It’s tempting to write off "burn rate" as cute startup jargon or a funny subplot on the television series Silicon Valley. But a correctly calculated burn rate is crucial for the responsible growth, planning, and success of a business.
In fact, 82% of small businesses fail because of cash flow problems. But what exactly is burn rate? And how do you calculate it? I’ve got the answers for you below.
What is burn rate?
Burn rate, or negative cash flow, is the pace at which a company spends money — usually venture capital — before reaching profitability. It’s often calculated by month (e.g., a startup with a burn rate of $30,000 a month is spending $30,000 a month) and is spent on both overhead and variable expenses.
A company’s gross burn is the total amount it’s spending on operational expenses each month (with the absence of positive cash flow). In our example above, a startup spending $30,000 a month on staff salaries, office space, and a cool new ping pong table would have a gross burn rate of $30,000 per month.
Let’s say, however, this company is also generating $5,000 a month in revenue. To calculate the net burn rate, you’d subtract $5,000 from $30,000 for a net burn rate of $25,000 per month.
Startup Burn Rate
The Two Key Metrics
Two of the most important variables that play into most startups' burn rates are cost of growth and unit economics. In this context, cost of growth refers to the costs that go into those operational expenses we referred to earlier.
Those typically include costs that stem from renting office space, employee salaries, and benefits packages. The term "unit economics" refers to what your company earns with every sale of your product or service — that figure can be calculated by subtracting each customer's acquisition cost (CAC) from their customer lifetime value (CLV).
Leadership at every startup should have a solid grip on both of those metrics. They'll be the primary factors in guiding your ability to accurately and effectively calculate your net burn rate.
Why a High Burn Rate Isn't Necessarily a Bad Thing
The term "burn rate" can sound pretty imposing and inherently negative. But for leadership at a startup, a high one isn't necessarily the worst thing in the world. For instance, let's say your burn rate is $50,000 per month and you're looking to procure a capital infusion.
If you were to go into a VC's office and ask for an investment of $4,000,000, they would probably ask, "Why do you need that kind of money if you're only burning $50,000 per month?" It would be hard to justify asking for that kind of investment if you can't demonstrate that you would be willing or able to spend it effectively.
In some cases, a higher burn rate indicates that you're ready for a higher valuation. So instead of aiming for the bare minimum, you should focus on optimizing your burn rate appropriately while spending thoughtfully and strategically — and sometimes, that means bumping your burn rate figures up a bit.
Investors are wary of a decreasing burn rate.
Investors give you money because they expect you to spend it. They're investing to accelerate your growth — not to give you a big pile of cash you never touch. So when you secure a capital infusion, you shouldn't be reluctant to increase your burn rate.
Cutting expenses and, in turn, stalling growth should be something of a last resort. If your company is rapidly expanding, investors would rather see you bump up your spending to keep pace than cut back.
In many cases, they might read a declining burn rate as an unwillingness to take the calculated risks and make the necessary maneuvers to help them see the returns they're looking for. That's not a great look for a budding startup.
How to Calculate Burn Rate
To identify how long your company can burn cash before needing to turn a profit (i.e., running out of cash), divide the amount of cash you have left by how much you spend every month (i.e., the cash you burn). If you burn $25,000 per month and have $100,000 left in reserves, you have four months of runway left.
Most investors and entrepreneurs recommend having at least twelve months of runway available at all times. That means if your burn rate is $25,000 per month, you’d want to have at least $300,000 in available cash.
This ensures that if there’s a temporary market downturn, a problem with one of your product releases, or an unexpected expense, you’ll be able to handle it without threatening the health and success of your business.
What is a good burn rate?
As I mentioned, most entrepreneurs and experts recommend having at least twelve months of runway at all times. That means a good burn rate is around one-twelfth of your available cash. So if you have $600,000 in available cash, a burn rate close to $50,000 would be good.
No matter the maturity of your startup, you need to have a solid grasp on burn rate as a concept. It's a vital component that will guide how you spend, how you forecast, when you opt to turn to investors, and how you make strategic decisions for your business.
Originally published Dec 27, 2021 8:00:00 AM, updated December 27 2021