Was thinking about some useful household finance metrics as the new year approaches…
From the day anyone starts working, we’re quickly educated on the concept of an hourly wage. Whether we start at minimum wage or otherwise, we’re conditioned to the idea of compensation being denominated in the time interval of hours. Even as many folks transition to being paid on a salaried basis, it’s not hard to calculate what you effectively make per hour. For example, if Bob’s after-tax bi-weekly paycheck is $1,500 and Bob works 50 hours per week, then he makes $15.00 per hour. This example presumes Bob has no other sources of income other than his paycheck.
The household metric that is often missing from the equation is the flipside: spending per hour. The most simple way to calculate this number is to take all of your expenses for a given period (say a month) – mortgage/rent, credit card charges, car payments, ATM withdrawals, utilities, insurance, interest payments, tuition, healthcare, charitable giving, etc. – and do the basic math to denominate that spending on an hourly basis presuming the same “spending hours” as “working hours”. To use the same example, if Bob spends $3,000 per month and has the same 50 “spending hours” per week, then a little basic math says Bob spends $13.85 per hour.
That takes us to the most important metric: profit per hour. Bob makes $15.00 per hour and spends $13.85 per hour which means he makes $1.15 per hour in profit. The reason I prefer the hourly denomination of profit more than a month or year is that it’s more practical for all of those little spending decisions we make every day. Congratulations to Bob for being profitable! Just knowing your hourly profit metric is an achievement in and of itself. But, let’s go on to a couple second order ideas for those interested.
First, you can say that spending hours and working hours are not the same in reality. If Bob spent $13.85 every hour of every day (24 x 7), he would end up spending $10,000 per month instead of $3,000. So, the key to making the math work is to limit your spending hours per week to the same as your working hours per week. If you work 50 hours per week, pick the 50 hours per week where spending is allowed and fix them. It might be 5 specific hours on each weekday and 12.5 hours on Saturday and Sunday. Once that is selected, the question is how much can you spend per hour in those “spending hours”.
To determine how much you can spend in those spending hours, you have to determine how much you have already spent just by existing. Take all of your “fixed costs” – all those costs that you bear whether you ever take your cash or credit card out of your wallet. This could be things like car payments, rent/mortgage, insurance, tuition, etc. Let’s say for a moment that of Bob’s $13.85 per hour of spending, $10.00 per hour is fixed. That means in those 50 spending hours per week, Bob can spend $3.85 per hour and still maintain his profit margin of $1.15 per hour. Now all of Bob’s discretionary spending decisions can be benchmarked against that $3.85 in hourly discretionary spend that he knows he is allowed. That’s a useful metric whether Bob is looking to get that bagel sandwich for breakfast or that fancy steak for dinner.
When investors and entrepreneurs talk about “burn rate”, they’re generally referring to the amount of cash a company consumes through its normal operations every month. For many venture-backed companies, they have a negative burn rate meaning that they are expending more cash than they are collecting. The obvious rationale to burn cash is that by spending more now, your company will be able to grow revenue faster, acquire market share and separate from the competition.
Investors will talk about “high burn rate” companies, “capital efficient” companies, companies that are “burning too much”, etc. But, how does this translate to hard numbers? Here’s my rule of thumb:
- Cash Flow Positive: If the company is growing and cash flow positive – congratulations. The model has been proven, you never have to raise capital again.
- $0–$250k burn rate: This is still a “capital efficient” company – a $10M round could last 3–4 years which is an eternity.
- $250k-$500k burn rate: This is average. Many young venture-backed companies are in this zone. A $10M round lasts 1.5–2.0 years.
- $500k-$750k burn rate: This is on the high side. You could be accused of “burning too much”. A $10M round lasts a 1.0–1.5 years. That’s a tight timeframe to create value.
- $750k-$1M burn rate: This is a “high burn rate” company. A $10M round doesn’t even last a year. There’s no room for error.
- $1M-$2M burn rate: Many investors won’t touch a company burning this much. The exception is if the spend is due to aggressive marketing against a known acquisition model that is profitable against the lifetime value of a customer.
- $2M+ burn rate: Most investors will run like the wind.
While some sectors such as biotech, cleantech and communications services don’t follow these norms – it’s a pretty good benchmark for most emerging technology companies.
The sentiment towards founder liquidity among investors seems to swing back and forth like a pendulum. Founder liquidity refers to instances when an investor invests capital to buy shares directly from a founder rather than or in conjunction with investing capital that goes into the company for traditional working capital purposes. When capital goes to a founder rather than into the company, there is typically neither an economic benefit or an economic cost to the company (though there may be non-economic benefits and costs).
Why would an investor be willing to use their capital for founder liquidity? Typically it’s because they want more ownership in a company that already has sufficient working capital. By acquiring shares directly from the founder, they can increase their ownership without increasing the post-money value of the company. Often times, founder liquidity is used for more mature companies that are profitable and hence the only opportunity for a new investor to gain an ownership stake is by providing the founder or other shareholders with liquidity.
Why don’t investors want to use their capital for founder liquidity? The drawback of using capital for founder liquidity is that the capital does not go into the company and therefore has no impact on helping the company to grow. Using a limited resource like capital in a non-accretive way is viewed quite negatively in bad economic times when capital is scarce or in situations where the company might need more working capital in the future. Another issue related to founder liquidity is whether it impacts the motivation of the founder or is viewed negatively by other employee/management shareholders who do not get liquidity themselves.
Why do founders want liquidity? The most common reason is that they have bootstrapped the company, taken on substantial personal debt, and have foregone all other forms of wealth accumulation to take the company to it’s current state. By taking some liquidity, they can strengthen their personal balance sheet and “go for a bigger win” at the company. Other times founders want liquidity because they are no longer actively involved with the company and are seeking to clearly separate from the company. In this instance, it’s of value to the company and investors to not have any possible dissident shareholders involved as well.
What’s my take on founder liquidity? Using capital for founder liquidity is a viable use of proceeds for more mature companies but it has to be done in a disciplined way. It has to be the right kind of company and, as importantly, the right type of founder. The right kind of company is one that does not need additional working capital and is highly predictable in nature. The right kind of founder is one whose focus, energy, and motivation will remain productive and positive despite a suddenly improved personal balance sheet. The two must be in place: right company, right founder.
I have seen a number of examples where founder liquidity has been a positive instrument for all parties involved. So, I have and will continue to support using capital for founder liquidity in very specific instances. That being said, I think a great predictor of success for a growth stage company is when a founder who could take liquidity – chooses not to. There may be no more significant of a vote of confidence a founder can give his or her investors than to forego liquidity and press ahead. While I don’t know for sure, I doubt that luminary founders like Steve Jobs (Apple), Jeff Bezos (Amazon.com) or Larry & Sergei (Google) took liquidity while their companies were private. If true, it’s a fact pattern worth emulating because in their case, it turned out to be the best financial decision they could have possibly made.