Fig. 01
Forget cash burn, in a world of easy money, Equity Burn should govern your decisions.
If Oscar Wilde were alive today, he no doubt would have decided to become a tech entrepreneur. And his famous quip would instead have emerged as the tweet, “venture capitalists know the price of everything and the value of nothing”.
As budgeting time rolls around again, I am bracing myself for another series of Board budget discussions where venture capitalists (myself included) opine on the “right” level of burn a particular business should adopt. Initially, the focus is on setting the ideal absolute level of growth for the following year (70%? 100%? 200%?). Then the discussion progresses to look at the efficiency of delivering that growth via a myriad of ratios including cash burn, sales efficiency (Magic Number), and profitability (Rule of 40).
Invariably, someone around the table will unhelpfully bring up another company in their portfolio whose metrics are far more ‘magical’. The conversation then awkwardly ends with a frustrated founder saying that if efficiency is what’s needed, the company can simply stop hiring sales people and the investors can reap the rewards of great efficient stats — at which point the proposed budget gets swiftly approved.
Introducing Cost of Capital
The above process, painful as it is, is beneficial to a company in marshalling its resources. It is also insufficient. We strongly believe that a company’s capital allocation discussions must take into account the company’s cost of capital.
Businesses are not created equal. Some are hot and, sadly, many are not. Even within the Dawn portfolio, two near-financially identical businesses on paper will attract dramatically different valuations based on a combination of team, market, and tech which yield that intangible quality, ‘hotness’.
If you are the CEO of a ‘hot’ business raising money at twice the multiple of the next company, should your decisions be constrained in the same way? Absolutely not. Instead, the CEO should double down on the company’s competitive advantage, a lower cost of capital, and feel able to deploy capital more freely, even if it is at the expense of efficiency.
We have come up with the concept of Equity Burn specifically for series A and B-stage companies to incorporate a startup’s cost of capital into decision making. We define Equity Burn as the dilution a company would suffer if it had to theoretically raise money just to fund the next 12 months of burn:
Equity Burn = Cash Burn over the next 12 months / Valuation Today
For example, if a company is planning to burn $10m this coming year and recently raised at $100m post, its Equity Burn is 10%. We have observed a range for Equity Burn of 2–10%, with most companies clustered around 6%, and with the better performing ones at the lower end. (Note: We are early in our data journey on this topic and we will refine and update our metrics over time with more data.)
Equity Burn is a useful absolute benchmark to guide CEOs with how much cash is reasonable to burn relative to company valuation, independent of performance. We have a second metric that adjusts equity burn so that companies that grow faster do better on this metric:
Adjusted Equity Burn (AEB) = Equity Burn / Growth Multiple
This measures how much equity value you are planning to consume next year per unit of growth delivered. So if you are burning $10m this year to deliver 70% growth and recently raised at $100m post, the Equity Cost of Growth is (10/100)/1.7= 5.9%. We found that AEB ranges from less than 1–7%, with most companies clustered around 4% — again with the better performing ones at the lower end.
So far, this approach has provided useful benchmarks for understanding the appropriate Equity Burn of A and B-stage companies. Of more practical use is the inverse value of AEB. This tells us, for every point of equity burned, how much growth a company should expect. The average from our sample is 11x. In other words, if a company’s Equity Burn is 5%, the company should expect 55% growth. We have initially set this average point to depict for every level of Equity Burn the growth required to keep a company’s cost of capital steady.
Fig. 02
If a company sits below the line, in the red zone, it is burning too much equity for the growth it is delivering, which means its future valuation multiple will suffer, and it will be less able to afford burning cash in future. The beginning of a doom loop.
In the green zone, the opposite is happening. The company is outperforming and is able to raise ever cheaper capital to win its market. We have found best performing companies hit a ratio of over 30x.
Implications of Equity Burn for entrepreneurs
- Entrepreneurs should benchmark the level of investment their business is making relative to its cost of capital. Companies with a lower cost of capital should feel able to spend more to chase growth. At the other end, this is an early warning for entrepreneurs with a high cost of capital that they are heading for low ownership stakes in their own businesses if changes are not made.
- Entrepreneurs should always know their cost of capital, since it dictates how much burn they can afford. Dipping into the funding market every 18 months to two years is not frequent enough: your cost of capital can change quickly.
- If your cost of equity is cheap, raise more money (not less to minimise dilution). Every company has its ups and downs, having one to two years’ worth of cheap capital on your balance sheet buys you time to weather the inevitable storms, or to gracefully adjust to a new reality.
(We invite founders to confidentially send data and receive updates on this analysis: norman@dawncapital.com)