Understanding Startup Burn Rate: Your Ultimate Guide
Here's a not-so-fun fact for aspiring business owners: 29% of startups fail because they run out of money. It's obviously never part of the plan, but things have a way of changing quickly. With so much at stake in the beginning, entrepreneurs would be remiss to underappreciate the warning signs that burn rates can provide.
This article explains the metric, what it measures, how it's calculated, and most importantly of all, what maintaining a good startup burn rate looks like.
Defining Burn Rate
Burn rate is a metric used to measure the rate at which a company spends its capital, typically over a period of time. It can be evaluated by measuring the net loss that an organization has accrued in comparison to what it has raised from investors or other sources.
Burn rate is an important metric for startups that measures how quickly a business spends its available capital in order to keep running and paying expenses. Companies need money to cover payroll, rent, marketing budgets, and more—and if they're not careful, they could run out of money before they can make it back.
How to Calculate Burn Rate
A standard burn rate calculation takes into
account the following data points:
- Total cash on hand (as of a specific date)
- Total monthly expenses (this includes salaries, rent, utilities, and all other operational costs)
- Any additional capital raised within the time period
To calculate the burn rate, subtract the total cash on hand from total expenses and any additional capital raised during that period. Then take that result and divide it by the number of months in the given timeframe. This will give you the company’s burn rate in that period.
For example, if a company had $10,000 of cash on hand and spent an additional $25,000 over two months while raising an additional $5,000 during that period, the burn rate would be calculated as follows:
(10,000 + 25,000 + 5,00) / 2 = 20.0K/Month Burn Rate
If that's too much to do on paper, the internet is full of helpful startup runway calculator tools that can help you quickly calculate your burn rate.
Gross Burn vs Net Burn
Two equally important iterations of the KPI, gross burn and net burn highlight different elements of burn rate business cash outflow. Gross burn rate is all of a company's outgoing money and is almost synonymous with the burn rate calculation above. Net burn, on the other hand, subtracts any capital raised during that period from total expenses to give a more accurate picture of cash outflow. This number should be lower than the gross burn rate.
H3: Run Rate vs Burn Rate
While we're comparing things, it's worth taking a moment to differentiate burn rate from another widely used metric in accounting - run rate. This refers to the rate at which a company is expected to grow in the future by extrapolating current performance over time. Run rate does not give an indication of cash outflow, but rather revenue growth, making it distinct from burn rate.
Cash runway extrapolates the amount of time a startup has left before it runs out of money. To calculate, simply divide your remaining cash by gross burn rate. This will give you an estimated period in which current funds can be used to sustain operations or finance growth - all without taking capital infusions into account.
Cash runway formula:
Cash Runway = Current cash balance/Burn rate
Why Cash Management is Critical for Startups
Burn rate is one of many defining factors for a startup's success. It underscores the influence of cash management, a skill that every startup must master to survive and thrive. Managing cash outflow is one of the more tangible elements of money management - monitoring expenses, allocating funds efficiently, and creating financial forecasts are all equally important ventures for any organization, but especially for a startup.
Cash management is also an essential skill in budgeting and projection-making. Knowing how quickly money goes out the door allows startups to set realistic expectations and plan ahead for growth. As a company expands, so too does its cash outflow, and careful monitoring of the run rate is necessary to ensure that the company's growth matches its increased spending. Without proper tracking and evaluation, a startup may find itself in overspending mode before it has been able to generate enough revenue to sustain it.
Cash management is also critical for a startup's ability to access capital. Financial institutions and potential investors will take an organization's burn rate into consideration when reviewing their books and assessing their ability to meet repayment obligations. A startup with a high burn rate is likely to be viewed as too risky for loans or investments, while those that demonstrate sound cash management practices may find it easier to access capital when the need arises.
What Is a Good Burn Rate?
When it comes to burn rate, there is no single answer that applies to all startups. What works for one company may not be suitable for another, depending on the sector and overall aims of the business. Generally speaking though, a burn rate should reflect a company's ability to generate revenue at the same rate that it spends.
For some companies, this may mean maintaining a burn rate of less than 10% month-over-month. Others may opt for higher levels of investment in order to achieve desired growth goals. Ultimately, it is up to the startup's management team to decide on a burn rate that works for their organization and its mission.
Key Insights into Burn Rate and Ensuring Financial Health
Regardless of where a startup lands on the burn rate spectrum, sound money management always reserves the potential to make an impact. Bookkeeping can never be 'too good', only better. Investing time in your business' burn rate positions it to capitalize upon more opportunities and get off the ground faster.
Here are a few tips to consider when analyzing your startup’s financial health:
The best way to manage your burn rate is to get a better grasp on what you’re spending and when. This means tracking expenses in detail to ensure you understand exactly where your money is going. Look for ways to trim costs and eliminate non-essential expenses that don’t add value to the business or have a direct link towards achieving goals.
Acknowledge Counterparty Risk
If you’re an early-stage startup, especially one without revenue, it can be difficult to secure financing and operating capital. But don't let that struggle turn into desperation. Before signing any agreement, make sure you properly assess the risks associated with a given counterparty (e.g., supplier, vendor) and negotiate favorable terms.
Startups that are still in their early stages may not have access to external sources of financing or other forms of capital. That makes it even more important to preserve and maintain liquidity. Make sure there is enough cash on hand to cover operational expenses so that you can keep that startup burn rate low during lean times.
Recruit the Help of a Professional at Wilkins and Co
Having a professional accountant or financial advisor can be invaluable when managing your startup's finances. The right expert can provide guidance and help with budgeting, forecasting, cash flow management, and other aspects of finance, so you don't have to worry about making costly mistakes.
The team at Wilkins and Co can provide you with comprehensive financial services to help your startup get on the right track. Our experienced professionals will tailor a strategy that fits your unique needs and guide you through every step of the process. Contact us today for more information.
Any remaining questions about cash burn finance? We'll answer some common ones below.
What steps can startups take for efficient cash management?
When it comes to mitigating burn rate startup operations need to prioritize cash efficiency. This may include implementing cost-cutting strategies, optimizing tax deductions, and tracking expenses through budgeting software. During a time when you may not have much money coming in, anything that can be done to stretch your dollar further can make all the difference.
Why is understanding the burn rate essential for startups?
Burn rate is a critical element of cash management for startups because it reflects how quickly the company is using up its available cash. Companies must understand their burn rate to ensure they have enough money in the bank to cover expenses and stay afloat for long periods of time before generating revenue or seeking additional funding.
How does net cash burn differ from gross burn?
Net cash burn takes into account any incoming revenue or investment capital. Gross cash burn does not include any incoming revenue or investment capital - only expenses.