An interesting read taken from Tomasz Tungus at Redpoint.
What should be the return on investment of a startup’s cash burn?
How does one calculate ROI? It’s a simple formula:
Cash_Burn_ROI = Revenue_Multiple/Revenue_Pay_Back_in_Years
If a business is worth 7x revenues and revenue payback is 14 months, the burn ROI is 6x or 7x. If a business is worth 5x revenues and revenue payback is 18 months, the ROI is 3x. Note, I’m using revenue payback, not gross margin payback here.
This math reaffirms the importance of unit economics. Startups have no influence over their multiple.2 So the best place to focus is payback period.
"This equation does highlight an important phenomenon. When the market pays high multiples for businesses, startups can maintain equivalent ROI with far longer payback periods. For example, at a 10x multiple, a startup can sustain 2 year paybacks at 5x ROI. We are currently in this market environment today."
Such an environment entices startups to burn large amounts of cash. At a 10x multiple, each marginal revenue dollar increases valuation by $10. So spending more makes sense for two reasons. SaaS customers are annuities. Buying more of them early leads to faster growth rates. Second, there are strategic advantages to growing faster including hiring, fundraising, and partnering.
That doesn’t mean a business should spend cash without an eye or two on the balance sheet. In 2016, SaaS multiples fell 57% from their highs. Overnight, ROI math changes. But the cost structure of companies doesn’t change that quickly. If there is a market correction, and the company is not yet profitable, reorienting the business to sustain the same cash burn ROI is a prudent strategy.
Remaining disciplined about unit economics and cost structure is critical to weathering the ups and downs of the market. It’s the single most important control lever a business has.
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