Burn rate and runway – a tale of two startups: Leano and Hardio

Look into my tired eyes
See someone you don’t recognise
Blinds that can’t be untied
Oh this is slow suicide
Feelings that I can’t disguise
And never will be reconciled
Oh something inside has died

Probably not many people would recognize this paragraph of lyrics, but I found that this song by the rock band Ash in 2001 is surprisingly fit for the mood of entrepreneurs coming into this year, especially its title “Burn baby burn”.

Now despite that the song was released in the aftermath of the burst of the dot-com bubble in 2000, it’s probably just a mere coincidence that some of the figurative lyrics are eerily reflective of the collective mind of the industry currently.

With the major public market corrections first in China last year then in certain star internet stocks in US recently, there’s no doubt that we’re gonna see major corrections in the venture funding and valuation.

“So the bubble is indeed bursting?” You asked. In fact whether there really is a bubble by itself would be a 2-hr long debate that leaves the participants a conclusion that’s no more clear than whether Donald Trump really meant what he said.

However one thing is sure: great startups are created in both good and bad years – GoPro, Tesla, LinkedIn and Skype were all founded in the aftermath of the burst of the bubble (2000), compounded by the Enron scandal (2001) that kept the public market at the bottom for a good part of 2002-2003.

Macro change isn’t and shouldn’t be a show-stopper for great entrepreneurs. The question is how to change the strategy when the going gets tough.

The keyword for this year is #BurnRate.

Tumbling like the leaves
Yeah we are spiraling on the breeze
Almost to the point of no return
Everything will burn, baby, burn

Burn rate is basically how much money a startup is burning every month. In good times it gives a first estimate of how much time you have before you successfully raise the next round. In bad times it gives a first estimate of how much time you have before you could become self-sustainable – or pass the point of no return which is called death, because the next round might not happen very soon.

Let’s say entering the year of 2016, you still have $2M of cash left from the $4M Series A you raised in June 2015. Your monthly burn rate is $400k after accounting for the meager recurring revenue you are able to collect from 1% of all your MAUs (monthly active users). This means you will run out of money in 5 months without further funding or change of strategy. However much you’re worth from that $4M Series A, it’ll be reset to zero when you reach that point of no return.

A gross figure of burn rate, however, could be deceptive. Knowing how long it is before you’ll be dead is not as useful as knowing how you are gonna die. If you know how you’re gonna die, you could potentially find the right strategy to revert your fortune as a startup and return to growth in a healthier way.

Here’s a non-exhaustive list of the key components in the burn rate of a startup:

  • Payrolls – this includes that of the in-house masseuse that was once “an inseparable part of the company’s value creation.”.
  • External service payments – notably the cloud service you’re using to service your users or clients and I do believe Jeff Bezos owes a drink to all the VCs in Silicon Valley.
  • Product development expenses – especially if you’re a hardware startup like the 140+ with us at the Hardware Club. You can’t really stop buying resistors or capacitors if your product is still under development.
  • Sales expenses – especially if you’re a B2B startup, even more critical if you’re a B2B SaaS startup.
  • Marketing expenses – especially if you’re a B2C startup or a consumer electronics hardware startup like most of the 140+ with us at the Hardware Club.
  • Manufacturing prepayments – especially if you’re a B2C startup or a consumer electronics hardware startup. like … you know.
  • Everything else – legal, HR, etc.

Note that some of these expenses are more volatile, while some are almost like death and taxes—, fairly constant if left untouched. Some are tied to and fluctuate with revenues. Some are tied to revenues but have a huge lag in time.

As the previously mentioned startup with $2M of cash and 5-month runway, you can start raising a new round now but every VC you meet this year will be asking about your burn rate and your plan for cutting the burn rate without hurting the growth of the company. Hence you might as well just start thinking about cutting the burn rate, since it gives you a better chance and a longer time period to get the new round.

Let’s say that you target at cutting the burn rate by half to give you a 10-month runway. Below we’ll simplify the scenarios to lean startups (software/mobile) versus hardware startups (consumer electronics), using two fictional startups Leano and Hardio for the sake of convenience.


Payrolls

Cutting payrolls is the fastest way to lower the expenses, at least in capitalistic countries. Unlike other volatile expenses, payrolls are visible and cutting them gives founders a sense of comfort, knowing that every dollar cut won’t crawl back next month.

Obviously all payrolls are not equal. For some startups the in-house masseuses are untouchable and the co-founders would lay off themselves before letting the masseuses go. For Leano and Hardio, difficult decisions have to be made.

Leano is in the B2B business. Their SaaS product is constantly improving to stay ahead of copycats. It’s very difficult to cut the people on the development team without hurting the growth of the company. 

On the other hand, the marketing people have attended 20 conferences last year, bringing back lots of random business cards and restaurant receipts. Leano decided to let all of them go.

Sitting next to the marketing people are sales people that are seldom in the office. For the SME clients that Leano focuses on, however, it’s been one contract after another contract for every single recurring revenue coming in. Leano decided to cut only the two sales people in charge of expansion into emerging markets and keep the rest of the team.

(However, one top sales person quit to join Salesforce.com before Leano CEO made the decision that includes keeping her and making her in charge of the new sales team.)

Leano further lets go the only HR personnel in the firm, who spent most of his time on Linkedin website every day. He’s the only one who remembered to take the company mug with him when cleaning out the table.

After everything is done, Leano cuts its monthly payrolls by 30%.

Hardio did a successful Kickstarter campaign in 2014 and has started shipping the products to backers and pre-order buyers shortly before they closed their Series A. The return rate has been low.

Hardio was founded by a software guy and a design gal. They have outsourced the electronics design to a design service company in UK. They ran into trouble in manufacturing when the design service company refused to provide further support on DFM/DFT (design for manufacturing/design for testing) in working with the EMS (electronics manufacturing services) company that Hardio found. This caused a 4-month delay in shipping. Hardio used their Series A money to hire two 35-year old electronic engineers and a mechanical engineer, who have been tweaking and improving the design that’s already in mass production “so that the next version will be produced more smoothly and at a lower cost”.

Hardio has no plan to redo the electronic/mechanical design of the current product and believes that the app/cloud user experiences are more key to attracting the friends and families of their current users. When the CEO told one of the two electronic engineers that his service was no longer required, he was greeted with 4-letter words that he believed to be Taiwanese dialect.

One iOS engineer in the software team was visibly shaken as he’s a good friend.

The hHead of dDesign came to see the CEO in anticipation of the conversation, saying that the website and app are still not entirely matching the industrial design of the product, that he and his team still need 2 months to get it done. The CEO said it’s fine but he wanted the dDesign team to not just iterate on UI/UX based on feedbacks from the cCustomer sService team, but to “listen to the users directly and wholeheartedly.”

“Do you mean you want my people to help withon replying to customer service emails? But there are already 4 people in the CS team? Arh… oh…. I see.”

When the 4 customer service staff members left with boxes in hands and one sales manager trailing them, they looked more tired than after a usual long day of handling customer complaints in the on-line chat rooms. The other sSales mManager that got to keep his job was told to prepare a report of performances of all distribution channels including physical and e-commerce.

The Hardio CEO then gathered the young and vibrant mMarketing tTeam, who reports to him directly. He explainsed to them the difficult decision of having to let some of their colleagues go, but since marketing is key to consumer electronic products, the entire mMarketing tTeam will remain intact. However, they have to generate better and emotionally deeper content to increase the engagement rates of their users. The CEO is also moving the budget of Facebook and Twitter advertisements from the mMarketing tTeam to the remaining sSales mManager and will account these expenses as part of the COGS (cost of goods sold) over e-market channels from now on.

VP of Operation has been in Shenzhen with his team for 2 months to deal with a quality assurance issue. He was informed by the CEO over a WeChat call of all the staffing changes and told that his team would remain intact. He went straight back into the factory after he hung up.

After everything is done, Hardio cuts its monthly payrolls by 24%.

 

External service payments

Both Leano and Hardio use AWS for their cloud services. 

Leano CEO discussed with the sales people and lay out the potential growth of MAU and the projected conversion rates for the next 12 months. They came to three scenarios and their respective requirement of AWS expenses. He carefully updated the worst-case, i.e. highest growth, numbers into his cash flow projections. He knows that since the growth depends on the sales process, he could slow it down if encountering unexpected cash outflows in other items. However he doesn’t want to give competitors a chance to catch up so he wants to plan for the highest growth possible given the current sales force.

Hardio has a low app/cloud engagement so far from the users that have bought their consumer electronics products. They are at low level of utilization rate of their current AWS plan, which isn’t much to start with. The CEO decided to keep the current expense and updated the UI/UX and marketing team the monthly wasted cost due to unused AWS capacity via a big whiteboard in the open office where everyone can see.

Hardio still has a minimum contract with the out-sourcing electronics company as part of his original post-Series-A plan to transition product development completely internally. Hardio CEO reviewed the contract terms and picked up the phone to call to terminate the contract.

Neither company was able to cut much in this category at this moment. Leano originally has a high growth expectation and had budgeted extra payments as the user number grows throughout 2016. Leano CEO is now pondering the downside of slowing down growths to contain the expense.

Hardio expects the current cloud service capacity would be able to sustain its user growth throughout the year.

 

Product development expenses

The programmers at Leano update their cloud software products roughly once per month. The development team is told to cut off the usage of a couple of expensive testing softwares and use open-source ones instead.

Hardio has a 2nd-generation product in the plan that they just started discuss with the 15-employee strong design service company that has also worked on their current product. Hardio CEO terminated the contract and put the development of the 2nd-generation product on hold. He directed whatever budget that is left to the app/cloud team, demanding them to work with UI/UX designers – doubled as Customer Service team – to increase the user engagement by 5 times before the end of March.

 

Sales expenses

Leano has always account the bonuses paid out to sales people in sales expenses, alongside the lunch and dinner expenses that inevitably come with the B2B sales process. However in the past Leano has not distinguished bonus levels between 1-year and 2-year contracts. Having read some articles on the internet about sales incentives, Leano CEO informs the sales team about the scheme change that will take place immediately. He however keeps the SalesforceIQ subscription in tact as it allows him to check the sales progress as well as the correspondences between his sales force and the clients.

“Damn I wished I had come up with the RelateIQ idea 10 years ago!” Leano CEO whispered to himself when signing off the subscription order.

Hardio’s sales people have been in charge of the relationships with all distribution channels: Amazon, Best Buy, Brookstone, Target, Home Depot, etc. The only sales manager left was told to minimize traveling expenses and use phone calls more often. He was also asked to account the return cost more carefully in the channel mix calculation.

 

Marketing expenses

Leano has no more marketing people left. Leano CEO went through all the conferences and trade shows that his former marketing team used to frequent. He reviewed the reports filed by them and selected 2~3 major conferences. He told the sales people to go next time instead but they have to come back with new signed contracts or at least letter of intents.

Hardio CEO had a 5-hr meeting with the Marketing Team to review the historical mareketing expenses on organic growths (content & community) versus non-organic growth (search engine & social network advertising). He made it clear that the Marketing Team should focus on content and community to foster organic growths. While viral campaigns are difficult to design they’re nevertheless much more effective when successful. 

The Hardio Marketing Team will from now on be evaluated solely on organic growth versus the money they spend to create content, push content and maintain community. The traditional on-line advertisement budget is now moved to the remaining sales guy who’s in charge of all distribution channel.

 

Manufacturing Prepayments

Leano does not sell hardware products so does not have manufacturing prepayments. Its main revenue-related operational expense and working capital were already discussed earlier in External Service Payments.

Hardio sells consumer electronics products. They pay their EMS partner 50% down payment when the design is frozen and the contract is signed. They pay the rest of the 50% when the freight is on-board (FOB) in Hong Kong. They’ve tried numerous time to negotiate the payment terms with their EMS partners but given their relatively low volume they weren’t able to gain much ground.

They have historically procured key components themselves in batches, sent to and held in the EMS partner’s warehouse. The EMS partner has told them many times that it’d be cheaper for the EMS partner to do the sourcing for them since some of those components are already in their production lines for other clients’ products. They therefore have a price advantage at least on those components given that they have volume, compared to Hardio. Hardio has been working and shipping with this partner for 1 year. The mutual trust is there so the CEO drafted an email to the EMS’s BU Head asking for a phone call to discuss this. He hopes that by giving the component sourcing part to the EMS partner as well, he will be able to manage the working capital better since he doesn’t have to set aside cash to purchase components in advance of going into production himself. He’s also secretly hoping that by allowing the EMS partner the potential to make some extra money out of the spread of the component costs, they will be more willing to give a better payment term for Hardio. The EMS partner is a private company with no debt and in financial health.

 

Everything else

As startups, both Leano and Hardio have been using as much outsourcing as possible, including payroll system as well as human resources. 

Leano did hire an Chief Talent Officer following their Series A at the request of the lead investor in order to hire “ahead of the curve”. The Chief Talent Officer, however, quit shortly before the end of last year, being head-hunted by another startup that had just raised a $40M round.

Hardio has a lot of external payments to track due to the nature of its hardware business. It has been using the same external accounting service since the Seed Round and will continue to do so.

 

At first I was afraid, I was petrified...

The CEOs of Leano and Hardio looked at their new cash flow projections and both saw a potential now to extend the runway to 9~10 months. They took a deep breath, picked the phone and dialed the numbers of their lead investors in Series A in 2015. The calls got through but instead of the usual ringtones, they hear a music playing:

Go on now go walk out the door
Just turn around now
'Cause you're not welcome anymore
Weren't you the one who tried to hurt me with goodbye
You think I'd crumble
You think I'd lay down and die

Oh no, not I
I will survive
As long as I know how to love
I know I will stay alive
I've got all my life to live
I've got all my love to give
And I'll survive
I will survive
Hey hey...

 

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