Technology start-ups want to give their new app or exciting software solution the best chance of success by getting it to market quickly. To achieve this, they often seek to attract significant investment, through fundraising of venture capital funds, which allows them to develop and test their product fully before launching it to the mass market.
On the path to that ultimate end position, the IPO, tech companies need to prove their worth to potential private investors and venture capitalists (VCs). There are many metrics that companies and investors will use to scrutinise a company’s worth and efficiency, including a recently proposed, new one: the “burn multiple”.
What do venture capitalists look for?
When it comes to investment, venture capitalists are different from banks. Banks look for a solid return on their investment. Venture capitalists want investments that are going to make that return quickly. So, they look for companies with rapid growth prospects. And for them, however good a business opportunity might look – even if it’s selling something to a market that is demanding it in quantity – if there isn’t a fast enough growth factor, then VCs just aren’t interested in investing.
While a bank will invest where the risk is low, VCs on the other hand want the best guarantee of a return, so they tend to look for riskier investments. This is because a lot of venture-backed companies will fail. So, VC investors need to secure excellent returns in order to make up for the large number of disappointments and business failures.
It’s all about the “burn multiple”
During an economic downturn, investors aren’t always able to look at growth. So, in times of recession, or like now, during COVID-19, the critical indicators are burn rate and margins. Companies with a high burn rate compared with their growth are not attractive to investors.
David Sacks is a co-founder of Craft Ventures, an early-stage venture fund. He previously founded and ran Yammer and was the original COO for PayPal. His entrepreneurial business experience is strong, especially in technology start-ups. In a recent article, he argues that, while Bessemer’s Efficiency Score is often used to assess capital efficiency, his own preference is a different take on that score.
Sacks’ concept is all about calculating a company’s “burn multiple”. The ratio shows a company’s burn rate in comparison with how it is adding new annual recurring revenue (ARR). It’s a concept that is particularly applicable to SaaS companies, because they offer subscription services. But it’s also a valid formula for any business with high growth potential.
The formula for calculating your company’s burn multiple is:
Burn multiple = Net burn / Net new ARR
Sacks argues that the lower a company’s burn multiple, the more efficient it is. He further categorises the score as follows:
|Less than 1||Amazing|
|1 – 1.5||Great|
|1.5 – 2||Good|
|2 – 3||Suspect|
|More than 3||Bad|
SaaS companies with a burn multiple of less than one are likely to be the future unicorn companies valued at more than $1 billion.
Calculate your own scenarios using different burn multiples
To demonstrate what it takes to maintain a burn multiple for each of Sacks’ categories, NetSuite has built an Excel spreadsheet, which you can download and use to examine various scenarios. It shows growth at each of the burn multiples and performance is shown over six years.
The calculator is based on some assumptions about a company before it starts to generate revenue, and spending is broken down into these 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
These costs are high at first, because the company hasn’t yet launched its product and so has not initially generated any revenue. However, beyond year one, production costs have been adjusted to a certain gross margin level (80%), overheads are set to increase as a fixed percentage of ARR (20%), and customer acquisition costs increase gradually – although they decrease as a percentage of revenue.
The spreadsheet also takes account of product costs, an annual change in revenue per customer and the churn rate. Because it shows what affect the burn multiple has on revenue and earnings, then only the number of new customers needed per year is affected. So, for example, if a company is selling an annual subscription to its app for £35, then it will need 1,000 times as many customers as it would if it were selling a £35,000 application.
However, these assumptions can be altered in the spreadsheet, allowing you to approximate your own operation as closely as possible by changing gross margin, overheads and customer acquisition costs.
For each year, the estimated company valuation is also given and this is based on a calculation of 20 times the earnings.
It’s really interesting to see what the different burn multiples show for the company at different stages of its growth. For example, using the initial settings in NetSuite’s spreadsheet, a company with a “good” burn multiple of 2 would become profitable in its fourth year, with a net margin of 32% and valuation of $150 million. That’s a financial picture that a venture capitalist would definitely be pleased with.
And using better burn multiples, the company reaches profitability earlier and is assessed to have a higher valuation.
Looking at your burn multiple can help analyse the efficiency of your capital. It can demonstrate if your costs are too high when compared with the income from new customers. Checking your burn multiple needn’t be about securing investment for an already up and running company, though. It’s also an additional metric that you can use to put growth into context versus any investment, and also to check if you need to cut costs.
A company’s burn multiple will change over time. A start-up will likely have high costs and will have only just started selling its product, so at seed stage it may see a burn multiple of around three. But over time this can be expected to improve, decreasing to nearer two. The measure of a capital efficient company is when burn multiple declines as the company matures.
Download the calculator and plug in your own figures to check your company’s capital efficiency. And if you want some help, we’d be pleased to lend a hand.
If you’re a SaaS subscription business, NetSuite can help with all sorts of relevant accounting, including recurring billing, managing different currencies, languages and tax rates, automation of revenue recognition and more. One of our consultants will be pleased to help you with a demonstration, business consultation or a quote.