What is a Burn Rate?
The burn rate is typically used to describe the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations. It is a measure of negative cash flow.
The burn rate is usually quoted in terms of cash spent per month. For example, if a company is said to have a burn rate of $1 million, it would mean that the company is spending $1 million per month.
Burn rate is the rate at which a company is losing money. It is typically expressed in monthly terms. E.g., “the company’s burn rate is currently $65,000 per month.” In this sense, the word “burn” is a synonymous term for negative cash flow. It is also a measure of how fast a company will use up its shareholder capital. If the shareholder capital is exhausted, the company will either have to start making a profit, find additional funding, or close down.
Burn rate can also refer to how quickly individuals spend their money, particularly their discretionary income. For example, Mackenzie Investments commissioned a test to gauge the spending and saving behavior of Canadians to determine if they are “Overspenders.”
Burn rate is also used in project management to determine the rate at which hours (allocated to a project) are being used, to identify when work is going out of scope, or when efficiencies are being lost. The term is also used in biology, to refer to a person’s basic metabolic rate; in rocketry, it refers to the rate at which a rocket is burning fuel; and in chemistry.
The term came into common use during the dot-com era when many start-up companies went through several stages of funding before emerging into profitability and positive cash flows and thus becoming self-sustainable (or, as for the majority, failing to find additional funding and sustainable business models and thus going bankrupt). In between funding events, burn rate becomes an important management measure, since together with the available funds, it provides a time measure to when the next funding event needs to take place.
Some entrepreneurs and investors say that part of the reasons behind the dot-com bust was the unsound management and financial investor practices to keep the burn rate up, taking it as a proxy for how fast the start-up company was acquiring a customer base.
How to Calculate Burn Rate?
Gross Burn Rate
Gross Burn Rate is a company’s operating expenses. It is calculated by summing all its operating expenses such as rent, salaries, and other overhead, and is often measured on a monthly basis. It also provides insight into a company’s cost drivers and efficiency, regardless of revenue.
Gross burn rate = Cash ÷ Monthly operating expenses
Net Burn Rate
Net Burn Rate is the rate at which a company is losing money. It is calculated by subtracting its operating expenses from its revenue. It is also measured on a monthly basis. It shows how much cash a company needs to continue operating for a period of time. However, one factor that needs to be controlled is the variability in revenue. A fall in revenue with no change in costs can lead to a higher burn rate.
Net burn rate = Cash ÷ Monthly operating expenses losses
What are the Implications of a High Burn Rate?
A high burn rate suggests that a company is depleting its cash supply at a fast rate. It indicates that it is at a higher likelihood of entering a state of financial distress. This may suggest that investors will need to more aggressively set deadlines to realize revenue, given a set amount of funding. Alternatively, it might mean that investors would be required to inject more cash into a company to provide more time for it to realize revenue and reach profitability.
Limitations of Burn Rate
As the saying goes, “you’ve got to spend money to make money.” Many companies will start out burning more cash than they’re taking in, and depending on the industry, it may be necessary to operate at a loss for some time before turning a profit. However, at a certain point, businesses have to become profitable.
The burn rate tells you how much cash the company is burning through, but it doesn’t address whether the burn rate is reasonable. It’s up to each analyst to carefully assess the business plan and determine whether the burn rate is justified or troubling.
The burn rate doesn’t breakdown expenses and qualify them individually, either. A business owner might know their burn rate is troubling, but that won’t help them figure out where spending could be cut, how profits could be increased, or where alternate funding could be found.
How to Reduce Burn Rate?
1. Layoffs and Pay Cuts
Typically, an investor may negotiate a clause in a financing deal to reduce staff or compensation if a company is experiencing a high burn rate. Layoffs often occur in larger start-ups that are pursuing a leaner strategy or that have just agreed to a new financing deal.
As a general rule, startups should keep expenses as low as possible. Strategic burn to gain market share and win customers is different from everyday spending on operational expenses. Founders will need to craft a “spend culture” that’s appropriate for their business.
A company on track to becoming a unicorn may want to offer free food and massages to retain high-priced talent during what is likely to be a protracted drive to profitability. But for most companies, offering fewer perks makes sense. Founders may even want to locate to a lower-cost home base. Don’t forget to factor in the state of the overall economy. Your investors will certainly be thriftier if there are storm clouds on the horizon or overhead.
A company can project an increase in growth that improves its economies of scale. This allows it to cover its fixed expenses, such as overhead and R&D, to improve its financial situation. For example, many food delivery start-ups are in a loss-generating scenario. However, forecasts in growth and economies of scale encourage investors to further fund these companies in hopes of achieving future profitability.
Often, companies spend on marketing in order to achieve growth in their user base or product use. However, start-ups are often constrained, in that they lack the resources to use paid advertising. As such, “growth hacking” is a term often used in start-ups to refer to a growth strategy that does not rely on costly advertising. One example is Airbnb engineers reconfiguring Craigslist in order to redirect traffic from Craigslist onto its own site.
What Is the Right Burn Rate for Your Startup Business?
Regardless of its situation, any company should have a burn rate that ensures at least six months of cash runway. Any less than that and you may not be prepared for unexpected changes in revenue or spending.
In other words, your monthly spending should never dip into the bare minimum of capital you need to keep your business running for the next six months.
Of course, every company is different. A financial strategy that works for one startup may be a major misstep for another. Consider framing your burn rate in terms of growth and deepening your awareness by drilling down into specific metrics such as burn per new hire or burn per department.
If you’ve got the means to embark on a period of growth, then crank up your burn rate for a while and spend some money growing your business. The “means” in this case are tangible resources—for instance:
- lots of cash in the bank
- a strong line of credit
- growing revenue sources
- support from venture capital
If you don’t have those means, it’s a good idea to reconsider your growth plan and maintain a conservative burn rate. That’s regardless of your company’s potential or the level of risk you’re willing to accept.
Intangibles such as the following may be appealing to investors, but think twice before you allow them to influence your burn rate:
- team skill and expertise
- workforce productivity
- growth of the market/industry
- brand awareness/reputation
- third-party valuations
- trade secrets
- client relationships
Always be aware that your company’s survival is closely correlated to your cash runway. When you run a startup, the money you have ultimately matters more than any money you’ll (potentially) make.
How Can I Control My Burn Rate?
Founders and investors are equally interested in measuring the actual burn rate and comparing it to forecasted data provided at the prior investment round. This is because it gives an indication of the company’s life expectancy and its ability to control spending as it grows. It appears therefore essential that startups put appropriate tools in place to measure burn rate and keep it under control, to avoid a premature death of the company.
The first step to control your startup burn rate is to know at which stage of development you are in and then stick to elements essential to that stage before moving on to the next step. In other words, avoid putting the cart before the horse. It is easy to get lured into investing heavily in marketing, sales personnel, and expensive extra engineering, but this does not make sense until you know that you have validated that your product has indeed a client base on which it can grow.
Knowing your customer well is a critical factor of success and it includes several dimensions including the market value, your likely market share, and the length of the sales cycle and of the intermediaries you use to market your product. For example, providing consulting services to a company who was using intermediaries to gain access to clients. These intermediaries were large banks and consulting firms, whose acceptance processes were sophisticated and lasted typically over a year. Before scaling up the business, it was therefore critical for this company to maximize the advance cash received and minimize the burn rate until a number of partnership agreements with these intermediaries were achieved.
Another mistake that companies make at an early stage is to bring in managers too early, or to have certain individuals, like the CEO, focus solely on one area like business development or fundraising, without much versatility elsewhere. At an early stage, cash is tight and individuals should have the capabilities and be ready to put several hats on: On a typical day, a CEO might therefore be having meetings with potential customers or potential investors, get involved in the design of the product, and end the day getting hands dirty with pure operational matters.