It doesn’t matter how much money you’ve raised; poor cash flow management kills startups.
If your startup isn’t profitable or your burn rate (expenditure) exceeds your income, there’s a strong chance your business will run out of cash and cease to exist.
Even a quick pivot won’t save a startup that’s draining resources faster than revenue is coming in.
Between 2010 and 2021 — when startup funding was flowing consistently — poor cash flow, high burn rates, and even higher valuations weren’t a serious problem. Investors were throwing money at viable (and many non-viable) startups. Running out of cash wasn’t such a big issue.
You could always raise more, right?
The world economy is sliding into a downturn. Venture Capital (VC) funding has tapered off. Valuations have dropped. Layoffs have increased.
For many startups, tougher times are ahead, especially for founders who’ve only ever experienced low-interest rates and a plentiful funding environment.
In this article, we examine what’s caused these economic and VC funding changes, the importance of cash flow management and, crucially, what startup founders should do to improve their chances of survival.
Why is cash flow management crucial for startups?
Poor cash flow management is the number one killer of startups.
A CB Insights postmortem of 406 startup deaths between 2014 and 2022 found that 70% failed within 20 months of raising finance (a minimum of $1.3 million raised) due to poor cash flow management. In most cases, burn rates were higher than revenue run rates.
In other words, they ran out of money.
Founders can learn lessons from these startup failures. If you’re a founder who is burning through cash like it’s 2021, you need to learn those lessons fast.
We are in the midst of noticeable changes in the VC funding environment. The drumbeats of an investing slowdown are getting louder on Twitter, LinkedIn, and the media.
Now is not the time for haphazard cash flow management.
Startup funding 2021 — 2022: Boom to bust
Before diving into what’s happening today, 2021 was a record-breaking year for startups. Valuations were insanely high. Over $620 billion was raised and deployed into thousands of startups by investors in VC firms.
In 2021 alone, over 150 unicorn startups (valued at $1+ billion) emerged every quarter, quadrupling that of previous years.
In late 2021 and into early 2022, the market started to fall. And it fell fast. The warning signs appeared in Q4 2021. The trickle became a flood in Q1 2022, when U.S. startup investment fell for the first time in two years, down 11% year-on-year.
Startups are likely to see steeper falls when Q2 data comes to light. The golden years of startup funding are over; at least for the moment.
A stark warning from Y Combinator
Y Combinator, the world’s leading startup accelerator — with the top 137 YC graduates worth over $300 billion — recently issued a stark warning to startup founders: “The safe move is to plan for the worst.”
Y Combinator’s warning is a response to several downward trends that are impacting startups:
- VC firms are pulling back funding deployment, and even walking away from signed term sheets;
- Job losses are being reported at hundreds of startups worldwide, and this trend is accelerating across numerous sectors, according to CrunchBase
- Tech giants such as Meta, Amazon, and Netflix have taken a beating in the public markets. Stocks are down across the board. Shockwaves are rippling across the tech sector and impacting VC funding activity
- We have seen a spillover from public market activity into VC and PE (Private Equity) investment actions, limiting the ability of funds to raise new capital
- Valuations have dropped dramatically, and term sheets are tougher
- One of the biggest, bravest, and boldest investment firms, SoftBank, recently reported a $27.7 billion loss on investments for the last fiscal year. Softbank CEO, Masayoshi Son, said they would reduce investment activity by 50% in 2022
All of the above is a reaction to the possibility of a recession in the U.S. and, most likely, worldwide. All signs indicate that we are flying fast into a perfect storm of macro and micro-economic headwinds:
- Rampant inflation
- Rising cost of living
- Increased gas and energy prices
- The ongoing impact of Covid-19
- Global supply chain problems and food shortages
- A steep decline in Chinese production and productivity
- The growing impact of extreme weather events due to climate change
- Brexit in the UK
- War in Eastern Europe.
International Monetary Fund: “biggest [global economic] test since second world war”
Combined, the numerous factors mentioned creating economic uncertainty and turmoil, increasing the chance of a worldwide recession. Kristalina Georgieva, IMF Chief, warns the global economy faces the “biggest test since second world war (sic).”
Consumers and businesses have less money to spend and invest. We see a downward trend in Gross Domestic Product (GDP) indicators and investor confidence, along with volatility in the cryptocurrency sector, and capital and funding restrictions.
The majority of active startups were born after the 2007-08 credit crash and global economic recession that lasted (in some regions) until 2013.
New generations of startup founders don’t know anything different. Although the pandemic was a test of strength and resilience for all, a global recession — or a prolonged period of contracted growth, higher inflation, lower business and consumer spending, and restricted access to capital — will last longer than the economic shocks of the pandemic.
Hence the stark warning from Y Combinator. The letter concludes by saying: “It’s your responsibility to ensure your company will survive if you cannot raise money for the next 24 months.”
Doubling down on the warning, YC says: “If for whatever reason you don’t think this message applies to your company or you are going to need someone to tell you this in person to believe it … please reassess your beliefs on a monthly basis to make sure you don’t drive your company off a cliff.”
Some are calling it a reset. A readjustment. A return to reality.
And they’d be right.
But for startup founders, it’s the motivation you need to reach profitability . . . fast!
Cashflow management is an integral part of achieving profitability. Let’s take a closer look at how to effectively manage your cash flow.
Why poor cash flow management kills startups
Let’s start with a simple question:
What’s the difference between a successful and a failed startup?
Startup founders might argue, “It’s not that simple.”
And to an extent, they’d be right. On the other hand, let’s consider the case of two fictional startups (without taking into account their sector, product, funding, etc.):
Monthly Recurring Revenue (MRR) is $150,000 = Annual Recurring Revenue (ARR): $1.8 million per annum.
Burn Rate (accounting for all fixed and variable costs): $100,000 per month = $1.2 million per annum =
Gross Profit: $600,000
Monthly Recurring Revenue (MRR) is $150,000 = Annual Recurring Revenue (ARR): $1.8 million per annum.
Burn Rate (accounting for all fixed and variable costs): $200,000 per month = $2.4 million per annum.
Net Loss: -$600,000
It doesn’t matter if Startup B raised $2 or $20 million; they will run out of money before achieving profitability unless they make serious changes to their cash flow management. That’s assuming any of their original capital remains.
Many companies burn through millions before reaching product-market fit, generating sufficient sales, and hitting a stable revenue run rate.
CB Insights data confirms this, with 38% of startups dying because they ran out of money and couldn’t raise more. Out of the top 12 reasons for startup failure, poor cash flow management is the number 1 killer of startups,
In another shocking list of 224 high-profile startup failures (companies that raised between $15M and up to $1.75 billion), CB Insights found that “an inability to generate sustainable revenue”, and “(of course) simply running out of money,” were common themes.
Spending more than you make will kill your startup. Cash flow is king. It’s the difference between life and death, success and failure.
Let’s outline 9 ways you can manage cash flow more effectively in your startup.
9 ways startups can effectively manage their finances and cashflow
1. Keep a close eye on MRR & ARR
Monthly and annual recurring revenue (MRR & ARR) are two of your most important metrics.
Every Founder-CEO, C-Suite Officer, and active board member should know these numbers in real time. Anyone responsible for revenue must have clear targets for increasing MRR and ARR.
Assuming payments from customers/subscribers come in through a single platform or processor — such as Stripe — these should indicate your top-line numbers. Although it is tempting to multiply MRR by 12 to give you the ARR, there are other factors to consider, like churn rate.
As long as the MRR increases, so should the ARR — even accounting for a percentage loss due to churn (losing customers). Work with your Chief Financial Officer (CFO), or an accountant, if you aren’t clear on these figures and want a more proactive way to manage your finances.
2. Monitor & increase Customer Lifetime Value (CLTV)
Customer Lifetime Value (CLTV) is another crucial metric.
You can work this out based on the average amount customers pay and the number of months — or years — they remain a customer.
Let’s assume customers pay $100 per month and stay with you for at least 3 years; you’ve got a CLTV of $3,600.
How do you increase that number?
Assess ways to raise prices for new customers. One of the best ways is to evaluate whether the value customers are gaining from your product — the return on investment (ROI) — will justify a higher price.
For example, if a $100 per month subscription saves a company an average of 100 hours of manual work (monthly), and the cost/value of that saving is $5,000, you could charge more.
It’s known as value-based pricing, and it’s one of the most effective ways to charge more while delivering the same work/product.
If you follow the example above and raise prices (for new customers) to $500 a month, suddenly your CLTV jumps from $3,600 to $18,000.
Think about the difference that makes to your bottom line.
3. Monitor sales lead conversion rate KPIs
Lead or demand generation is crucial for B2B startups.
You need a solid pipeline of sales leads, and these must be viable Sales Qualified Leads (SQL). A database of “prospects,” many of whom may not have the budget or need your product, simply isn’t going to cut it.
Whether a sales lead comes from marketing activity — making it a Marketing Qualified Lead (MQL) — or from direct outbound sales, qualification through to the next stage of the pipeline is an essential Key Performance Indicator (KPI).
Monitor how well your sales team does converting these leads quickly. B2B sales should be fast-paced and responsive. Leads don’t stay warm for long. As a founder, you should have a real-time sales pipeline overview.
Keep track of conversion rates at every stage. Ensure you’ve got processes to manage performance and make quick iterative improvements to keep pushing conversion rates higher.
4. Proactively manage churn rates
Churn rates are equally important. If you’ve got a win-close conversion rate of 10%, but a churn rate of 5%, then your growth rate is effectively cut in half.
In this market, startups can’t afford to burn through cash while simultaneously losing customers. Here are some steps you can take to reduce churn rates:
- Work with customer service teams and account managers to assess why subscribers are leaving
- Identify common themes and trends
- Create an action plan to resolve customer issues, whether that’s with pricing, the onboarding process, the product, sales, account management or customer support
- Aim to fix as many of these issues within the shortest time frame possible
- Assess the impact of these changes. You should notice a reduced churn rate, and you could benefit from an inbound referral uptick from customers who show increased satisfaction with your product
5. Monitor burn rates and the runway
Monitoring burn rates is mission-critical and always has been. However, we’ve seen countless innovative ways that startups — even those who’ve raised $100M+ — run out of money.
When burn rates are out of control, and revenue isn’t sufficient to meet the needs of the business (without investment capital), startups die. It’s that simple.
Startup founders should ask themselves three questions every week:
- How much revenue are we generating?
- How much money are we currently spending?
- At the current rate of revenue vs. spending, how many months/years can we keep going?
Until the answer to that third question is, “we’re doing great, we are profitable, we can keep going at this rate indefinitely,” you need to move every lever at your disposal.
As a founder, you can reduce your burn rate (spend less) which increases your runway. Keep pushing growth forward until you’ve achieved a stable, sustainable level of profitability through increased revenue.
6. Reduce costs (without impacting growth levels)
Be careful when assessing which costs to cut. Go through every budget item. Review whether assets, subscriptions or certain staff are essential.
Compare the impact you want (ROI) against the actual output. Make a judgment within your leadership team on whether every line item is cost-effective. Then, make adjustments accordingly.
Every cost you trim will increase your runway, giving your startup longer to survive.
However, founders need to be careful.
Don’t cut costs at the expense of current and projected growth rates.
Marketing and sales activities, in particular, need to be reviewed very carefully. Cutting growth-related expenses might seem like a saving, but this could prove to be a false economy, especially if it negatively impacts your ability to keep growing and hitting revenue targets.
7. Review headcount
Headcount is a major area where startups can reduce costs; especially over-funded startups. Newly-funded founders tend to recruit too many staff, and employees are one of the most significant expenses for any business.
Reducing headcount isn’t easy. Many employees at early-stage startups join because they believe in the company’s vision and founder. And laying off staff is one of the greatest challenges a founder faces. Only take this step when absolutely essential.
Treat departing staff well. Help them find new roles. Pay the best severance package you can afford. The last thing you need when cutting staff is a public relations nightmare.
You need to balance the long-term reputation of the brand you’ve built, alongside the short and mid-term cost savings.
8. Generate more revenue; increase MRR & ARR
No matter how many budget line items you reduce, if you aren’t generating additional revenue your startup won’t survive.
Remember, revenue keeps you functioning, but profit keeps you sane.
As a founder, you need to proactively manage — without micromanaging — your sales and marketing teams. Do everything you can to ensure they hit their targets.
Find out which new sales and marketing channels are worth investing in, such as channel partnerships and referrals. Consider resuming any successful pre-pandemic activities like attending trade shows and industry conferences.
9. Reach profitability quickly and keep funds in reserve
Your aim is to reach profitability quickly. If you’ve got 18 months of runway left, aim to hit a sustainable profit level within 12 months. If you’ve got less than a year remaining, do everything you can to cut costs and strive to gain profitability in under 6 months.
You’ll have a viable startup once you get there — the promised land of profitability. You won’t need further funding (and raising finance might be difficult in the next 24 months).
So, for the moment, don’t spend that extra money; bank it. Keep funds in reserve. You never know when you might need surplus cash on hand.
To quote the motto of House Stark in Game of Thrones, “Winter is Coming” for startups.
Over the next couple of years, the world economy is likely to contract, and growth will slow. Investment opportunities will be few and far between. VC’s will deploy funds into late-stage startups, where the chance of an outsized exit are much larger.
Early-stage startups — including those who’ve already raised a pre-seed, seed, A or B round — won’t attract as much funding as was possible in 2021.
Valuations will reduce, and, if terms are offered, they won’t be as attractive. Think long and hard before attempting to raise more money.
Instead, startup founders need to invest their time and money wisely. Focus on growth. Achieve profitability. Cut costs, whenever possible, and put yourself in a survival frame of mind.
The upside of a downturn is that those companies that survive come out stronger and more able to take advantage of growth opportunities when the economy improves. And it will.
Remember, as Y Combinator said: “It’s your responsibility to ensure your company will survive if you cannot raise money for the next 24 months.”
9 actionable steps founders can take to survive & thrive:
- Keep a Close Eye on MRR & ARR
- Monitor & Increase Customer Lifetime Value (CLTV)
- Monitor Sales Lead Conversion Rate KPIs
- Proactively Manage Churn Rates
- Monitor Burn Rates and the Runway
- Reduce Costs (without impacting growth levels)
- Review Headcount
- Generate More Revenue, Increase MRR & ARR
- Reach Profitability Quickly and Keep Funds in Reserve