If you’re working on building your startup or new company, the early days are absolutely vital. Calculating burn rate, or the rate at which your company is using its cash, is an important metric for both you and your investors. Understanding this data point can also help with calculating your runway, which is crucial to have visibility into to avoid running out of cash.
While important, your startup’s burn rate is not the ‘end-all’ of financial metrics. This article from Founder’s CPA will explore everything you need to know about calculating burn rate for your startup.
What Is Burn Rate?
The term ‘burn rate’ refers to the rate at which a startup or new company uses — ‘burns’ — its liquid cash. Burn rate is effectively negative cash flow and is typically measured in monthly increments.
Startups use burn rate to refer to the period during which early-stage financing — loans, private equity investing, and so on — forms the operating capital of a company. Once a startup begins generating positive cash flow, burn rate is usually (but not always) shelved.
Why Is Burn Rate Important?
As a measure of negative cash flow, burn rate is a crucial metric for understanding your startup’s overall financial health. Knowing your burn rate allows you to track the amount of cash used each month to finance your company’s operations. That, in turn, allows you (and investors) to determine how much time you have left before the company runs out of cash.
It’s not uncommon for high-growth startups to run a deficit for the entirety of their early-growth stage. Many technology and medical startups, for example, take years to become profitable.
What Does a High Burn Rate Mean For Me?
The term “high burn rate” comes loaded with many implications. Many startup founders may leap to the conclusion that a high burn rate is a problem that needs fixing. However, a high burn rate only means that your company is burning through cash at an accelerated rate. Whether or not your unique burn rate is untenable is largely dependent on your specific circumstances.
After all, cash spent on growth, marketing, sales, or talent acquisition is not necessarily a bad thing! It’s a balancing act that is difficult to get right. If you’re interested in learning more about what a high burn rate means for your startup, the experts at Founder’s CPA offer free consultations.
How is Burn Rate Calculated?
There are two methods used when calculating burn rate. These methods are as follows:
- Net Burn Rate: the difference between monthly cash in and cash out.
- Gross Burn Rate: the total amount of cash spent each month.
Gross Burn Rate
Gross burn rate is an accounting method that consists of the total amount of cash spent each month. For example, imagine that your company burns through $10,000 per month (e.g., salaries, supplies, and server costs). Your monthly gross burn rate is $10,000 per month.
Depending on the burn rate and your company’s cash reserves, it may make sense to calculate your burn yearly, monthly, or weekly (monthly, however, is standard). Some companies with large amounts of debt and high operating costs (like airlines) may even resort to daily burn rates in extreme circumstances.
Net Burn Rate
Net burn rate is an accounting method that includes new cash and fresh sources of income. For example, if your startup burns through $10,000 per month but is generating $5,000 per month through sales, your net burn rate is $5,000.
What is the Best Method for Calculating Burn Rate?
It’s a good question. On the surface, it might seem that your net burn rate is the most useful of the two metrics. After all, net burn includes the cash actively coming into the coffers.
However, it’s not so simple: if your (current) income is dependent on a single client, losing that client may change your burn rate calculation. In this specific instance, your gross burn rate may provide a better look into your startup’s fiscal health.
Investors will typically look at your net burn when calculating burn rate, as it is the best indicator of your startup’s financial health and growth potential. As a general rule, keep both of your burn rate metrics in mind and you’ll avoid unpleasant surprises.
What’s This ‘Runway?’ Mean For Burn Rate?
‘Runway’ refers to the amount of time a company has before it runs out of cash. If your net burn rate is $10,000 a month and you have $100,000 in the bank, you’ve got 10 months to start generating positive cash flow.
When calculating your runway, it’s important to use your net burn rate. The goal here is to discover exactly when your company will run out of cash: net burn rate helps with that. Of course, as discussed above, it’s important to not rely on your net burn rate if that number fluctuates dramatically. For example, a month or two of one-off sales to a single client may skew your runway by several months.
Regardless, the timeline generated from calculating your financial runway is vital. With it, you’ll know exactly how long you have to become profitable (or obtain further funding).
What Happens When Burn Rate Becomes Too High?
Every startup’s burn rate is unique. It’s possible to make tentative determinations of when your burn rate is too high, but it’s recommended that you consult with Founder’s CPA — accountants who specialize in startups and small businesses — in order to make an accurate judgment.
If you discover that your burn rate is too high, there are steps you can take to reduce it.
How Do I Reduce Burn Rate?
At its core, reducing burn rate means reducing operating costs. That can take many forms:
- Layoffs or reducing hours worked
- Downsizing office(s), if applicable
- Focus on ROI
Reducing Burn Rate With Layoffs
Unfortunately, many startups hire too many employees too quickly. Salaries add up quickly and typically represent a considerable majority of a startup’s operating budget. However, paying for quality talent is something of a necessity — a tricky balancing act, to be sure — so it’s a great idea to solicit some expert advice from professional accountants.
Personnel turnover in startups is not unexpected. It’s not easy to get staffing completely ‘right’ the first time around, so don’t be afraid to rotate staff until everyone is on the same page. Likewise, solidly-performing employees that do not conform to your company’s culture or values may end up as a liability.
Take the time to address hiring errors and your burn rate will thank you for it!
Reducing Burn Rate By Downsizing Expenses
Leased office spaces or extraneous services may also represent an area where cuts may make an appearance. Between office leases, furniture, and office supplies, there’s a great deal of potential for cost overreach.
Reducing Burn Rate By Focusing on Return on Investment and Growth
Regardless of your cash reserves, it’s vital that every expense represents potential growth. Whether it’s new software, office equipment, or a new round of fresh hires, you’ll want to double-down on making sure you are growing your business above all else. Cash spent on unnecessary expenses is cash better spent on research, development, marketing, or sales.
What Sort of Burn Rate Timelines Are Reasonable?
If after calculating burn rate you’re wondering what a “good” burn rate is, know that every situation is different. There’s no universal rule, but there are some guidelines that most startups can benefit from.
Most startups should aim to have at least a year’s worth of financial runway on hand at all times. If you start dipping into the sub-12 month category, you may need to start pursuing revenue generation or increasing your growth rate more aggressively. If you find yourself with a runway of fewer than 6 months, consider immediate layoffs or look to raise additional funding quickly.
Can Your Burn Rate Be Too Low?
Sort of. The answer to that largely comes from the funding stage of startups. For example, if you’re only burning through $10,000 a month but are looking to raise millions in extra funding, investors may raise an eyebrow.
It seems like a strange problem to have. After all, most startups run through their entire VC funding within the first 12-18 months. If the money is in the bank, you’ll want to get it working for you (sooner rather than later). If you’re in a hyper-growth industry (technology startups, for example), your cash should be working to grow your business.
Working With Burn Rates
There’s no doubt that calculating your burn rate and financial runway is a vital task for every startup. Knowing your burn rate lets you know exactly how cash you’re using a month and lets you make accurate, informed business decisions. If you’re interested in the implications of your burn rate, or simply need help calculating it, Founder’s CPA is eager to assist. Our team of professional accountants offers free consultations to startups and small business owners: we’re happy to help!
