Think Tank

Realms of profitability in the era of start-ups and cash burn

Chirag Mavani, Chief Financial Officer, The Souled Store

As more and more start-ups successfully raise funds around an ecosystem built on growth over profitability, which in essence is driven by a ‘burn rate’ phenomenon, it is essential to decipher the nature of such a cash burn and understand the realms of profitability and growth along with their significance.

Cash burn as a means of competitive advantage as against the mere sustainability of the business model are two very different situations. However, they are often separated by a very fine line and highly susceptible to misinterpretation. In the current era of ubiquitous burn rates across start-ups, it is key to embrace different facets and challenges of profitability and growth:

  • High vs prudent growth: Today, stakeholders unequivocally prefer high growth to profitability. In such circumstances, it is crucial to keep track of what the company would have earned if it had notpursued an aggressive growth strategy, and instead continued to grow in the traditional way. If such notional statistics are not encouraging at the earnings level, and do not justify a break-even or profitable scenario, it will be difficult to predict the company’s long-term future. In essence, choosing a conservative growth plan over an overly aggressive growth strategy is always wise, especially when the excess growth is the result of a high burn rate with an unknown payback horizon.
  • Rationalising spends: Conventionally, a company pursuing rapid expansion may look into a variety of options in order for its growth path to achieve traction. Naturally so, in such cases, the cost base – in the form of direct and indirect expenses – often moves north. When you add to this a focus on 'development,' it then becomes crucial to detect leakages in the form of charges that add no value but are nonetheless incurred. Rationalisation of such expenditures might result in significant cost reductions for a company with a high burn rate.
  • Healthy cohorts: The customer repeat metric is always a good indicator of brand loyalty. It helps assess the growth potential as well as the capability to generate future earnings. A loyal customer base empowers an entity to go aggressive on growth with profitability taking a back seat. On that note, a high customer lifetime value (LTV) is often regarded as one of the key ingredients in shaping a robust future for a brand.
  • Burn rate vs risk level: Entities that resort to burning cash in the pursuit of growth should visualise the end-game on a monthly and annual basis. ‘Growth at all costs’ is not a viable model, and is likely to fail in the long-run, if profits remain a distant dream. Risk levels for an entity tend to rise with increased burn rates, and if the situation persists for long, questions around the frugality of the business model are likely to be encountered.
  • Contingent liabilities and hidden expenses: In today's world of fierce competition, regulations, rigorous compliance requirements and robust internal controls have all become critically important. Experimenting with various accounting methods is common among start-ups, and the process entails a number of costs, commitments and obligations that a company must agree to and grant. It is therefore critical that such costs are properly accounted for in a timely manner, with adequate provisioning to ensure that there are minimal adjustments in the form of write-offs or expense deferrals, which could result in an unanticipated surprise on the P&L statement in future years.

A preference for rapid growth helps an entity navigate its path by creating value for customers and investors, as well as by increasing employment opportunities. Yet, it is also important to walk the tightrope between growth and profitability, because the external environment is bound to experience cyclical changes. Essentially, no firm can escape such ups and downs, or remain unaffected by the overall sentiment prevailing in the economy. In times of economic success, the growth model works well, but in times of economic slowdown, the company's ability to generate profit matters most.

Cash, which is often regarded as the ‘King’ during a downturn, was elevated and referred to as ‘Emperor’ when the pandemic spread its wings across the globe in 2020. Evidently, start-ups, riding on the model of cash burn, found themselves unprepared for a downturn. Most took a major hit in the crisis, with several of them vanishing in a span of just 4-6 months.

In sum, companies that successfully gauge the ability to shift the momentum from growth to profitability at an appropriate time can garner the prowess to withstand different challenges that emerge from dynamic external circumstances. Eventually, the companies that thrive in the long run are those that are focussed on the ultimate objective of maximisation of shareholder wealth.