Cash runway is an important financial process for entrepreneurs to understand, as it describes the amount of time a business has until it runs out of cash and must find other sources of financing. This article explains what cash runway is, how it is calculated, and how it impacts entrepreneurs and their businesses.
In this article, we will go over
- What is Cash Runway
- How much runway do I need to get a good funding deal?
- How do well-funded companies burn through their cash?
- Useful Cash Runway terminology:
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- What drives the EV of a business
- What's ARR
- What are the dynamics between ARR and the Churn Rate
- How to calculate the average Churn Rate
- Default Alive and Default Dead
5. When is the best time to fund?
What is Cash Runway?
Cash runway is a term used to describe the amount of time a company has before it runs out of cash. It is calculated by dividing the company's current cash balance by its average monthly burn rate, which is the amount of money the company spends each month.
A longer cash runway means that the company has more time to raise additional funding or generate revenue before it runs out of money. A shorter cash runway, on the other hand, means that the company may need to act sooner to secure additional funding or reduce its expenses to avoid running out of cash.
It is important for a company to closely monitor its cash runway to avoid potential financial difficulties.
Here’s a DALL-E generated image for cash runway, to get us started nicely. What a time to be alive!
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How Much Runway Do I Need to Get a Good Funding Deal?
In general, however, having a longer cash runway can be beneficial for a company when it comes to securing funding. It can help to demonstrate to potential investors that the business has the financial stability and resources to continue operating while it works to generate a return on its investment.
A longer runway can also give the company more time to prove its business model and achieve milestones that can increase its value and make it more attractive to investors.
The requirement for 12 months of cash runway is not a fixed rule, and the amount of cash runway a company needs can vary depending on its specific circumstances. Having 12 months of cash runway may, however, be viewed as a sign of financial stability and a lower risk of investment for most investors, and potentially increase your chances of securing funding.
Investors may be willing to provide funding to a company with a shorter runway if they believe in the company's potential for success. Ultimately, the amount of cash runway a company needs will depend on its individual goals and the state of the market.
How Do Well-funded Start-ups Burn Through Their Cash?
It is every start-up’s dream to secure a round of funding. The sums can feel astronomical, a source of endless growth. Sometimes this envisioned success can lead founders to hire employees and scale in the provision of said growth, and not necessarily for what the company needs to access it.
Expanding new markets, investing in research and development, acquiring other companies, building or leasing new office space, hiring new talent, launching major marketing campaigns, the list of expenses goes on…
These investments have an element of gambling, depending on the modalities of your industry, the state of the economy, and the unexpected expenses or challenges that might come up on the road.
Yet start-ups must invest heavily in order to grow and compete in their industries, and this results in a rapid burn rate of cash. Though it’s expected from newly funded companies, it is important for them to carefully manage their cash burn rate and make strategic decisions about how they allocate their funds in order to maximise their chances of success. The next article will cover Cash Burn in greater length.
Useful Cash Runway Terminology:
Particularly useful for our SaaS partners, here is some additional information to take into account when thinking about your cash runway. For B2B Software, the key driver of a company’s value is growth (ARR), gross margin, and retention. Let us look into those.
What drives the EV of a business?
The enterprise value (EV) of a business is the sum of its market capitalisation and its debt, minus any cash on its balance sheet.
In other words, it represents the total value of the business as seen by investors and is often used as a more comprehensive measure of a company's worth than its market capitalisation alone.
The EV of a business is driven by a variety of factors, including its financial performance, growth prospects, and the state of the overall economy.
What's ARR?
Annual Recurring Revenue (ARR) is a metric used by subscription-based businesses to measure the value of their recurring revenue on an annual basis. It is calculated by multiplying the average monthly recurring revenue (MRR) by 12.
For example, if a business has an MRR of $10,000, its ARR would be $120,000. ARR is a useful metric for investors and analysts because it provides a consistent and predictable way to evaluate the performance of subscription-based businesses. It is also used by companies to set targets and forecast future revenue.
What are the dynamics between ARR and churn rate?
The relationship between ARR and churn rate is an important one for subscription-based businesses, as it can have a significant impact on their overall financial performance.
The Churn Rate is the percentage of customers who cancel their subscriptions over a given period of time. A high churn rate can lead to a decline in ARR, as the business loses revenue from customers who are no longer paying for its services.
On the other hand, a low churn rate can lead to an increase in ARR, as the business retains more of its customers and therefore generates more recurring revenue.
How to calculate the average churn rate?
To calculate the average churn rate, you need to first determine the total number of customers at the beginning of the period being measured (this is known as the "customer base").
Next, you need to determine the number of customers who churned (cancelled their subscription) during that period. Finally, you can calculate the average churn rate by dividing the number of customers who churned by the total customer base and multiplying the result by 100 to convert it to a percentage.
For example, if a business had a customer base of 1,000 at the beginning of the period and 20 of those customers churned during the period, the average churn rate would be 2% (20 / 1,000 * 100).
Default Alive or Default Dead
In the context of a company's cash runway, the terms "default dead" and "alive" refer to the financial health and viability of the company.
Default Dead
A company is considered "default dead" if it does not have enough cash on hand or access to additional funding to meet its financial obligations, such as paying employee salaries, rent, and other expenses. In this case, the company is at risk of defaulting on its debts and potentially going bankrupt.
If you have any suspicion that your company might not have enough cash runway, and will potentially be ‘default dead’, you need to take immediate action. There is just one thing worse than having to close your company, and that’s to be oblivious to the fact until the last minute.
It’s hard enough to close your business, you don’t want to do it the messy way. Here’s a great article about default dead if you’re interested (until we write our own).
Default Alive
On the other end of the spectrum, a company is considered "alive" if it has sufficient cash or access to funding to meet its financial obligations and continue operating. A company that is "alive" has a positive cash runway, which means it has enough cash or funding to sustain its operations for a certain period of time.
Where are you at?
Usually, 12 months is a great runway, because it’s usually the threshold which separates companies that have a chance to secure another round of funding...and the others.
The length of a company's cash runway is an important factor in its financial health and viability. Companies with a longer cash runway have more time to generate revenue, find additional sources of funding, or make other financial operations which take a deeper j curve, i.e. need more time to be implemented.
When is the best time to fund?
The best time to raise capital can vary depending on a number of factors, including the stage of the company, the industry it operates in, and the current economic environment.
In general, it is often advisable for a company to raise capital when it is in a strong financial position and has a clear plan for how it will use the additional funds to grow and succeed.
This can help to attract investors who are confident in the company's ability to generate a return on their investment. Additionally, market conditions may also play a role in determining the best time to raise capital.
For example, if the economy is strong and investor confidence is high, it may be a good time to raise capital, as investors may be more willing to invest in new opportunities.
On the other hand, if the economy is weak or there is uncertainty in the market, it may be more challenging to raise capital and investors may be more cautious about committing their funds.
Ultimately, then, the best time to raise capital will depend on the specific circumstances of the company and the state of the market.
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