6 months buffer” is important since no one (excluding some outliers from boom periods) get a check for millions after their first pitch.  The reality is your first pitch is a win if you get invited to a 2nd pitch with the other partners.  And that’s a win if you involved in due diligence, and so on.  A round can be fast (2 months), but the reality is that you need to plan for it taking at least 6 months (9 months is smarter).  Pitches, evaluation, internal discussion, another pitch, another internal discussion, term sheet preparation, term sheet analysis, due diligence preparation, due diligence analysis, due diligence questions and feedback and further preparation, investment contracts, your attorneys’ feedback, other attorneys’ feedback, etc… you get the picture – it always takes longer than you expect and the less runway you have, the more desperate you become and the less negotiating power you enjoy at the table.

A good example would be an SAAS company that does [insert earth shattering technology here] for [insert largest growing demographic here].  In this example, the founders are three recent university graduates bootstrapping their idea from a CompSci project into a real company.  5T€/Month takes care of a small office, telephone, web server and hosting, etc.  Another few thousand for attorneys’ costs, travel, misc.  .  Finally, the two founders need to live, so at a about 4T€ brutto X 3 plus some interns for another 1T€, we have expenses of about 20T€/month.  When the company starts ramping up, it’ll be closing to 35T€ when they hire a few more people, need a slightly bigger office, servers which can handle the expected loads, a bit of marketing, etc.

For such a company, being able to demonstrate paying customers over several months would be a pretty convincing story for investors, especially when these are showing good growth.  The assumptions are that the company will launch in 4 months, so if it takes a month to find its feet and then start generating revenue.  Three months later the company can talk to an investor, point back, and say “look at the revenue we are generating; it may be small, but it is growing; with another investment, we could jump start it into another order of magnitude by doing [insert strategy here]”.

Although the founders are probably talking with VCs the entire time, when the can say the above is when they first start to become seriously on the VC radar.  In this example, that is in month 8 (4 Months development, 1 month “live” but not yet significant, 3 months proven traction).

When you consider that the decision + Term Sheet negotiations + Closing will take 6-9 months, this means the company has to have a total of at least 14 months runway and 17 months would be smarter.  In the SAAS example above, this corresponds to an initial capital need of 280T€ to 340T€.  If we were talking about a company with closer to 45T€/Mo. Burn, then the initial capital would be 630T€ to 756T€.  Which do you think is easier for the three recent graduates to raise?

So What is a “Concrete Milestone”, anyway?

In my previous post we talked about the timing for raising capital, and how a “significant milestone” is when a deal can become serious enough for a VC to start looking at it more closely.  As discussed, this does NOT mean that you shouldn’t be trying to get on their radar before that – I believe establishing a relationship is critical, especially when we’re talking about seed and early stage investments.  Rather, while a deal might be known to a VC, it suddenly gets a lot more attention when the company appears to be on the way to success; a concrete milestone reached is a strong argument for that.

So what exactly is a significant milestone?  Well, that depends on your industry and technology.  Below is a chart known to most entrepeneurs, which breaks down the challenges a start up faces in the early years.  There are certainly exceptions, but I believe it captures the general steps fairly well, which is while I’ll use it for this discussion.

(You’ll notice that “Idea” is farthest and smallest to the left.  I wanted it to be included, but couldn’t make it so small you couldn’t read it – but basically the “idea” itself is worthless in terms of value to the company.  Execution of the idea is the big value driver).

Valuation vs Time at Stages

Valuation vs Time at Stages

(By the way, I invest in tech deals in the seed stage, so my focus is nearly always on the technology part of a start up.)

Technology-Product Milestone:  These are often the hardest to evaluate, since the potential revenue is so far in the future. On the biggest extreme would be pharmaceutical deals, where the benefit from the technology could be 10 years away.  In these cases developing and completing the technology into a product is possibly the biggest break thru for the company.

Product-Market Milestone: Most of the deals I see are new products based on existing technology.  Since the technology already exists, making it into a product is typically not impressive.  There are many reasons for this, not the least of which is the IP on the deal.  What can be impressive, however, is finding a market for that product.  This is demonstrated most easily thru the elusive traction that VCs often are seeking in a deal.  What “traction” means can itself also depends on the product.  It could be that some LOIs (Letters of Intent) are sufficiently convincing, but typically an established revenue stream is what the VCs will want to see. Here you need to show not just revenue, but month over month growth, etc.

Growth and Competition are typically outside of my focus in seed stage investments, though of course they are examined.  However, if you are bringing a deal to a VC which no new technology, no new product or new market, and are instead trying to take on existing players in an established market, you will need to be very, very convincing on your competitive strengths.  For example, nearly every week I see Facebook and Groupon clones.  These clone-deals are using existing technology, existing products, in an existing market, which has already shown high growth.  So the question is, what distinguishes these deals from the crowd?  Normally not much.

So the thing to remember when making your narrative and pitch, is to keep in mind what stage you are in and what milestone you need to reach or show that you are able to reach.

Confusion on Break Even and Cash Flow Positive Points

I’ve had a few conversations with founders lately about Cash Flow positive and Break Even points, and I realize there is often some confusion about what these two terms actually mean. Many times a founder will plot out his cash flows and assume his break even point is when these flows start trending positive.  But that’s not Break Even, the Break Even point is when the company has turned a sufficient cumulative profit (or more specifically, the cumulative cash) to cover the initial investment.  The Cash Flows are simply the “difference on monthly basis” (1st derivative) of the cumulative cash,  ie, the change in your monthly bank statement.

Although the topic is a relatively simple one, I think it would help to look at these concepts visually.  The diagram below shows the relationships between cumulative cash, cash flows, cash flow positive, break even, and investments.

Cash Flow Diagram

Let’s start with the monthly cash flow, since that’s what we  look at to see how quickly the company is burning cash in the early stages.  As we discussed in the last post, the cash flow is the cash basis (as opposed to GAAP or accrual basis) of money coming in and going out of the company. The net cash flow is simply the total of all cash transactions for that month. For this discussion I’ve further used the SAAS example from the earlier post. While unrealistic, we’re assuming the product is ready to launch immediately and that a few people are immediately ready to pay, and that costs are remaining constant.  The product gets launch in October 2011 and there’s barely any revenue. The total cash flow for that month is about minus 40T€.  The next month costs remain the same but a few more people use the product, so there is more revenue (assuming they pay in the month they use the product) and total cash flow is a bit shallower, now maybe minus 37T€.  Next month same story, but more users, so about negative 34T€.  In this example this continues in a more or less linear fashion (no hockey stick – for simplicity) for the next year, until the estimated 40T€ in monthly costs start becoming more and more covered by the monthly revenue, until around the end of 2012 when they equal each other.  As monthly revenue minus monthly costs reach zero, the company has achieved a very significant milestone of cash flow positive (which means it can basically survive even if there are no further investments and can begin plowing revenues back into the company to further spur growth).

At this point every euro the company earns is considered a profit (on a monthly basis). However, this is not break even! NPV and time value of money make the calculations a bit trickier, but basically if the company hasn’t generated the same amount of cash as the original investment, they are still just paying back the original investment.  The blue line of the diagram represents the sum of all the cash flows. For you calculus minded, this would be the integral function of the cash flows; while the cash flows represent the derivative function of the cumulative cash.  As the cash flows turn positive, the cumulative cash stops going deeper into negative and begins to turn around (inflection point), just as we’d expect of a company who is suddenly no longer burning thru the investment each month but instead beginning to pay it down. Once it is paid (when the blue line is at zero again), then the company has finally hit break even.   (This happens here at about three years after the investment, which for a low-cost company as in this example is quite a long time.  This is when it would be nice to see the hockey stick from revenues, in which case break even would be hit much faster.)

Since it is not possible to have a negative bank balance (without debt or some sort)- since that makes the company insolvent the total cash on hand is actually the sum of the cash flows plus the investment. What investment is needed? Quite simply, just look at the deepest point in the cumulative cash curve. What does it take to bump that above zero? That’s your investment target, giving you the green curve, which is the total cash including financing.  (In this example the needed cash was about 230T€, keeping in line with the earlier posts’ assumptions).

Now I’ve kept this example intentionally simple so that we could look at the graph without a lot of complex curves. In reality, there are a few things which will greatly complicate how your cash flow planning looks:

  1. There is probably going to be a period of initial “cash flow from investments”, in which computers, office, etc are acquired.  This doesn’t impact the cash flow from operations but most definitely will impact your total cash on hand.  (Remember, there are three types of cash flows: Financing (get a loan or investors), Investment (acquisition of equipment, etc –don’t confuse with financing cash flow!!!), and Operations (the real driver, this includes the operational revenues and expenses).
  2. As discussed in the previous post, sometimes the initial investment is not enough to break even or even to reach cash flow positive. In these cases, there will be additional “troughs” in the cumulative cash curve, each one representing a new financing.  Their dept from zero will likewise correspond to what financing is needed that round in order to survive further.  This applies also to investment models which are dependent on milestones and tranches make sure that those match the liquidity situation!
  3. The Cash Flow from Operations line should rarely be linear (which would imply a lack of scalability).  This example used a typical subscription based model, in which a user signs up and then pays on a monthly basis. That makes forecasting relatively easy, along with cash flow management. Other revenue models, like sales, will require a much more detailed understanding of the drivers in order to accurately forecast.  In real world situations, the revenue curve itself is non-linear, as viral marketing and scalability impact the growth rate.
  4. This may be too obvious to need saying, but obviously the lower the burn rate, the faster cash flow positive is reached and the less investment is needed (and therefore the less equity you have to sell). There are some situations in which bootstrapping simply cannot work (like hardware-based, long development-cycle companies), but when you can do it, it’s normally a very good idea, at the very least in the beginning.