Know Your Burn Rate or Get Burned

During the dot-com era, there were many companies that had to close their doors because they didn’t properly manage their cash flow. When these companies ran out of cash, they were forced to go back to the venture capitalists that provided the wherewithal to get the companies started in the first place.

Venture capitalists are a tough bunch and they don’t like it when the companies in which they’ve invested don’t properly predict how they will burn through the capital that was provided to them. So, in many cases, the VCs just pulled the plug on these dot-com companies and allowed them to fail.

Burn Rate

This all brings us to the burn rate. Investopedia describes burn rate as follows: “The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow.” The term became popular during the dot-com era — the legendary time when business plans were supposedly sketched out on paper placemats at restaurants. Most of us remember what happened to so many of these ill-conceived companies.

The person responsible for calculating the burn rate is usually the chief financial officer. It is incumbent upon him/her to calculate the burn rate as conservatively as possible. The burn rate then is folded into the company’s budget, which then becomes part of the business plan.

Calculating and Defending the Burn Rate

I’ve seen some very detailed burn rate calculations. They are computed on a month-to-month basis and start with the cash invested at the outset of the company. They then go on to show each month’s use of cash — the way that the company is “burning” through cash.

The chief financial officer must be prepared to defend all of the details of the burn rate. The venture capitalists will inevitably want backup for all of the monthly numbers. If the CFO has many poorly defended numbers, my experience is that the venture capitalist will walk away from the deal.

The CFO should fully realize the mission of the venture capitalist. It is the VC’s job to fund a company — many times a startup — and attend board meetings to insure that the VC’s money is being properly spent. A VC wants a relatively quick exit from a company. Therefore, the founders and officers of a startup should expect that the VC wants an exit strategy whereby all of the initial VC investment is returned, along with a handsome profit.

In this fashion, the company will have less of a challenge raising additional funds for future investments. All the VC has to do when it’s time to raise additional capital for the client company is to show the client’s track record to potential investors. And, if it can be shown that funds invested into a venture can historically be expected to be returned relatively quickly and at a relatively high return, the VC will more than likely be able to attract additional funds in order to invest in new startups.

Shilling’s Chilling 38 Studios Adventure

Curt Shilling’s 38 Studios adventure had a very unhappy ending. The State of Rhode Island is on the hook for potentially more than US$100 million for having invested in a company that either didn’t have a good handle on its burn rate and/or never had competent burn rate calculations in the first place. The jury is still out as to exactly what happened to the famous baseball player’s company.

When I first read about the State of Rhode Island lending $75 million to a startup video game company, as a Rhode Island resident, I was stunned. Why would anyone, let alone a state agency, invest so heavily into one company. The video game world is highly competitive and highly unpredictable. This type of investment is best handled by private venture capitalists, not by a state agency.

Very predictably, the company failed, even sooner than I had thought it would. The simple explanation was that the company ran out of cash and didn’t conservatively predict its cash needs — read burn rate.

Wikipedia has a nice synopsis of what happened here: “38 Studios, formerly Green Monster Games, was an American entertainment and IP development company founded in 2006 by Major League Baseball pitcher Curt Schilling and named for his jersey number. Originally based in Massachusetts, the company moved to Rhode Island as part of securing $75 million in loans from that state’s quasi-public Economic Development Corporation (EDC). In February 2012, the company released its only title, Kingdoms of Amalur: Reckoning, a single-player action role-playing video game for several platforms. The game got mixed reviews, some very negative and some very positive, and sold an estimated 330,000 copies in its first month. 38 Studios folded a few months later. The failure of the controversial Rhode Island loan has spurred investigation by the news media and the government.”

An Unhappy Ending and a Clear Warning

I’m not sure how the State of Rhode Island is going to ultimately get a substantial part of its money back for its foolish investment in a video game. Of course, the predictable lawsuits have been filed and there are plenty of recriminations flying about. But ultimately, the citizens of Rhode Island will pay a steep price for the financial foolishness of their state’s Economic Development Corporation. The irony here is that Shilling has always passed himself off as a small government man, a person who believes that the government should stay out of the affairs of businesses. Yet, in my opinion, he took a massive government handout in order to start his company. And, sadly, Rhode Island was the fool who rushed in “where angels feared to tread.”

The moral of this story: Know your burn rate or get burned!

Good luck!

Theodore F. di Stefano

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected]. Follow Theodore F. di Stefano on Twitter.

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