How to Calculate Burn Rate for Startups
Startup burn rate is simple to calculate, but not a simple matter. It’s a very important figure that every startup founder should be familiar with. Startup burn rate involves the cash a business spends per month and is related to another important metric, namely startup runway. Let’s look into these in more detail.
The burn rate is the pace at which a startup is spending money before it reaches profitability – burn rate is also referred to as negative cash flow. The term literally means how quickly a new venture “burns through” its capital.
Calculating your burn rate will give you an indication of how long your business can keep going before you run out of money. The length of time the business can keep running is referred to as the cash runway.
Calculating burn rate
The formula for calculating burn rate is:
starting balance – ending balance ÷ number of months
If you want to calculate your burn rate for the first quarter, find your cash balance at the beginning of the quarter and the balance at the end of the quarter. Subtract the ending balance from the beginning balance and divide the result by three (number of months in a quarter). The resulting figure is the rate at which you are spending your cash reserves each month.
Let us suppose your startup has $100,000 in the bank and you raised $2 million from investors. You now start spending money on hiring people, renting offices, buying equipment, and generally running the business. You want to know how long the investors’ money will last. To do this, you calculate the rate at which you have been spending money. It’s best to do this calculation over a couple of months to get a more realistic figure.
So, you decide to calculate your burn rate for the first quarter. Your starting balance is your bank balance plus the investment $100,000 + $ 2 million = $2,100,000. In the meantime, your bank balance is now 1,800,000 after three months.
Your burn rate is $2,100,000 – $1,800,000 = $300,000 ÷ 3 = $100,000. Your business is going through $100,000 a month.
Calculating the burn rate over one month, gives a false impression of the burn rate as it takes only one month’s figures into account. You may be spending vastly different sums from one month to the next and that wouldn’t be reflected in your burn rate. For instance, if the burn rate is calculated at $50,000 for January, you may estimate the company can operate much longer than if you had a more accurate estimation of an $80,000 burn rate.
You can choose to calculate gross burn and net burn to gain a greater understanding of your spending.
- Gross Burn: The total operating costs the company incurs each month. Expenses included, for example, salaries and office space.
- Net Burn: The total amount of money the company loses each month. It takes revenue you may have earned into account. To calculate your net burn, subtract your revenue from expenses over a month.
What’s the difference? Let’s explain it with an example. Let’s say your company spends $30,000 in operating expenses, but it is also bringing in $15,000 every month from subscriptions to your SaaS platform. Your monthly gross burn rate is $30,000 because that is what you’re spending to run the business. Your net burn rate would be $15,000, because while you’re spending $30,000, the business is making $15,000.
Why is burn rate important?
Startups can’t afford not to know what their burn rate is – after all, the metric tells you how fast your business is going through its funding. It tells you that you may have to curtail certain expenses so the money can last longer.
The fact that 82% of startups fail because of cash flow problems is a clear indication that founders are not paying enough attention to this metric. Funded startups use a regular calculation of their burn rate to ensure that they are spending investors’ money responsibly.
Startups need to keep a close eye on burn rate
Entrepreneurs building companies that are meant to become really big typically depend on investments from venture capitalists to develop and grow their companies. These companies often take many years before they become profitable, going through successive funding rounds before taking off.
For instance, the founders may opt for Series A funding to broaden the company’s product offerings and take it to additional markets. After the successful conclusion of the funding round, the company will start spending the money to achieve these goals. All the while, investors will keep a close eye on how their money is being used – is the startup too free with it, or is it too cautious. If it’s too free with the money, it may run out too fast; if it’s too careful, growth may be too slow. In either of these cases, investors may conclude that the startup doesn’t have a handle on its finances, which may put any future funding attempts in jeopardy.
Burn rate and future funding
For companies that will need several funding rounds, the burn rate will also help them to know when to start looking for additional funding. In most cases, a funding round is meant to keep a startup going for 12 to 18 months.
Considering that it can take 6 – 9 months to secure funding, it’s prudent for a startup to calculate its burn rate in order to know when to start fundraising again. In practical terms, there will be only a few months between the successful conclusion of one funding round and the commencement of the next one.
Burn rate and cash runway
Your burn rate measures the pace at which you are spending cash, and your cash runway measures how long you can keep spending it at that pace before you start running out of cash.
The formula for cash runway is also simple.
Cash runway = current cash balance ÷ burn rate
If your balance is $1,800,000 and your burn rate is 100,000 per month, your runway comes to 1,800,000 ÷ 100,000 = 18 months. You have enough cash left for 18 months.
Since funding rounds are normally spaced at one-year intervals, the company leadership in this example may conclude that the company’s burn rate is too low and that they should probably increase spending to reach their goals before the next funding round starts.
Burn rate and cash runway are both important metrics. Together, these figures show founders how fast the business is spending money and how long it can continue to do so at the current rate. Both high burn rates and low burn rates have implications for startups and investors.
Is there an ideal burn rate?
The ideal burn rate is when your expenditure is equal to your runway. Seeing that the ideal runway is at least twelve months, a good burn rate would be not spending more in the twelve months than you have in the bank. In other words, if you have $1,200,000 in available cash, a burn rate of no more than $100,000 per month would be ideal.
The problem with a low startup burn rate
By now, you may be thinking that if a high burn rate means the company is in danger of running out of cash, then a low burn rate must be ideal. Not necessarily.
Remember, investors invest in your company because they want it to grow so they can eventually gain a substantial return on their investment. For that to happen, you have to spend the money they give you. You need to invest in the necessary initiatives that would allow your company to grow and earn those revenues. That means you will need to increase your burn rate.
The last thing you or your investors want to see is growth that’s stalled, not because there’s no money, but because the money that is readily available is not being spent. Usually accelerating growth involves taking risks, and some risk-averse entrepreneurs may waiver at this point, which investors do not like and shy away from.
What to do about a burn rate that is too high
Simply put, a too high burn rate puts the business in danger of running out of money and the founder being declared bankrupt. A high burn rate may indicate that the business is leaking money somewhere, but before a startup gets there, there are steps that can be taken to control burn rate.
One precaution is to always keep your startup’s stage of development in mind and not make financial commitments that would be more appropriate at another funding stage. For instance, it doesn’t make sense to invest large sums of money in marketing and sales if you have not validated your product yet, and don’t know exactly who your target market is.
Also, while investors want to see a professional management team that can run the business both operationally and financially, making too many high-profile appointments in the early stages may cost a startup more than it can afford in the long run. In the beginning stages, the CEO and one or two other workers will have to wear multiple hats to save on expenses in order to get the startup off the ground.
If steps to control the burn rate don’t succeed, founders can take some additional steps to decrease it.
- Reduce costs. Review your profit and loss statement and eliminate unnecessary expenses. Look critically at every item and ask yourself if that expense is contributing in any way to your business efficiency or your ability to produce income. If it doesn’t, consider eliminating it. One crucial business expense that can easily leak money is marketing and promotion. Not all marketing campaigns are effective, and if it doesn’t result in leads or customers, you are wasting money.
- Increase revenue. An obvious way to boost revenue is increasing your pricing so you can increase your gross profit margin. Consider that even a slight increase of 1 – 3% could increase your margins without having a noticeable effect on the price for your customers. An improvement to your gross profit margin will lower your burn rate and give the business a longer runway.
- Sell assets. Many startups won’t have any assets to speak of, but if you do, you might consider selling off things like expensive equipment to generate cash. Of course, the business would do well to rent expensive equipment until the company turns profitable. The same goes for basic office equipment.
Anyone running a business should be familiar with the concepts burn rate and runway. These two metrics are indicators of the potential success or failure of an undertaking. Entrepreneurs who intend to participate in several funding rounds will need to have these metrics available for investors. While there are many measures startups can take to reduce their burn rate, it’s also good to remember that a high burn rate is not necessarily a bad thing, especially for fast-growing startups.