A startup company’s burn rate refers to how quickly it can spend its money. You can also think of burn rate as the amount of time a company can continue operating until it has no more money left to spend. Entrepreneurs use it to measure the sustainability of a business venture. Burn rates are usually expressed in months but may also be estimated in weeks or even days.
If you literally get all your money, set it all on fire, and watch until everything burns away, you’ll get a sense of what burn rate is.
Read More about “Burn Rate”
There are two types of burn rate—gross and net burn rate. These differ in terms of computation. Still, both types help startup companies keep their spending in check, especially since some tend to overspend after securing funding from investors. Overspending is dangerous, as there is no guarantee as to when a company will become profitable.
Both gross and net burn rates are crucial since investors make it a point to examine burn rates to decide if the company is worth investing in. Below are the two types of burn rate.
Type #1: Gross Burn Rate
The gross burn rate is simply a measure of how much a company spends per month. You can obtain this by adding all of your operating expenses, which include salaries, bills for electricity and other utilities, and rental and additional overhead costs. You then divide your cash or venture capital by the total amount of operating expenses.
This formula sums up the computation for the gross burn rate:
Gross Burn Rate = Venture Capital Cash ÷ Total Operating Expense per Month
So, if a company has US$100,000 in its account, and its monthly operating expenses is US$10,000, its gross burn rate is 10 months. That means that it will take 10 months of operation before its cash runs out.
Type #2: Net Burn Rate
The net burn rate, meanwhile, measures the sustainability of a business and answers the question, “How long can a business continue operating until revenue picks up?” You can determine it using the following formula:
Net Burn Rate = Venture Capital Cash ÷ Monthly Operating Loss
You get the monthly operating loss by subtracting the total operating expenses from the revenue. So, if the company in our example has an average income of US$5,000 per month and an overhead of US$10,000, its monthly operating loss is US$5,000. Using the formula above, that gives it a net burn rate of 20 months. It will take 20 months before the company runs out of money.
How to Set Your Burn Rate
Your company can use either the gross or net burn rate formula shown above to predict how long it will stay in operation, given its available resources. It’s just a matter of what data is available to its owner.
How to Control Your Burn Rate
Startups often have to struggle in the beginning. And if they don’t want to fold, they can do the following if worse comes to worst:
- Layoffs and pay cuts: In many cases, investors negotiate a clause in a financing deal to reduce staff or compensation if the startup experiences a high burn rate. Layoffs are often done by larger startups that wish to become leaner or just agreed to new financing deals.
- Growth: Companies can project growth to investors. That should let it cover its fixed expenses (e.g., overhead and research and development [R&D]) to improve its finances. Growth forecasts encourage financers to further fund startups to achieve future profitability.
- Marketing: Organizations can also opt to spend on marketing to grow their user base. But since they don’t have the budget, they can employ “growth hacking” or use a growth strategy that doesn’t rely on costly advertising.
Objectives of Reducing Burn Rate
Of course, businesses wouldn’t want their burn rate to consume them. So they should employ different strategies to meet the following goals:
- Increase revenue: An increase in income will improve the net burn rate since the company’s cash won’t run out at a faster pace.
- Decrease overhead costs: Looking for ways to decrease operating expenses will affect both the gross and net burn rates. This strategy is the reason why some employees get laid off, so their companies can save on salary expenses.
Ideally, companies should strive to increase their revenue and decrease overhead expenses without sacrificing the quality of their products or services. That is where keeping track of burn rate comes into play. Knowing their burn rate can keep them from sinking.