Start-ups raising capital is inspiring news for the start-up ecosystem and founders. A material proportion of the founder’s time goes into estimating, planning for, and raising capital. Even a great idea, in the absence of capital, might not be able to live up to its potential. To establish a large business and achieve scale, initial investments are inevitable. They ensure that the entrepreneur can build the right model to explore the yet-to-be-explored markets and access their target customers. Hence, we’ve constantly heard about burn rates, operating losses, and large capital raises in private markets, incrementally so in 2021. The great digital companies all had to make these initial investments before they could start funding their growth from internal accruals. That said, all burns are not equal.
Understanding the quality of capital burn is critical, even more so in times like these when capital is available in abundance. Some of the poster children of the start-up ecosystem might have the right relationships and pull to bring in large amounts of capital, which in certain cases could make them lose track of the quality of burn. Hence, excess capital raises could be counter-productive in the absence of discipline. Capital burn, which helps drive STICKY AND ACCELERATED revenue growth, is justifiable. However, if it provides only a short-term boost to the GMV/GTV, and the revenue (or a large part of it) goes away in the absence of capital burn, then the merit of such a burn needs to be critically evaluated.
A simplistic process to evaluate the quality of burn is to understand the level at which the burn takes place. If a company is losing money at the gross level to maintain its operations, it is very likely a cause of concern (with some exceptions). However, losing money at the net level to invest in technology, branding, and marketing could yield long-term results and be a future growth driver for the company.
Does it make sense to lose money at the gross level? Selling a product or service below its cost-to-the-company implies that the more the company sells, the more it loses even before attributing the overheads. It’s as simple as that, and obvious. This, if continued, requires consistent fund raises, which might not be sustainable.
One of the few exceptions can be for products/services where there is a significant network effect, which could translate into better economics as and when the scale crosses a certain critical mass. However, it is important to keep track of the quality of the user base in such cases.
Another exception can be to drive discovery. When the consumers themselves do not know the value of a product/service and the entrepreneur needs to incentivize the consumer to discover product value; then it might make sense for the company to offer the product/service at a lower price point, which will help drive product usage and enhance value. However, such discounting is only justifiable once or twice per customer. Multiple iterations of the same gross-margin level discounting for the same customer could be a red flag and an indication of artificial demand. Prolonged negative gross margins over time might become counter-productive and lead to discount-hunting by customers.
Capital, particularly if it drives negative gross margins, could build a perception of a market that is actually non-existent, particularly for discretionary demand-driven businesses.
It’s easier to drop prices, but much more difficult to increase them at a later stage, because the additional demand fades away once the company moves to prudent economics, in turn impacting the valuation-driving GTV/GMV numbers. This concept should ideally be baked into business models, but founders juggle several moving pieces at the same time and sometimes the competitive environment makes them chase growth even at sustained negative gross margins. Declining/tapering growth, along with the market leader making continuous sizable losses, is often a clear indication of an artificially inflated market.
All burns are not bad; managing growth-focused investments vs. profitability tradeoff is the key
Anurag Goel is General Partner at Cactus Venture Partners.