All startups require cash in the early stages of their development. The startup death valley curve or startup J curve refers to the graph which results if the cash balance of the startup business is plotted against time.
In preparing the startup death valley curve the idea is to show the external funding requirements of the business. For this reason only internal forms of finance such as founders equity and cash resulting from sales are included. External finance such as loans, grants and other equity are excluded.
A typical startup death valley curve would appear as follows. The horizontal axis shows time since the startup was first launched, and the vertical axis shows the cash balance of the business at a particular point in time for the second time.
The startup death valley curve shows the cash balance of the business can be positive, meaning the business has cash available to spend, or negative meaning that the business does not have cash and requires external funding.
The section of the curve where the cash balance is negative is referred to as the death valley or the valley of death as it is the time where the startup is at its most vulnerable. If the startup is to survive it must find sufficient external funding to manage its way through the valley of death until its cash balance eventually becomes positive (the point at which the curve crosses the horizontal time axis for a second time).
Startup Death Valley Curve Explained
The startup death valley curve starts with a positive cash balance when the founders inject the initial funding (usually equity) as cash.
As the business starts to develop its products and customer base it incurs costs and, in the absence of any sales revenue, cash flows out of the business. Eventually the founders equity cash runs out and the cash balance is zero (this is the point where the curve crosses the horizontal axis for the first time).
As cash continues to be spent the startup enters the death valley section of the curve. The cash balance is now negative indicating that external funding is required.
Eventually the business will start selling its product to its customer base and sales revenue, profit, and a cash will start to be generated. As cash flows in the valley of death reaches its peak depth and the curve starts to turn upwards.
As more cash in generated the curve progresses upwards and crosses the horizontal axis for a second time indicating that the cash balance is again zero. Finally the cash balance becomes positive, the business has managed to survive the valley of death, and hopefully investors will see a return.
Lean Startup Death Valley Curve
In a lean startup the business aims to reduce cash outflow in the early days using bootstrapping techniques. The effect of this is to change the shape of the curve.
A typical lean startup death valley curve is shown below.
Again the curve starts with the cash injected by the founders as equity. In the absence of any sales there is a cash outflow but this is minimized by the use of the bootstrapping techniques and the cash balance while negative is lower than in a normal startup.
The bootstrapping methods should be sufficient to carry out product and customer research and evaluation, but as the product is further developed and launched and a customer base is created additional spending is incurred and there is a need for more substantial finance such as equity crowdfunding.
Finally the business enters its growth phase and there is a substantial outflow of cash. In order to finance this growth the startup will need to seek a further round of funding such as that provided by an angel investor.
As can be seen from the curve it is critical for the business to obtain sufficient funding of the appropriate type at each stage. The process of obtaining funding is a continuous one and adequate time needs to be allowed between funding rounds for negotiation.
Startup Death Valley for Different Industries
The shape of the startup death valley curve depends on a number of factors such as the amount of equity injected by the founders and the use of bootstrapping techniques. However, the type of industry in which the business operates and the business model will also have a significant impact on the size of the death valley area.
A technology business such as a biotech startup requires heavy investment in research & development and capital expenditure. As a consequence of this the startup valley of death will tend to be deeper and last for longer than normal. In contrast a service based startup needs little resources to establish itself leading to a shallow and short lived valley of death.
Typical startup death valley curves for a tech business and service based business are shown below.
Risk, Reward and Investors
The startup death valley curve represents a period when the cash balance of the business is negative and indicates that external funding is required. If the funding is not obtained in time the business will run out of cash and fail. It follows then that the size of the valley of death shown on the curve is an indicator of the level of risk the investors associate with the business.
If the business survives the valley of death the cash balance becomes positive. The higher the cash balance and more rapid the inflow of cash the higher the return to the investor will be.
When investors look at the startup death valley curve they are looking for the risk and reward to be consistent with each other.
High Risk High Reward
If there is a high return indicated by a rapid rise in the curve after the valley of death and a high positive cash balance, investors will expect to see a corresponding high risk represented by a deep and long lived death valley. This is the situation in the startup death valley curve for the tech business shown above in red.
If the investor is presented with a startup death valley curve which shows a rapid growth in the positive cash balance (high return) but a shallow and short lived valley of death (low risk) they will likely conclude that the founders have not understood their business and not invest.
Low Risk Low Reward
Likewise if the return is low indicated by a slow rise in the positive cash balance, they will expect to see a corresponding low risk represented by a shallow and short lived valley of death. This can be seen in the curve relating to a service business shown in green above.
If the investor is presented with a death valley curve which has a deep and long lived valley of death (high risk) but a slow growth in the positive cash balance (low return) they are unlikely to invest.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.