Software

Burn Rate vs. Annual Recurring Revenue: Watch Your Efficiency

By Art Wittmann, Brainyard Editor
Burn Rate

In short:

  • Our free calculator is based on David Sacks’ “burn multiple” concept, which correlates burn rate to a company’s ability to build new annual recurring revenue.
  • While SaaS providers are its target market, the idea is applicable to any company with the potential for high growth.
  • Do your numbers add up to unicorn status in a few years?

Recently, David Sacks wrote an article about how VC-backed firms should think of their operations in COVID-19 times. Sacks was the original COO of PayPal and later founded Yammer, which he sold to Microsoft. He went on to co-found Craft Ventures, which funds early-stage startups.

Not too early, though, as we’ll see.

The fact is, most companies aren’t interesting to venture capitalists. VCs want the capacity for rapid growth, and if they don’t see it, they don’t invest. You could land an exclusive deal to open a string of ice cream shops in a wealthy part of the world that hadn’t ever seen ice cream, and you would still struggle to draw the attention of a VC. All that brick and mortar and milk and refrigeration? That’s for banks, not venture funds. Growth won’t happen fast enough.

Actually, unless this mythical part of the world is lactose intolerant, it’s a safe bet that ice cream will sell very well, and growth will happen as quickly as you can build new shops. Any banker would consider the concept a low-risk investment.

VCs are about riskier bets. Really risky. Depending on whose stats you believe and how you define failure, less than 25% of VC-funded startups produce good returns, and only about 5% produce the returns that were originally promised. About one-third go under completely, with the remaining roughly 40% continuing to operate, but not at growth or profit levels that make VCs happy. That means the 25% that succeed need to do so in a big way. So big that they make up for all those other disappointing investments.

Back to Sacks and COVID-19. You might ask: How does a venture capitalist talk compassionately about expected growth during a pandemic? The answer is, he doesn’t. Except for encouraging startup leaders to be careful of their burn rates “as the economic crisis deepens,” the article could have been written six months ago.

Sacks introduces the concept of the “burn multiple,” which correlates a company’s burn rate to its ability to add new annual recurring revenue. The lower your burn multiple, the more efficient your company is, he says. Here’s the formula:

Burn Multiple = Net Burn / Net New ARR

This is a riff on Bessemer Venture Partners’ Efficiency Score, which is the same formula with numerator and denominator switched. Sacks goes on to give this chart, below, as guidance on what makes for a desirable burn multiple.

Burn Multiple Efficiency
Under 1 Amazing
1 - 1.5 Great
1.5 - 2 Good
2 - 3 Suspect
Over 3x Bad

Sacks deals mostly in the software industry, and since he’s talking about ARR, we’re assuming he’s thinking of SaaS companies here. It’s pretty obvious that if a SaaS startup’s burn multiple is less than 1, the company is on the bullet train to unicorn status.

To see what it means to maintain a burn multiple at each of these levels, we built a simple spreadsheet, available below, that demonstrates growth at given burn multiples, and we graphed out performance over six years. We made some assumptions about the size and makeup of the company in its pre-revenue days. Since we’re talking about SaaS, we broke spending into three areas:

Production Cost = Cloud Cost + Support Cost

Customer Acquisition Cost = Sales Cost + Marketing Cost

Overhead Cost = Executive Team Cost + General Business Cost + Development Team Cost

Initially, these costs are higher than they should be because the company has yet to generate any revenue. After the first year, production costs efficiently adjust to a set gross margin, which is 80% in our examples. Overhead increases as a percentage of new ARR, which in our examples is set to 20%. CAC does not adjust efficiently because we don’t want to fire most of the sales and marketing team and cut those budgets after the first year, when sales won’t be sufficient to produce the desired CAC.

Download the Burn Multiple Calculator

Get the Brainyard’s spreadsheet that allows you to edit Bad, Suspect, Good, Great and Exceptional burn multiples based on your business reality.

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We also take into account the cost of the product, an annual increase (or decrease) in revenue per customer and churn rate.

Normally, each of these would affect the burn multiple, but since we set out to see what certain burn multiples did to revenue and earnings, these factors affect only the number of new customers needed in a given year. So, if you’re selling a SaaS app at $50 annually, you’ll need 1,000 times as many customers as if you’re selling at $50,000 per customer. Similarly, churn rate just means you’ll need more customers, but the burn multiple doesn’t change.

All of these factors can be modified in our spreadsheet, so the model can be made to approximate other industries, where cost of goods sold would suggest different gross margins, overhead costs and customer acquisition costs.

We also provide an estimate of the value of the company, set at 20 times earnings. This too isn’t real life, since it doesn’t take into account the effect of CAC or churn rate on the value of the company.

Here’s what a burn multiple of 2.0, which Sacks calls “good,” does over six years:

SaaS Burn Multiple

It’s good indeed. The company is profitable in its fourth year, and by the sixth year it has a net margin of 32% and valuation of about $150 million. Nice work if you can get it. Any VC firm would be pleased.

But what if we’re better than good? Here’s the result for a burn multiple of 1.2:

SaaS Burn Multiple

The company is profitable in Year 3, and by Year 6 it has a net margin of 32% and valuation of just under $440 million. It’s coincidental that net margins are about the same in these two examples. Because our model keeps overhead growth at a constant rate over the six years, it dominates expenses when our burn multiple is high, while at a lower burn multiple, customer acquisition costs become more dominant.

A constant burn multiple of about 1.5 gives the optimum margin in our model, at about 34% in six years. This company looks to be headed to unicorn status in about two years. Mr. Sacks is eyeing a new private plane.

So what happens if we get into the amazing range? Here’s a burn multiple of 0.9.

SaaS Burn Multiple

Profitable in Year 3, this company is seeing better than geometric growth and has a valuation of $717 million. Because we need a lot of customers to achieve this burn multiple, our net margin is down to 20%. Who cares? Break out the champagne and let’s go yacht shopping, because we made unicorn in seven years. This is the “growth over earnings’ model that VCs love.

It’s unlikely that a burn multiple will remain static, as we’ve shown so far. In many startups, it takes a bit of time to perfect a product so that it can achieve the geometric growth that VCs want. In these cases, your burn multiple might start out just OK, or even suspect, and then move to good or great as you get the product right. Here’s that scenario, with a burn multiple that starts at 2.5 and shrinks to 1.5 in Year 6:

SaaS Burn Multiple

Here we end Year 6 at a net margin of 21% and valuation of $94 million. It takes four years to turn a profit, but things are going very well.

Another scenario might be that we have our product right at the outset, but that over time, we just can’t maintain that rapid growth. In this case, our burn multiple starts out at 1.5 and goes to 2.5 over the course of six years. Here’s what it looks like:

SaaS Burn Multiple

Profitable in just three years, we’re at a $206 million valuation by Year 6 with a net margin of 38%. That early success has enabled us to get profitable quickly while allowing for lower CAC as a percent of revenue. It’ll take longer to get to unicorn status, but it’s hard to beat the net margin. It’s so good that the market might give a better than 20-times-earning valuation.

Overall, you can see that analyzing burn multiple is useful in understanding a company’s efficiency. Sacks might be slightly ambitious in his assessment of what’s good and what’s suspect, but that’s why he doesn’t invest in ice cream shops. Tech, and SaaS in particular, is one of the few markets where you can get to billion-dollar valuations in less than a decade. If he can’t see that runway for your company, it’s likely he’ll take a pass in favor of what he hopes is the next Zoom.

Grab a copy of our spreadsheet and run the numbers yourself. If you improve the model, let us know. We’d love to see a version that reflects reality for the ice cream entrepreneurs of the world.

Art Wittmann is editor of Brainyard. He previously led content strategy across Informa USA tech brands, including Channel Partners, Channel Futures, Data Center Knowledge, Container World, Data Center World, IT Pro Today, IT Dev Connections, IoTi and IoT World Series Events, and was director of InformationWeek Reports and editor-in-chief of Network Computing. Got thoughts on this story? Drop him a line.

Mark Bianco

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