Burn Rate: Everything You Need to Know
Burn rate is how quickly a company spends its cash reserves before it generates positive cash flow and it is tracked monthly by gross burn or net burn.7 min read
Burn Rate: What Is It?
Burn rate is how quickly a company spends its cash reserves before it generates positive cash flow. This rate is tracked each month, so if the burn rate for a company is $50,000, it means that the company is spending $50,000 each month.
The two types of burn rates are gross burn and net burn. Gross burn includes all of the money a company spends in a given month in order to run the business. Net burn is the amount of money that the company loses.
Let's say that a small startup spends the following every month:
- $6,000 for office space/rent
- $18,000 for employee salaries and benefits
- $2,000 on server costs
- $1,500 on miscellaneous
That means that each month, the company's gross burn rate is $27,500. However, if the company is producing some income, you can subtract that amount to get the net burn. So if the company earns $15,000 in the month, the net burn rate is $12,500. The net burn rate is a more useful number to understand, since it tells you how much money is lost each month. If you hear someone mention the burn rate, it typically refers to net burn rate unless stated otherwise.
Why Is Burn Rate Important?
For startups that are working to get off of the ground, understanding and knowing burn rates for the company are essential. By knowing how much money the company is starting with and how much money is spent every month, the company can estimate how long it has have until it runs out of money. This will help business owners anticipate what they need to do to keep the company afloat. This might mean raising more funds through investors, lowering the burn rate, or raising income.
Tracking current burn rates can allow business leaders to produce burn forecasts to estimate how much will be spent in the coming months. They can also forecast revenue that will be coming in to create net burn forecasts that give a better idea of what will actually be spent. If the burn rate starts to exceed the burn forecasts, however, or if revenue doesn't meet expectations, the best way to handle it is to reduce the burn rate.
Also look for patterns. If the burn rate is decreasing each month, it's likely due to revenue increasing month after month. If the burn rate is increasing, it means that revenue is not keeping pace with expenses. This should be factored into the burn forecasts.
The burn rate is also important because it shows investors they can trust you with their money. Your reputation is at stake. If your burn rate is too high, it may make it harder to raise money later if it's needed or in the future for your next venture.
Should You Track Burn Rates?
It may be a given that using burn rates is a useful tool. Even so, you might want to consider whether tracking burn rates is helpful as you plan for the future.
Here are some reasons why burn rates are helpful:
- They give a projection of how much time you have before you're out of money, also called your runway. With this information, you can plan strategies for where you want to take the company.
- Knowing how long your runway is before the company needs to take off and become profitable, you can work on getting more investors on board if needed before the money runs out.
Here are some reasons why they are not helpful:
- They can't predict the future. You may have unexpectedly high revenue one month that reduces your net burn rate, but if you assume you'll have the same amount or more after and you don't, you might overspend.
- For companies that are on the verge of being in the black, a burn rate might not be helpful, and tracking it might waste resources that could be put to better use.
- Although the burn rate is a helpful tool, you don't want your burn rate to prevent you from spending opportunity capital. The best option isn't always to save cash. The opportunity cost of not spending money may be high.
As you calculate the burn rate for your company, here are some common mistakes that you may want to be aware of.
Getting Too Many Investors Involved
For every dollar of funding you spend, you're one dollar closer to needing additional funding. Though bringing on more venture capitalists will keep your business afloat, there are consequences. These include:
- Splitting up your company proceeds among more equity holders.
- Needing approval from more people before you can make major decisions. These decisions may include things such as selling the company and making acquisitions.
- If you sell more than 50 percent of your business, the equity holders as a group gain control of business.
Not Paying Attention to the Length of Your Runway
Your runway, also referred to as zero cash date, is the length of time you have before you run out of cash. That length of time should never dip below six months. To calculate this, divide the net cash by your net burn rate. Use a reasonable amount of time, such as six months or a year, when figuring out your average net burn rate.
It should be noted that company that market services will reach profitability quicker than companies that sell products. Take that into consideration as you determine your runway.
Forgetting About Covenants for Venture Debt
If you've chosen to get venture debt in order to lengthen out your runway, you may have less time than you previously estimated. Many venture debt contracts include financial covenants that prevent you from dipping below a specific level of cash in the bank. It's something to take into account as you determine your runway.
Calculations for Burn Rate
Here is a quick rundown of calculations that will help you in relation to burn rates.
Formula for net burn for one month:
Net Burn Rate = Expenses - Revenue
Formula for average net burn rate:
Average net burn rate = Expenses(x) - Revenue(x)
Where x represents the number of months that is being included in the average.
Formula for average gross burn rate:
Gross Burn Rate = Expenses / x
Where x represents the number of months that is being included.
Formula for Runway:
Runway = Cash Balance / Net Burn Rate
Frequently Asked Questions
- How do I know if my burn rate is too high?
That is a question best answered by your investors and chief financial officer, but one rule of thumb offered up by Fred Wilson or Union Square Ventures is to multiply the number of your employees by $10,000 to figure out how much you should be spending each month to run your business. If you want to use this as a benchmark, just realize that this information is from 2011. Costs have risen since then, so you may have to adjust accordingly.
Another way to decide if your rate is too high is to look at your financial runway. How long will it take, according to the burn rate, for the money to dry up? What are you comfortable with? If you feel that a year is all you need, check to see if you'll still have cash on hand in a year. If you'll be out of cash, either your burn rate is too high or you need to raise more funds.
You have to remember that investors don't want the money just sitting in the bank. They want you to use it. They just want you to be responsible with the funds.
- What can I do to keep my burn rate reasonable?
One way is to spend no more than 5 percent of your budget on things outside of rent, payroll, and benefits. Also, keep hiring to a minimum. If you find that your burn rate is too high, the easiest way to redong>uce your burn rate is by reducing staff. It's better to avoid hiring in the first place than to have to fire a good employee because you hired too aggressively.
If you're worried about not having enough staff, one solution is to use contractors that are hired on a temporary basis. If you end up increasing revenue and needing these employees, you can hire them on full time, but if not, the contracts can end as expected and not be renewed.
- How can I reduce my burn rate?
If you find that your burn rate is too high, here are some things you can look at to reduce how much your company spends each month:
- Take a look at your budget. More than likely, you can find things in your budget that aren't contributing to the company's success. What can you cut?
- Reduce the number of employees. This is the easiest way to save money. Defer hiring more staff, lay off non-essential workers, and reduce the benefit you offer.
- Streamline your focus. Take a look at revenue streams and see which ones are losing money or just breaking even. If they're not profitable, take those assets and move them over to streams that are more successful.
- Send out bills sooner. Make sure that bills are sent to customers right when the work is complete. Depending on the size of the project, send an invoice for 50 percent down (make sure this is including in the terms and conditions) and then bill for the last 50 percent right when the project is complete.
- Pay bills as late as possible. When you receive bills, looks at the agreed upon payment terms and hold onto your cash as long as possible.
- Hold off buying large-ticket items. Unless it's an investment that will increase revenue, hold off on buying large expenditure items as long as is reasonable.
- Consider refinancing debt. If you have debt that's bogging you down, including venture debt, consider refinancing the debt for more favorable terms or increased time in order to lower payments.
- Raise more funds. This is of course the last resort, but it's better to raise more funds than run out of cash.
- Is gross burn important to track?
Though most business owners and investors focus on net burn, gross burn rates should not be discounted. Revenue can decrease suddenly if the overall market turns south. Here are some factors that may make a company vulnerable:
- If the company relies on few customers to provide a large percentage of revenue.
- If the company has a large number customers that are startup companies.
- If the company is reliant on ad revenue.
- If the company provides a good or service that is more of a want rather than a need.
If any of these are relevant, problems can arise if profits fall and gross burn rates are high.
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