Understanding the importance of burn rate is critical for every entrepreneur. Having cash is very necessary for early-stage startups to stay afloat. Yet, having money is one thing; knowing how to spend and manage it is quite another.
A study done in 2019 by CB Insights shows that 29% of startups fail due to them running out of cash. In fact, the only reason that entrepreneurs really fail is that they either quit or run out of money.
The most common reason they quit probably centers on running out of money too. This is where the importance of cash burn comes into play.
Cash is always the lifeblood of any company, whether times are good or bad. To successfully operate, pay personnel, and keep the doors open, you need cash in the bank.
Or else you’ll run out of funds and be out of business. Having no funds means you will be out of business in no time. Understanding your startup’s burn rate, and how to manage and monitor your cash runway is critical to your company’s survival and success.
It will help if you develop a plan of action by reviewing and revising your startup’s financials, which is done by calculating your cash burnout and cash runway.
The following are some of the reasons why startups should pay close attention to their burn rate.
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What is the Burn Rate?
The burn rate is the amount of money a company or startup spends or ‘burns’ through. This rate is measured every month. Therefore, if a company’s burn rate is $60,000, it indicates the company spends $60,000 each month.
There are two types of burn rates, namely:
- Gross burn: the total amount of money spent by a corporation in a given month to run the startup or business
- Net burn: the amount of money lost by the startup or company
Burn Rate Measures Startup Longevity
A burn rate is when a startup or company spends its cash, and it shows how they spend its money on overheads before earning income from its operations.
You can think of burn rate as an hourglass, calculating the time your startup has before it runs out of money. Therefore, you need to pay attention to your startup’s cash flow to avoid spending too much money too fast.
Around 82% of startups fail due to cash flow problems. Understanding the importance of burn rate is essential for both identifying areas for improvement and preparing for the future. Ignoring your burn rate is not an option, especially if you’re a funded startup.
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How to Calculate Burn Rate
To calculate the burn rate, you can use the following formulas.
Net burn rate:
Net burn rate = Expenses – Revenue
The net burn rate is the rate at which your startup is losing money. You calculate it by subtracting operating expenses from revenue, and it gets measured monthly. The calculation will determine how much money your startup needs to continue operating for a period.
Gross burn rate:
Gross burn rate = Monthly expenses
The gross burn rate is your startup’s operating expenses. You can calculate the gross burn rate by adding all your operating expenses, such as salaries and rent, which are measured monthly.
How to Calculate Cash Runway
If you’re burning money, the cash runway is a calculation of how long your money will last you.
Cash runway = Cash Balance / Net Burn Rate
For venture-backed startups using funds to expand their businesses, cash runway is a big concern since they must either become cash flow positive or close another funding round before running out of funds.
The cash runway metric is also used to determine how quickly mature organizations are increasing their cash reserves or investing that money to finance faster growth. That’s the reason why you should understand the importance of the burn rate.
Handling Cash Flow in a Crisis
You can have reasonably clear expectations of your customers’ behaviors and how your startup will operate when your startup is in ‘normal’ times.
However, these expectations can mean nothing in uncertain times. For your new startup to survive, you will need to put your focus on forecasting and budgeting.
To test different scenarios, you’ll need to develop multiple sales forecasts and spending budgets. Flexible financial modeling software can really help with this.
Ask what expenses do you minimize to extend your cash runway if the downturn is only temporary. If the downturn continues, you may need to restructure your startup and experiment with new business strategies.
It’s also crucial to consider how you’ll get back on your feet. You’ll want to look into several financial possibilities for a quick versus a delayed recovery.
Things may play out differently depending on your industry. Calculating a variety of financial situations may appear complicated, but it does not have to be.
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Why is Burn Rate Important?
Understanding and analyzing the company’s burn rate is critical for startups trying to get off the ground. For example, the startup may forecast how long it will have until it runs out of money by knowing how much it starts and spends per month.
This will assist business owners in anticipating what they will need to do to keep the startup afloat. Finding new sources of funds, lowering the burn rate, or increasing revenue are all possibilities.
The burn rate will show investors that you can be trusted with their money.
- Understanding your startup expenses: Your financial runway gets affected by the cash burn along with the ready money you have in the bank. It is essential to pinpoint where you are losing money and the best ways to reduce your expenses to lengthen your financial runway in a crunch.
- Investor decisions: Your burn rate can also affect investor decisions. because it can indicate whether or not you are likely to enter into financial distress. Investors can use this as a negotiating point. As well as for assessing how much they should invest, and how long it will be before they will really see if you are up to the job of managing their money.
- Not all high burn rates are bad: Having a high burn rate is not necessarily bad. If your startup is growing fast and there is a strategic burn rate for gaining consumers and producing higher profits, it can attract investors more than a low burn rate startup.
Tracking Burn Rates
Understanding the importance of burn rate is critical and here are the reasons why tracking burn rates can be helpful:
- They provide an estimate of how much time you have until you run out of money, also known as your runway. You can develop strategies for where you want to take your startup based on this knowledge.
- If needed, you can get more investors on board in time, before the money runs out if you know how long your runway is until the startup takes off and becomes profitable.
Reasons why burn rates aren’t helpful:
- Burn rates can’t predict the future. For example, you may hit product-market fit and enjoy higher revenues, which lowers your net burn rate. Though riding on optimism alone means you risk overspending.
- A burn rate may not be helpful for startups on the cusp of profitability.
- Although the burn rate is a valuable metric, you don’t want it to keep you from investing in opportunity capital. Saving money isn’t always the best option. The cost of not spending money could be significant.
Common Mistakes to be Aware of
Here are some common mistakes to avoid when calculating your company’s burn rate.
Involving Too Many Investors
Every time you spend money, you’re one step closer to needing additional funding. Having more investors can keep your startup running, but it will come with consequences, such as:
- Distributing your company’s profits to a larger number of shareholders.
- You’ll need to get approval from multiple people before making any important decisions, such as selling the startup, pivoting, or making acquisitions.
- You can lose control of the company.
Not Giving Enough Attention to the Length of Your Cash Runway
Your cash runway is the time it takes before you run out of money and should ideally never get below six months.
Not all startups are the same, and a financial strategy that works for you might not work for another.
Your burn rate is your countdown to not just needing to close more funding, but to start a new fundraising campaign. It is also your timeline for needing to achieve the next milestone in your business so that you can attract more funding.
If your startup is experiencing a growth period, increasing your burn rate for a period of time and spend money expanding your business isn’t bad, as long as you have the following tangible resources in place:
- An excellent line of credit
- Money in the bank
- Increasing sources of income
- Strong support from current investors
If none of these are in place, increasing your burn rate brings extra risk.
Forgetting About Startup Debt
Make sure you know the fine print of any debt you have taken on. You may be found in default or negligent if you run the company into the red.
The Implications of a High Burn Rate
A high burn rate means your startup is running out of money at a fast pace and that you’re heading into a state of financial distress. This could indicate that investors will need to set more aggressive timetables to realize revenue.
Alternatively, it may mean that investors would have to put more money into a company to give it more time to generate revenue and become profitable.
Or investors may demand tougher terms because they know you are in a weak and desperate situation.
Would you like more information on the best options to cut back on your business expenses? Check out this video I have created explaining cost-cutting tips for startups. You’re sure to find it helpful.
How to Reduce Your Cash Burn Rate
There are several methods that a startup can make use of to minimize its high burn rate and avoid running out of capital. Here are a few to consider:
- Evaluate your budget
- Cut back on the number of employees and reduce salaries
- Send your bills out to your customers sooner
- Ask suppliers for extensions and payment plans
- Hold off on large expenditure items
- Consider refinancing your debt to get more favorable terms
- Negotiate lower rates with your vendors
- Raise more funds instead of running out of cash
- Sell excess inventory to generate cash
- Get more potential clients into your funnel
- Raise your prices and increase marketing to create more sales
- Encourage cash sales with your customers
Startups can go out of their way every day to reduce expenses and increase income. You can be successful and ensure sustainable growth if you work on your strategy and learn more about how you’re spending money.
Building a Financial Model for Your Startup
When you’re building a financial model for your startup, it’s essential to emphasize the burn rate and cash runway until you need the next round of financing.
Most startups still in their early phases will raise money in phases to fund them in their various stages. Therefore, it’s crucial to emphasize how long your startup can endure until it needs another cash injection.
Adjusting Your Burn Rate Has Long-Term Benefits
Reducing your cash burn rate can be a daunting task, but it’s necessary when your startup is facing tough challenges.
Remember that there is always an end to a bad situation. Every dip and recession is followed by a period of growth. Reducing your burn rate and extending your runway will put you in a better position to recover when the economy improves.
The crucial thing is to minimize the loss and position your company to benefit from future growth, even if you don’t know when it will happen.
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