Default Alive

What does default alive mean?

Default alive (viable on its own strength) describes a company that, with unchanged revenue growth and constant costs, reaches break-even before its liquid funds are used up. Liquid funds are bank balances and cash; break-even here means the month from which incoming payments cover outgoing payments. If this does not apply, the company is called default dead: it then depends on further financing or on a change in its cost or revenue development.

The distinction comes from the US founder scene. It was coined by the investor Paul Graham, co-founder of the accelerator Y Combinator, in a 2015 essay that sets the two terms against each other. As a test question for growth companies, it has also spread in Germany. It is used in shareholder and advisory board meetings, in financial planning and in conversations with investors. It is not a legal term. It condenses liquidity planning into a single question, namely whether the business sustains itself before the funds run out or whether its continued existence depends on the next round.

The test question and its inputs

The test combines three quantities: the stock of freely available liquid funds, the development of outgoing payments and the development of incoming payments. Two points in time result from them. The first is the month in which incoming payments cover outgoing payments for the first time. The second is the month in which the funds would be used up if the net burn, that is, the monthly excess of outgoing over incoming payments, develops as planned. If the first point in time is before the second, the company is default alive.

Formula: default alive if the sum of the monthly net burn until break-even is smaller than the available liquid funds less a safety buffer.

The difference from the simple runway calculation lies in the dynamics. The runway divides the liquid funds by the monthly net cash outflow and shows how long the funds last. The default alive test additionally asks whether the outflow shrinks to zero through growth within this time. A company that today spends far more than it takes in can therefore be default alive if its incoming payments rise fast enough. Conversely, a company with a small cash outflow is default dead if its revenue stagnates and the funds are eventually used up.

Assumptions and limits of the calculation

The informative value of the test depends on four assumptions:

• Extrapolation of growth: The calculation assumes that incoming payments continue to grow as before. Anyone who cuts sales and marketing spending in the calculation while extrapolating the previous growth is calculating too optimistically, because growth generally flattens as sales effort falls.
• Cost development: The original test question assumes constant costs. This is rarely realistic, because growing revenue usually requires more staff, infrastructure and customer support. For a reliable statement, the burn rate is therefore extrapolated with the hires that have been decided on and are foreseeable.
• Cash basis rather than earnings basis: What matters is when incoming payments cover outgoing payments. Break-even according to the income statement can come earlier or later, for example because of payment terms, prepayments or investments.
• Minimum liquidity: A company that reaches break-even with a remaining balance close to zero has no room for deviations from plan. The statement is reliable only with a safety buffer.

In a financial model with base case, cautious case and optimistic case, the test can be carried out separately for each case. The cautious case is the most informative. If the company is default alive there too, or can be brought there through prepared cost measures, its dependence on the next financing falls considerably.

Legal link: going concern forecast

German insolvency law knows a related but legally independent test. Under Section 19(2) of the German Insolvency Code (Insolvenzordnung, InsO), a company is over-indebted if its assets no longer cover its existing liabilities. This does not apply if continuing the company over the next twelve months is predominantly likely in the circumstances. The basis of this going concern forecast (Fortführungsprognose) is a financial plan showing that the ability to pay is maintained over the forecast period.

For a company that is default alive, such a forecast can generally be justified from its own business. A company that is default dead, by contrast, bases it on an expected financing. This is permissible but requires reliable indications that the funds will arrive in time, such as binding commitments from existing investors. Which evidence suffices in an individual case is an insolvency law question for the company's law firm. The management of a GmbH (German limited liability company) should know the answer before the runway becomes tight, because in the event of over-indebtedness it is obliged to file for insolvency under Section 15a InsO.

Significance in a financing round and valuation

The answer to the default alive question determines the negotiating position in a financing round. A company that can reach break-even on its own strength negotiates without time pressure and can turn down offers. A company that is default dead and whose runway is shrinking negotiates from a weaker position with every month. In due diligence, investors often recalculate the test with their own, more cautious growth assumptions and ask which costs could be cut how quickly if financing does not materialise.

Being default alive is, however, not the sole goal of a venture-capital-financed company. Investors finance growth. A company that reaches break-even only because it largely stops growing is valued differently from one that grows fast with justifiable cash consumption. The Rule of 40 captures this balance in one metric: revenue growth and profit margin in percent should together amount to at least 40.

Worked example: calculating default alive or default dead

A software company has EUR 1.5 million in liquid funds. Outgoing payments are EUR 400,000 per month, incoming payments in the first month EUR 200,000. Incoming payments have been rising for some time by EUR 20,000 per month, which at the start corresponds to growth of 10% a month. Costs stay the same.

• Net burn in the first month: 400,000 minus 200,000 = EUR 200,000.
• Static runway: 1,500,000 divided by 200,000 = 7.5 months.
• The net burn falls by EUR 20,000 every month: 200,000, 180,000, 160,000 and so on down to EUR 20,000 in the tenth month.
• Break-even in the eleventh month: incoming payments 200,000 + 10 × 20,000 = EUR 400,000, equal to outgoing payments.
• Cash consumption until then: 200,000 + 180,000 + … + 20,000 = 20,000 × (1 + 2 + … + 10) = 20,000 × 55 = EUR 1.1 million.
• Remaining funds: EUR 1.5 million minus EUR 1.1 million = EUR 400,000. The company is default alive.

Variant: Planned hires raise outgoing payments by a further EUR 10,000 month by month. The net burn then falls by only EUR 10,000 per month.

• Break-even only in the 21st month: 200,000 minus 20 × 10,000 = EUR 0 net burn.
• Cash consumption until then: 10,000 × (1 + 2 + … + 20) = 10,000 × 210 = EUR 2.1 million.
• After nine months, 9 × 200,000 minus 10,000 × (0 + 1 + … + 8) = 1,800,000 minus 360,000 = EUR 1.44 million has been used. The funds last into the tenth month.
• Shortfall until break-even: EUR 2.1 million minus EUR 1.5 million = EUR 600,000 plus a safety buffer. In this variant the company is default dead.

The same starting position leads to opposite results depending on the cost planning. The static runway of 7.5 months says little about either case. In the variant the funds last a good nine months. Because a financing process often takes 6 to 8 months, the management must decide immediately whether to postpone the hires or begin the process.

Distinction: default alive, runway, break-even and cash flow positive

• Runway: the reach of the funds at the current or planned outflow. Default alive asks whether the outflow ends within this reach.
• Break-even: the break-even point according to the income statement, at which revenue and costs balance. The default alive test looks at the balancing of payments and asks whether it is reachable with the funds available.
• Cash flow positive: the state in which incoming payments already exceed outgoing payments. Default alive describes the path there, not the state reached.
• Cockroach: denotes a company that stays in the market for a long time through low cash consumption and adaptability. Default alive is the arithmetic test of whether this succeeds.

Common mistakes

• Extrapolating growth without costs. Anyone who assumes rising incoming payments with constant outgoing payments, although growth requires additional employees, moves break-even forward on paper.
• A one-off test. The answer changes with every month in which growth or costs deviate from plan. It belongs in monthly reporting.
• Assuming financing as certain. A plan that achieves viability only with a round that has not yet been committed describes a company that is default dead.
• No buffer. A break-even reached with funds almost fully used up cannot withstand any deviation from plan.
• Cost reduction too late. Because of notice periods, measures take effect only after months. Anyone who starts them when the runway is short no longer reaches viability in time.

Frequently asked questions

Can a company with losses be default alive?

Yes. What matters is not today's loss but whether incoming payments reach outgoing payments before the funds are used up. A company with a high cash outflow and quickly rising revenue can meet this condition.

How is it calculated whether a company is default alive?

With a monthly extrapolation of incoming and outgoing payments based on current growth and planned costs. It yields the month of break-even and the cumulative cash consumption until then, which is compared with the funds available. A spreadsheet with three inputs suffices: liquid funds, monthly outgoing payments and monthly growth of incoming payments.

Do investors prefer companies that are default alive?

Not in every case. Venture capital investors invest in growth and accept losses for it. They do, however, check that a company can become viable on its own strength in an emergency, and they assess how credible that path is.

What can a company that is default dead do?

It has three options: cut costs, accelerate incoming payments or raise financing early, for example a bridge round (interim round) from existing investors. The earlier the decision is made, the more options remain.

The Roemer Capital view

Every financial model that Roemer Capital builds for a financing round includes, besides the three cases, a further calculation. It shows whether and how the company would reach break-even without the planned round. This calculation does not mean that the round could be dispensed with. It demonstrates that the management knows its cost structure and remains able to act in an emergency.

Roemer Capital also derives the timetable of a round from it. A company that is default dead should begin the process while the funds still last 12 to 18 months. Only then is there enough time to compare several offers instead of having to accept the first.