How A Startup’s ‘Burn Rate’ Influences Its Success by Knowledge@Wharton
Wharton’s Ron Berman and NYU Abu Dhabi’s Pablo Hernandez discuss their research on startup
A critical factor that determines whether a startup succeeds or fails is its level of spending, or burn rate. These include decisions about how much to spend on product launches, how much initial funding to raise and how to allocate other funds. Some startups aggressively spend to attract quality employees, get economies of scale early and grab market share from the incumbent. But overspending can also signal bad management and a waste of resources that could be used to compete against rivals. However, being thrifty has its downsides, too: The startup might have trouble meeting demand or is not aggressively exploring opportunities for profit.
The key is to reach a balanced rate of spending, according to a research paper titled “Startup Survival and a Balanced ‘Burn Rate’,” co-authored by Wharton marketing professor Ron Berman and Pablo Hernandez, an economics professor at NYU Abu Dhabi. They also found out that the more education entrepreneurs have, the more likely their startups will succeed. However, an entrepreneur’s level of experience generally does not have much impact on a startup’s survival, their research showed. The research was supported by Wharton’s Mack Institute for Innovation Management.
Knowledge@Wharton recently spoke to the authors to talk about their research in more detail. An edited version of the conversation appears below.
Knowledge@Wharton: Can you tell us about your research?
Ron Berman: What our paper looks at is how the burn rate of startups influences the chances of a startup to go bankrupt. The burn rate, which is more of an industry term, is how much money does a startup spend every month per employee. For example, if a company spends $300,000 every month and they have five employees, the burn rate would be $60,000 per employee. It’s a number typically the industry uses to compare different companies and see which ones are burning too much or too little money.
Pablo Hernandez: I want to add to that it’s a very simple metric because you just have an amount of money divided by the number of people there. You don’t go into the details of where do you spend the money.
Knowledge@Wharton: And why is that important to a startup?
“If you spend too much or too little, the companies are more likely to fail. There is a balanced burn rate [they should aim for.]” –Pablo Hernandez
Berman: There are two reasons why burn rates are interesting and important for us to look at. The first thing is that startups typically operate on investors’ money and they want to make sure they don’t run out of money until the next time they can fund-raise, so they want to make sure they don’t burn too much money too quickly. And the other reason is that investors from their [viewpoint] are trying to figure out which startups are operating efficiently, but also more successfully. And because the startups are very different types of businesses, the only apples-to-apples comparison is typically how much money they can make or spend. And the burn rate, as Pablo said, is a great metric for that.
Knowledge@Wharton: What are your paper’s key takeaways?
Hernandez: There are quite a few, but I think that the most important one is [the] notion that if you spend too much or too little, the companies are more likely to fail. There is a balanced burn rate [they should aim for to improve their survival rates]. In addition, we also look at how the entrepreneurial characteristics, in particular human capital, are related to sound decision-making [and] this balanced burn rate. And we find that one dimension of human capital — education — is positively related to a balanced burn rate. And hence, lowering the chances of failure.
Berman: Just to give an example, we find that more education actually reduces the chances that a startup will fail. Another interesting takeaway that we find is something we call confidence or optimism of an entrepreneur, which actually helps the startup a little bit. This is a unique part of our research.
Knowledge@Wharton: What conclusions, if any, surprised you?
Berman: Let me first start with what is not surprising in our findings. A very well-known result is that if companies burn too much money, they’re probably going to fail, and that makes sense. If you’re over spending and if you’re spending lavishly on things the company doesn’t need, you might go bankrupt. The surprising result was that actually under-spending money — spending too little — also increases the chances of failure of a company. We have a few conjectures of why that happens, but this is one surprising result.
“We find that more education actually reduces the chances that a startup will fail.” –Ron Berman
A second surprising result is that a lot of past research has looked at what’s called human capital, as Pablo mentioned. And typically, human capital used to be two things: experience and education. We find almost no effect for experience. Adding a lot of experience to entrepreneurs doesn’t make the companies fail less. But we find quite a big effect for education. So, there is a big gap between failure of, let’s say, someone with a bachelor’s degree versus someone with a high school diploma or someone with a master’s degree versus someone with a bachelor’s degree.
Hernandez: Actually, that effect is significant. If we look at entrepreneurs with a bachelor’s degree versus an entrepreneur with a high school diploma, there is a 5% more chance that the entrepreneur with the bachelor’s degree succeeds or doesn’t fail [compared to] the other entrepreneur.
Berman: And although 5% might seem small … it is a big effect. It is a big effect just from the difference between entrepreneurs with a high school diploma to entrepreneurs with a bachelor’s degree.
Knowledge@Wharton: What are some practical implications of your findings? How can people use this information to help themselves?
Hernandez: You can look at it from the perspective of the investors and the perspective of the entrepreneur. From the investor’s perspective — given that investors are exposed to sometimes a large range of companies — they can estimate how an individual company is spending with respect to the others and they can assess whether the expenditures are balanced or not. For entrepreneurs, it may work in a similar way. For entrepreneurs, they can go and look at the benchmark, the industry benchmark, and see whether they are too different — they’re spending too much or too little compared to what the industry is doing on average.
Berman: Given these numbers, for example, investors can say, “I need to look at the portfolio of 50 companies. I cannot give attention to all of them, but I can single out the ones that are very extreme — too little or too much [spending] and maybe look into them and see whether they have problems.”
“The surprising result was that actually under-spending money — spending too little — also increases the chances of failure of a company.” –Ron Berman
Entrepreneurs, on the other hand, are typically unsure of how much to spend. I don’t know if I should spend more or less. I don’t know what the competition is doing, etc. If you take those numbers, this metric is very simple to look at and it can [show me] how close am I to what the market is doing? And if I am different, it doesn’t mean it’s bad, but they need to have a good explanation for why…. They need to give good reasons. So, this is the practical implication.
Knowledge@Wharton: What sets your research apart from other work in this area?
Berman: There are a few aspects that make our research unique. The first one is the data source that we’re using. This is confidential data that we received from the Kauffman Foundation, which collected [data from] 2004 to 2011, a long survey on a representative sample of companies that were founded in the U.S. It’s over 3,000 companies. And they asked them to give information about employees and other things. And we’re one of the only researchers that have used this data in this approach.
Hernandez: Another important departure from previous literature is that even though the burn rate is a term that is used widely in the industry, there is surprisingly little research, at least to our knowledge on that important metric.
Berman: The final thing is that our research looks at the dynamics of the company. A lot of research just says, “These are the companies that started, and we see how many failed.” For us, we’re trying to see what are the chances of failure next year and [subsequent years], which allows us to filter out a lot of causes. For example, in our data we [included] 2008, the economic crisis. Of course, more companies failed during the economic crisis, but we’re able to filter that out and say what is the effect of the burn rate above that? And so, in statistical language, this gives us more power, and we can say [with more certainty] what is going on with those companies.
Knowledge@Wharton: How will you follow up this research?
“Adding a lot of experience to entrepreneurs doesn’t make the companies fail less. But we find quite a big effect for education.” –Ron Berman
Hernandez: We have two major points. The first one is try to see whether our results are robust. So, we are currently trying to find the same effects or looking for the same effects on a data set that’s provided by the government, and that is a research in progress. The other thing is what we were talking about earlier when we mentioned the mechanisms, what’s driving this balanced or unbalanced burn rate.
Berman: We have a theory. Again, as I said, the interesting or the surprising result is that spending too little is bad and spending too much is bad. Both sides are bad and you want to stay in this optimal center. And the question is why do you get those extremes? Our current conjecture is that a lot of it comes from the fact that entrepreneurs are unable to predict demand in the future and competition in the future. As a result, they need to plan today for what will happen. And sometimes they over-plan, like they overbuild capacity, which costs a lot of money. So this is spending too much.
Sometimes they under-plan. And when they build too little and there’s a lot of demand in the market, they’re unable to supply and make the money they could have made. As a result, other companies are raising the funding, and for this entrepreneur, he [looks at] other opportunities and just decides to close the business. This is our current working theory. Our next steps are basically to validate that, both using the data and using a theory model that would try to explain that.
Hernandez: Actually, Ron mentioned a very important point that is fundamental, which is the opportunity cost that we think has a lot to do with this surprising result — spending too little may lead to failure. The entrepreneur might say, okay, I’m making money, I’m not losing money. But I’m spending so much time [on this business]. I probably have a lot of education, a lot of connections that I may [put to] use in another business. And that is something that we conjecture is at the core of our results.