Startups often spend more than they earn. But running out of money because you can’t manage to raise more capital is the ultimate killer. The two most important metrics of any venture are the amount of cash available and the monthly burn rate. If you’re within three to six months of running out of cash, you’re in trouble.
When you ﬁrst raised your funds, you convinced investors and your own team that you had a major opportunity to build something that would succeed. Many investors insist on identifying milestones and are willing to keep funding startups that achieve them on time. For example, angel or seed investors typically offer funding through the formation of the team and product development. Series A investors will fund product and market development to revenue, and so on.
As a result, the challenge is to achieve these milestones with the funds available. But if you can’t manage your finances in order to meet those agreed-upon milestones, it can become impossible to ﬁnd new sources of capital. Here are five of the most common ways startups waste money.
It’s common for startups to hire too quickly, before they’ve properly evaluated their needs. In the haste to get revenues ﬂowing, hiring errors are common, particularly if you confuse the sales and marketing functions. The most common early over-hiring errors occur in sales, leaving many startups short on products to sell but long on the personnel to sell them. In the early stages, many young companies don’t focus enough on bringing in people with the marketing and business development expertise to work with potential customers.
Such was the case at Licom Technologies. The company introduced a family of new communications equipment that went through extensive testing with a few major carriers. The proper role of the marketing team was to assess the market readiness of those products, but while that was under way, Licom’s many salespeople didn’t have much to do. Their compensation packages were combinations of a salary and commissions, and when sales didn’t materialize some months into their tenure, many resigned. It was a waste of the company’s money and didn’t generate any value, and it was predictable from the start.
Most early-stage ventures have an aura of informality and don’t formally monitor employee performance. At startups with a small number of employees who’ve worked together in the past, shared knowledge and trust can help get difﬁcult things done. But if that culture continues too long as the company grows, less competent people are free to do serious damage.
Before long, teams of strangers will have to learn to work together, so the company needs to figure out how it’s going to track performance and productivity. And those trusted with management responsibilities (perhaps for the ﬁrst time) need to receive training. No one’s going to like this—especially in a scrappy startup environment—but chances are, it needs to happen sooner than you’d think. Otherwise it’ll start costing you.
Poor coordination between marketing and product development makes it difﬁcult to complete products. Worse, if you select the wrong ﬁrst product—by targeting the wrong customers—you waste time and money. If you misjudge product features, run into technology issues, or need more time, you’ll have to delay your launch, which means it’ll be longer until you start seeing revenue.
Sometimes the difﬁculty in getting products to market comes from a belief that “it’s not good enough,” leading to constant (and wasteful) engineering iterations without good reason. Frequently, this problem is caused by the demands of one or two customers that deﬂect attention from broader market needs.
Young companies with exciting new technologies often find opportunities to work with established corporations. Whatever their outcome, pursuing such partnerships can suck up a great deal of management’s attention. Sometimes this comes at the expense of more productive work and distracts you from more promising activities.
In the search for revenues, but in the absence of honest cost accounting, ventures end up subsidizing customers while believing that they’re building a customer base.
You might think running a business without clear cost accounting is so ridiculous that it couldn’t happen. But it can and does. A software company once came to us seeking funding. It had excellent products and annual revenues of $100 million. It was noteworthy, however, for its inability to be proﬁtable even as its revenues grew by 30% each year. Annual operating losses exceeded $20 million, and these losses increased with increasing revenues. How could such a promising company do so poorly ﬁnancially?
The reason was erroneous accounting, as became obvious when we looked closely at its cost accounting. Although the gross proﬁt margin was 80% (quite reasonable for a software company), the actual product costs were about 110% of the sale price. The reason? Each sale involved a huge amount of customized engineering and services to install the product and train the customer to use it. These costs were hidden under the heading of “marketing” or R&D costs, and were reported as such to the board of directors.
It was clear that the company had an unsustainable business model, because the products were being sold at a loss and most of the engineering was devoted to customer installation support, not product development. But the investors weren’t aware of that. As revenues grew, so did the losses. It was clear the company had to change its pricing structure or it would go out of business.
Any one of these financial errors could eventually prove fatal to a startup, but a combination of them is even more dangerous. That makes it all the more crucial to keep them in mind at every stage of your growth, from founding to product launch and beyond. Otherwise you may soon find yourself out of cash and out of luck.
This article is adapted from If You Really Want to Change the World: A Guide to Creating, Building, and Sustaining Breakthrough Ventures by Henry Kressel and Norman Winarsky. It is reprinted by permission of Harvard Business Review Press.