The burn rate is the rate at which a company's available cash position is decreasing, but why is this so important? Entrepreneurs are hyper-focused on knowing and monitoring their company's burn rates, particularly with early stage companies and those in periods of hyper growth because startups can go from making profits to making losses pretty quickly.
Even those with good product market fit, be it due to an economic downturn, production issues, R&D glitches or any other number of factors, having a sense of a company's cash balance and expense structure is always useful if the startup has to suddenly pivot their business or slow down fixed expenses.
When Covid first hit the US in March of 2020, every startup was reviewing their cash position and dramatically cutting expenses to lower their cash burn.
The second reason why understanding the burn rate is so important is because it allows a startup and their VC investors to forecast when they might be able to invest in key growth or expansion opportunities.
For example, when to launch a new product rollout, a new country launch, or hiring new team members, which results in an increase in expenses.
Cash burn can be calculated either using a gross burn or a net burn.
Gross burn only takes into account indirect or monthly expenses, for example, such as sales and marketing or R&D reflecting expenses that would be incurred if no further sales were made.
Net burn includes gross income earned from operations and reflects the true measure of the amount of cash burn each month.
Most startups financial forecasts show both gross and net burn rates, but net burn rate is usually more useful because it takes into account the startups revenue and profits, and it measures the efficiency of those monthly expenses.
In other words, it tells the VC investor how much profit they need to break even in a high growth or scaling scenario where a startup is generating revenues.
The net cash burn measures how much funding you need to keep your business afloat and will help determine if and when the startup may need to focus on cost cutting measures or additional fundraising.
It's a better big picture look at the sustainability of the startup.
However, if a startup is in the early stages and not yet generating meaningful revenue growth, which could be indicated by a 10% month on month revenue growth rate, then the gross burn rate might be more useful as it tracks monthly cash outlays and can help to identify areas where the startup may be spending too much and where it can adjust.
Another important metric associated with the burn rate is the runway. A runway is is the current number of months that the available cash to the company will continue to finance that company's operations.
You can calculate a runway on either a gross or net burn basis.
The runway's really important as during negotiations of a capital investments VC investors will look at the current runway as part of their due diligence process to determine how quickly the startup will spend their investment capital.
It is literally a discussion of, for example, how far will $30 million take you and what will the company look like in terms of key financial results at the end of the runway period? This can expose weaknesses in startups projections.
For example, if the startup is burning a $100,000 per month and raising a $10 million capital round, the VC investors would rightly want to know why they need so much capital and what will change in the eight years it will take to spend that capital.
Most startups aim to keep close to a year of runway available at all times.
If they fall below six months until zero cash, the startups should be looking to either cut cost dramatically or raise funding.
In a hot investment market where capital is readily available and the startup is growing quickly at more than 50% per year, then it might be worth the startup to keep that burn rate high and raise additional capital as needed.
But in more challenging times, such as 2022 to 2023, where fundraising declined, startups need to be laser focused on cost cutting using measures such as laying off employees or reducing non-essential expenses to extend their runway.
An entrepreneur may exclude certain expenses or include certain cash flows such as monetary prizes or grants that may not be recurring and which could overestimate the runway.
As a VC investor, it is prudent to fully understand how the runway was calculated by the company itself.
