Limitations of Accounting
Although accounting may be heralded as being the language of the business, it is definitely not error-free. This has been highlighted by the fact that accounting scams have occurred one after the other for many years. In fact, even after stricter regulation and tightening of accounting rules, accounting scams just don’t cease to stop. As […]
Multiplier Effect: How Fractional Reserve Banking Creates Money ?
The modern banking system is considerably different from what the average person believes it to be. Banks are not institutional moneylenders. They do not simply collect money from people and lend them to others. Instead, banks in the modern world have the power to create money when they lend it out. The process by which […]
Asset-Backed Commercial Paper
In the previous articles, we have already read about commercial papers and why they are an important segment of the money market. In most cases discussed earlier, commercial papers were related to unsecured debt. However, this need not always be the case. It is possible for commercial paper to be backed by other securities or […]
Alternative Assets in Pension Funds
Pension funds across the world generally invest in traditional asset classes such as debt and equity. However, over the past few years, many experts have suggested that pension funds should branch out and invest in alternative asset classes. Theoretically, investing in alternate asset classes has many benefits. However, when the pension fund actually starts making […]
Commonly Used Terms in Derivative Market
The derivative market can seem like a world unto itself. The market is so large and so different from the other markets that it has its own language. A new person trying to trade derivatives may not even understand the information that is being offered to them. It is therefore necessary to understand the vocabulary […]
Burn rate is a metric that is specific to the start-up world. On the one hand, most of the financial world is obsessed with frugality but at the same time, investors in start-up companies often pressurize the management to spend as much money as possible within a short span of time. The excess of spending over revenue is called “burn” in start-up terminology. Start-up founders who do not have experience dealing with investors may be shocked to find out that these investors actually encourage them to “burn” more money.
In this article, we will have a look at the rationale behind this excessive focus on burn rate and why it harms start-up companies.
It is important to understand that even though investors and founders are on the same side, they may not have the exact same objectives. Investors are in it for the short run. Most venture capital firms raise their money by borrowing funds from high-net-worth individuals. These funds are borrowed for a specific period of time. The funds have an expiration date when the original capital plus profit has to be returned to the high-net-worth individuals.
Now, it is important to realize that venture capital management does assume that about 50% of their investments will fail. For them, it is important to realize which of their investment is likely to earn money for them. For a venture capitalist, one of their companies going bankrupt is not the worse outcome. This is something they have already accounted for and hence it does not surprise them.
On the other hand, if a company takes too much time, it cannot figure out whether it is a winner or a loser. This can be very painful for venture capitalists. Their entire business model is based upon identifying the winners as soon as possible. They then proceed to cut the losses and inject more capital towards the winners.
Hence, investors are on a completely different time schedule as compared to the actual start-up founders. They want the business to scale up as soon as possible. They carefully monitor the results of the scaling-up exercise. If they find the results favorable, they will continue to invest in the company. Otherwise, they will simply desert the company making it more difficult for them to survive. There are several start-up organizations that have failed since they have not been able to keep up with the pace of venture capitalists’ expectations.
It is important to realize that even though investors can pressurize the firm to spend money at a faster speed, they cannot force the company to do so. The ultimate decision lies in the hands of the founders as well as the chief executive. It is important for them to be receptive to the needs of the investors. However, it is also important for them to ensure that they are not completely driven by the whims and fancies of investors.
On the one hand, there is a chance that the current venture capital investors might classify the company as a loss-making bet and hence stop making further investments. On the other hand, the company may run out of funds and hence may not be able to raise funds from the market since it has a weak bargaining position.
The bottom line is that the concept of “cash burn” and “burn rate” is quite new. Many start-up founders do not know how to effectively manage this metric. They also don’t realize that their failure to manage this metric could lead to catastrophic outcomes for the firm.
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