Growth or profitability?
Growth or profitability?
🔥 Unpacking burn rates, data on what's “normal”, and how burn impacts valuations
👋 Hi, it’s Kyle and I’m back with a new edition of Growth Unhinged, my newsletter that explores the unexpected behind the fastest-growing startups. Subscribe to join 48,472 readers who get Growth Unhinged delivered to their inbox every Wednesday morning.
What’s the right amount of burn for your software startup?
That’s a question on nearly everyone’s minds, especially lately. And it’s extremely hard to answer without resorting to the dreaded it depends.
This post is here to help you find answers, including bringing you new data from public and private software companies. What to expect:
What burn rate means and why you should measure it
How burn impacts your valuation
When to optimize for growth versus profitability
Typical burn rates for VC-backed startups
Special thanks to finance guru
for his contributions to this post. Go check out CJ’s newsletter, Mostly metrics, for regular insights into financial metrics and business models.
What burn rate means and why you should measure it
For the uninitiated, burn rate refers to how quickly a company uses up its cash reserves to cover expenses. It’s commonly reported on a monthly basis, but it could be done quarterly or annually.
Your burn rate helps you understand your startup’s capital efficiency along with its sustainability as a business without requiring more capital.
Efficiency metric —> burn multiple: your cash burned in a period divided by net new ARR added in the same period (the lower the burn multiple, the better).
Net new ARR should include new logo ARR added plus expansion ARR minus any churn experienced in the same period.
Investors want to see startups spend capital in a productive way that generates future returns. A burn multiple below 1x, where you make more than $1 million in net new ARR for every $1 million in cash you burn — is usually seen as best-in-class. I’ve included some rough rules of thumb in the context of fast-growing, VC-backed startups. (Of course, make sure you have the cash on hand to afford it.)
1x burn multiple or better = Best-in-class
1x-2x burn multiple = Good
3x burn multiple or higher = Suspect
Sustainability metric —> runway: your cash on hand divided by your monthly burn rate (the longer the runway, the better). Aim to have ~18+ months of runway as a buffer.
Startups fail when they run out of money, writes Jason Fried of 37signals. Funding could come in the form of debt or equity. In a high interest rate environment, both sources are harder to come by.
How burn impacts your valuation
Tech company valuations are usually looked at as a multiple on recurring revenue. But revenue multiples fluctuate widely across companies.
Median revenue multiples currently hover around 5-6x next twelve month (NTM) revenue, according to CJ Gustafson’s Mostly Multiples deep dives. (During the bubble of 2020-2021 revenue multiples peaked above 15x 🤯)
Best-in-class companies still see above a 10x multiple with standouts including Crowdstrike (20.8x), Datadog (14.4x), Cloudflare (14.2x), Snowflake (13.4x) and ServiceNow (13.0x).
Two metrics strongly predict these revenue multiples: (1) growth rate and (2) profitability, as measured by free cash flow (FCF).
Compound metrics like the Rule of 40 were created as a shorthand for measuring efficient growth. (If you add your growth rate and FCF margin together, you should aim for 40% or higher, the thinking goes.)
Recent analysis from Bessemer Ventures indicates that growth and profitability aren’t interchangeable, though. For publicly traded companies, growth rates matter at a 2-3x multiplier compared to profitability.
But Bessemer included a rather big footnote: this holds “as long as the growth is efficient.” For early-stage companies that are still burning cash, their analysis indicates that growth rates matter only 1-1.5x compared to profitability (in other words, they’re about equally important).
To sum it up: if you’re already profitable, incremental growth matters far more than incremental profitability. If you’re not profitable, you need to monitor both and — in a perfect world — improve them at the same time.
When to optimize for growth versus profitability
The unfortunate reality is that there’s usually a trade-off between growth and profitability.
If you want to grow faster today, you’ll likely need to invest resources in things that might take 12-18 months (or longer) to pay back. This could include new product development, recruiting capacity, hiring sales reps, scaling paid marketing, and so on.
But there’s a limit to how much you can invest today before seeing the payoff. To find out where folks draw the line, I looked at benchmarks data from 700+ private companies surveyed in the 2023 SaaS benchmarks report I’ve referenced before. What I found ⤵
1️⃣ It's extremely rare to find SaaS companies that blend fast growth with profitability.
Only one-in-ten fast growth companies (>50% year-on-year) were break-even or profitable.
For these fast growers, median burn rates vary from $400,000 per month (companies with $1-5M ARR) to $1,000,000 per month (companies with $20M ARR or greater).
2️⃣ There's a big shift once growth rates start to fall below 50% YoY.
Roughly one-in-three slower growth companies were break-even or profitable.
This number jumps to one-in-two among businesses with less than 20% YoY growth.
The takeaway: when growth slows below 50% year-on-year, expect to craft a path toward breakeven or profitability.
I ran this insight by CJ who agreed, adding:
“In my opinion, once you get below 50% year-on-year growth, you should sprint to profitability. Getting to profitability is a lot like controlling your own destiny. There’s also a non-quantitative element of security. Plus, from an investor’s standpoint, if you are profitable, your growth rate kind of becomes their IRR on you each year.”
- CJ Gustafson, tech CFO and author of
Typical burn rates for VC-backed startups
Even if you’re growing quickly, there are limits to what amount of burn would be considered healthy.
First, a caveat. There is no optimal burn rate (besides zero burn, that is). What's healthy for one startup might lead another to run out of cash. You should consider how much cash you have on hand as well as your level of confidence that any investments will leave the business better off.
What we can look at is data on typical burn rates across VC-backed companies. Using the same benchmarks data referenced earlier, here’s what I found ⤵
1️⃣ "Normal" depends on your size and growth rate.
Higher growth SaaS companies with above $20 million ARR are still burning an average of ~$1 million per month. Only ~5% of these companies are breakeven or profitable.
On the flip side, a lower growth SaaS company with $1-5 million ARR is only burning ~$50,000 per month. About ~25% of these companies are breakeven or profitable.
2️⃣ What's "normal" today looks wildly different from 2021/2022.
Median burn rates are down materially year-over-year.
The biggest decreases are among software companies above $5 million ARR and especially those above $20 million ARR. The median burn rate for a $20-$50 million ARR business fell from $1.5 million per month in 2022 to below ~$150,000 per month in 2023.
When CJ saw these numbers, he urged readers to avoid equating “normal” with “good” or “healthy”:
“I’m guessing that a lot of the companies surveyed for the chart were burning more than they should have at the time. The majority of people can still get caught in a bad spot — so it doesn’t necessarily make it “good” just because more people are stuck there than not.”
- CJ Gustafson
The TL;DR:
Burn is normal, and even healthy, in the early stages as long as you have the cash to support it.
There’s almost always a trade-off between growth and profitability.
The relative importance between the two metrics will vary over time. A balanced approach is usually best for valuations.
When growth slows below 50% year-on-year, expect to craft a path toward breakeven or profitability.
Maybe I'm an outlier, but I don't think burn is required. I was bootstrapped and profitable for many years until I had a liquidity event once we were above 8 figures ARR and had a 9 figure valuation.
I don't think this was crazy luck or that I had some secret formula. I created products that fit distinct market needs, told people about them in creative and cost effective ways, and signed real deals for real money that paid the bills.
My theory is that 99% of software companies can grow and can scale while profitable.
I feel like a celebrity with this level of Growth Unhinged treatment.
Well written and excellent insights. Startups operators, pay attention!