Cash Burn Rates at Startups

Recently and have sounded a vivid alarm. I said at the time that I agree with much of what Bill says and I want to expand on the topic further. New founders in the last 10 years have ONLY been in an environment where money is always easy to raise at higher valuations. THAT WILL NOT LAST. When the market turns, and it will turn, we will find out who has been swimming without trunks on. Many high burn rate companies will VAPORIZE.

High cash burn rates are dangerous in several ways beyond the obvious increased risk of running out of cash. It’s Important to understand why:

  1. High burn rate kills your ability to adapt as you learn and as the market changes. The company becomes unwieldy and too big to easily change course.
  2. Hiring people is easy; layoffs are devastating. Hiring for startups is effectively a one way street. You can’t change once you’re stuck.
  3. Your managers get trained and incented ONLY to hire, as the answer to every question. The company bloats and becomes badly run at same time.
  4. Lots of people, a big shiny office, and high expense base equals a fake we’ve made it! feeling. This removes the pressure to deliver real results.
  5. More people multiplies communication overhead exponentially which slows everything down. The company bogs down and becomes a bad place to work.
  6. Raising new money becomes harder and harder. You have a bigger bulldog to feed, need more and more cash at higher and higher valuations. Therefore you take on an escalating risk of a catastrophic down round. High-cash-burn startups almost never survive down rounds. They VAPORIZE. Further, to get into this position, you probably had to raise too much cash at too high a valuation before; this escalates the down round risk even further.
  7. Even if you CAN raise an up round, you are increasingly likely to incur terrible structural terms like ratchets to chin the bar. That nice hedge fund investor willing to hit your valuation bar? Imagine him owning 80% of company after a down round. How nice will he be then?
  8. When the market turns, M&A mostly stops. Nobody will want to buy your cash-incinerating startup. There will be no Plan B. VAPORIZE.

Finally, there are exceptions but if you’re reading this, you’re almost certainly not one. They are few and far between. Worry.

Reference Material:

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16,17,18

Common Fallacies About The Valuation Of Public and Private Technology Companies

First, ask any MBA how to value tech companies, she’ll say “discounted cash flow, just like any other company”.

Problem: For new and rapidly growing tech companies, up to 100% of value is in terminal value 10+ years out, so the discounted cash flow framework collapses. You can run as many discount cash flow spreadsheets as you want and may get nothing that will help you make good tech investment decisions. Related to the fact that tech companies don’t have stable products like soup or brick companies; future cash flows will come from future products. Instead, the smart tech investor thinks about:

  • Future product roadmap/oppurtunity
  • Bottoms-up market size and growth
  • Talent and skill of the team.

Essentially you are valuing things that have not yet happened and the likelihood of the CEO and team being able to make them happen. Finance people find this appalling, but investors who do this well can make a lot of money, but spreadsheet investing is often disastrous. It doesn’t mean cash flow doesn’t matter, in fact the opposite is true: this is the path to find tech companies that will generate tons of future cash.

Corollary: For tech companies, current cash flow is usually useless for forecasting future cash flow, a lagging not leading indicator. This trips up value investors (Prem Watsa!) all the time; tech companies with high cash flows often about to fall off a cliff. Because current cash flows are based on past products not future products and profitability often breeds complacence and bureaucracy.

Always, always, always, the substance is what matters: WHO and WHAT. WHO’s building the products and WHAT products are they building?

Brand will not save you, marketing will not save you, channels will not save you, account control will not save you. It’s the products. Which goes right back to the start: Who are the people, what are the products, and how big is the market? That’s the formula.

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13,14,15

Follow Up: Current Information On Large Capital Technology Valuations

Following up on the earlier post on new tech growth company valuations, here’s some current information on large cap tech valuations.

Since some big tech companies now have gargantuan cash reserves. I like to look at the Price/Earnings ratios adjusted for cash on balance sheet.

Apple, the shining jewel of American capitalism, has chinned all the way up to the 2014 estimated Price/Earnings ex-cash of 11.2. Google, the company everyone agrees is the General Electric of the 21st century: 2014 Price/Earnings ex-cash of 19.4. Big legacy tech foursome 2014 Price/Earnings ex-cash: Oracle 12.6, IBM 11.1, Microsoft 10.7, Cisco 9.5.

These are still so low as to qualify as generational lows. Public tech Price/Earnings haven’t traded this low, for this long, since the 1970s. I’ve said it before and I’ll stay it again: If this is a new tech bubble, it’s managing to bypass all of the big public tech companies. So to rationalize all of this, you pretty much have to believe one of three things:

  1. This is the weirdest equity bubble ever. It ignores the large capital companies that are easy to trade which is not what happened in the late 90’s.
  2. The public market is still scarred after the 2000 and 2008 crashes, hates tech equities, except a handful of companies delivering rare growth.
  3. Many large-capital technology companies are in dire trouble. They are about to be taken apart by a new generation of disruptive challengers.

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12